Fellow Shareholders:

In last year’s letter, we discussed Goldman Sachs’ performance within the context of favorable market and economic conditions. We also said that our job is to plan for markets and conditions that won’t always be as benign.

While the first half of 2007 was largely characterized by a positive operating environment, the latter half of the year saw significant turbulence across global markets. Despite these more difficult conditions, Goldman Sachs produced very strong performance for the year because of the talent and dedication of our people, a culture of teamwork and a deep and broad client franchise.

In 2007, net revenues increased 22 percent to $46.0 billion and net earnings rose 22 percent to $11.6 billion. Diluted earnings per common share were $24.73, an increase of 26 percent from $19.69 for the previous year. Our return on average common shareholders’ equity was 32.7 percent. The firm also returned $9 billion of capital to shareholders by repurchasing 41 million shares of our common stock. Book value per common share increased 25 percent during 2007, and has grown from $20.94 at the end of our first year as a public company in 1999 to $90.43, a compounded annual growth rate of 20 percent over this period.

As we have stated before, our business does not lend itself to predictable earnings. However, over the long term, we are committed to the goal of providing our shareholders with returns on equity at or near the top of our industry while continuing to grow book value and earnings per share.

In this year’s letter, we will discuss some of the changes that financial markets are undergoing and how the firm’s institutional strengths help us to respond to these changes. In particular, we want to highlight what we believe to be the differentiating element of Goldman Sachs — our culture — and how it infuses our approach to risk management and client service. While the value of “culture” may not lend itself to empirical analysis, we know that it is the bedrock of our financial performance.

The Credit Cycle

During the last several years, the global economy has benefited from a number of developments. The global integration of markets and economies, the rise of emerging markets, the growth of private pools of capital and the ability of central banks to combat inflation coalesced to help make capital historically cheap.

A world awash in liquidity led to an influx of investments across different asset classes and markets. We saw significant increases in real estate prices, for instance, and a growing role for financial sponsors in global M&A. Significant value was being created, but many were asking if a credit bubble was taking shape.

Not surprisingly, the broad availability of credit had implications on the pricing of risk. As capital flows increased around the world, the search for excess yield drove credit spreads down to unprecedented levels. The tightness in credit spreads, extraordinarily low default rates and the run-up in housing prices in the U.S. and much of Europe simply were not sustainable.

In hindsight, it seems easy to identify precisely what happened. In the day-to-day management of our business, identifying a bubble and calling its exact end is much more difficult. As the number one global adviser in M&A, we are also a significant financier of many of the largest corporate transactions. As a co-investor with our clients, we are active in private equity and real estate investing. In our mortgage business, we price assets and structure securities for institutions and other large investors.

Our strong market share comes, in part, from the fact that we are active in these and other markets, and because we are willing to assume risk on behalf of our clients. But, at the same time, when conditions deteriorate, losses are unavoidable. And in the course of the year, we were not immune to them.

The Strength of our Client Franchise

Some commentators have speculated that our overall performance was due to a few so-called smart bets to mitigate losses. The fact is that we have a diverse set of businesses and no single business or trading opportunity dictated our performance.

What drove performance was the quality of our client franchise. To us, franchise describes the extent to which clients come to us for advice, execution and, sometimes, partnership. And through these relationships, business opportunities are made available to the firm.

In Investment Banking, we have a broad franchise that serves corporations, financial sponsors, institutions and governments. In the last year, we advised on each of the five largest sponsor transactions. When conditions became more difficult over the summer, clients sought us out as an advisor in challenging situations they faced — for example, Countrywide, Home Depot Supply and, in connection with Northern Rock, the U.K. Treasury, the Bank of England and the Financial Services Authority.

During the same period, we priced an $896 million equity offering for Apollo Management on our innovative GSTrUE platform, which we developed earlier in the year. GSTrUE pioneered the offering and trading of privately placed securities, bringing the liquidity of an exchange with the flexibility of a private placement. We are proud that GSTrUE will be integrated into The PORTAL Alliance — an industry-wide platform for the trading of unregistered securities.

Investment Banking remains the front end of our growing franchise. This is particularly true within the context of our principal investing activity. The majority of our principal investing opportunities are sourced through our client franchise as clients seek us out as a co-investor and other principals seek us out as partners. And while retaining our leadership position in global M&A, we also launched merchant banking funds with aggregate commitments of $50 billion during the year.

In our Securities businesses, we are, first and foremost, a market maker. We price assets, manage risk and execute transactions on behalf of our clients. This was particularly visible during the many tumultuous trading days during the summer. On some occasions, our U.S. shares trading platforms processed over two billion shares a day, more than double our average volume. We also experienced record customer activity in our credit, rates and currency businesses, not only during the summer, but for much of the year. In our Asset Management business, we manage $868 billion in total assets under management.

In the last year alone, we attracted inflows of $161 billion. Our ability to offer clients access to a broad range of investment strategies, from active equity to private equity fund of funds, to plain vanilla fixed income and money market products has been a key differentiating factor.

There are, however, important areas for us to continue to address. Like many others in the quantitative fund space, we have had issues with the performance of certain of our quantitative funds. We know that we disappointed our clients in those funds, and, we are focused on learning from this past year’s events. In addition, direct quantitative hedge funds represent only five percent of our assets under management, and we realize the importance of expanding our product portfolio in actively managed strategies.

Our Stake in the Global Economy

Each of our businesses benefits from a number of different factors or trends — from the development of products and instruments to specific market dynamics. All of our businesses, however, will continue to be positively driven by the global integration of economies and markets.

In 2007, our pre-tax earnings outside the U.S. exceeded 50 percent for the first time.

In a seminal research piece that coined the term “BRICs,” we identified early on the breakout potential of the high-growth countries of Brazil, Russia, India and China. Historically, however, we have not built much physical infrastructure in the emerging markets. That changed in the last two years as we opened offices in Mumbai, Moscow, São Paulo, Dubai, Doha and Tel Aviv.

We are also making strategic investments in these markets. We are currently negotiating a strategic alliance in Saudi Arabia with NCB Capital, the securities arm of National Commercial Bank, the largest bank in the Middle East. We have invested over $1 billion in India and plan to invest more. And we have recently acquired an asset management platform in South Korea with $7 billion in assets under management to further develop our distribution capabilities in the region.

The next step for us is to build out our securities capabilities in these growth markets. In Brazil, we are now licensed to do onshore fixed income activities. In Russia, we have built a platform to trade both cash equity and fixed income products and select over-the-counter derivative products. In India, we have cash, futures and options capabilities.

In China, we can trade cash products through Gao Hua Securities Company Limited, our joint venture partner. And in South Korea, we received our banking license, which allows us to offer a broader range of products to our clients. We continue to see more opportunities in these and other developing markets.

Globally, Private Wealth Management (PWM) also represents a significant opportunity for the firm, and we are determined to grow our footprint.

While important as a revenue source in its own right, our PWM business connects us with a growing class of entrepreneurs around the world, who not only benefit from our private banking skills, but also rely upon our investment banking and securities expertise.

We have made key management hires in PWM and are developing onshore capabilities in China and Brazil. We are expanding our Swiss banking capabilities to grow our offshore franchise in important markets. We also have GS Bank USA, an industrial loan corporation in the U.S., and a fully operational bank in Ireland to augment our global private banking platform.

Our strategy of being an advisor, financier and investor is proving especially effective as we expand globally. Although we are relatively new to some of these markets, we have been able to win important mandates because of the attraction of our model, the strength of our reputation and our commitment to the local region. For example, we opened offices in Dubai and Mumbai in 2007 and were #2 in announced M&A in both the Middle East and India.

This is all part of a broader strategy of identifying high-growth areas around the world and building our franchise in tandem with these economies.

Our Culture

Our ability to perform rests on a shared passion for teamwork, integrity and excellence. Teamwork is not an abstract goal, but a reality. It allows us to complement an individual’s skills and expertise with those of his or her colleagues to provide exceptional client service across different parts of the firm. Our people are also results-driven and measure their effectiveness by the successes of our clients.

Culture is a difficult concept to define, but we believe it is what truly differentiates Goldman Sachs. Goldman Sachs’ partnership ethos still runs throughout the firm. This mentality creates a sense of ownership of the firm’s capital, risk and profitability at all levels. We have over 30,000 employees, but we try every day to make the firm feel smaller. Whether we communicate with people divisionally, regionally or at the senior leadership level, we reinforce the same values. Each person at Goldman Sachs is a steward of our legacy and the culture it represents.

One example of this is The Chairman’s Forum. For the past year, the three of us conducted over 30 halfday sessions in the U.S., Europe and Asia with every Managing Director (MD) to talk about his or her role in advancing our client franchise. We spent more time on this initiative than any other. Given the fact that our MDs set the tone throughout the firm, there were few more important ways to invest our time.

The firm also imbues a sense of partnership through our compensation process. We take a comprehensive view on performance versus one limited to individual results. While individual performance matters, everyone’s pay is dependent on how Goldman Sachs performs overall. People are incentivized to act in a way that supports the firm as a whole and not to be parochial about their specific division or business unit.

Ultimately, our success depends on the quality of the people we attract and retain. We spend enormous amounts of time on these issues. It begins with recruiting. At Goldman Sachs, everyone from our junior to our most senior people commits time and focus to our recruiting efforts. Our Management Committee members have participated in nearly 80 recruiting events over the last year. The priority we place on recruiting is one reason why more than 80 percent of the offers we extended globally to undergraduates and graduates in 2007 were accepted.

Once they come into the firm, our people expect ongoing training and development. Within GS University, there are over 2,400 online and classroom courses. Ninety percent of our people participated —completing 950,000 hours of training during the year. Our people also expect to have a broad range of experiences over the course of their careers. Many of us, including most of our senior leadership, have worked in multiple divisions and in multiple regions.

Even after people leave Goldman Sachs, they still tend to identify with our firm and we foster that connection. In the last two years, we have held 15 events for alumni in the U.S., Europe and this year, Asia. Over 50 percent of our retired partners have attended at least one event and nearly 12,000 former GS professionals have registered on our alumni web site. In October 2006, we held an alumni event in London and over 1,000 people attended.

We have a rich history and tradition, and we invest in it. Our alumni help us recruit, participate in volunteer activities and come back to speak to our people. In many cases, they are also clients of the firm. Not only does all of this help validate our culture, it provides a real, tangible value that transcends any single generation. Good people hire good people. Through this process, the feeling of ownership is passed on. Our culture is self-sustaining and self-perpetuating.

Risk Management

Not surprisingly, the culture of our firm anchors our approach to risk management.

That approach is characterized by accountability, escalation and communication. A large part of this discipline is represented in the marking process, which assigns value to a position based on its currently traded market price. We believe that rigorous markto-market accounting for financial instruments is fundamental to prudent management because it facilitates a clear view of risk. It allows us to manage market risk limits, monitor exposure to credit risk and manage our liquidity requirements. Effective risk management is demanding and often difficult, but it lies at the heart of the management of a financial institution, and, we believe it is a core competence that helps define Goldman Sachs.

We also put great value in our firmwide committees such as the Risk Committee, which monitors financial risk; the Commitments Committee, which looks at our underwriting and distribution activities; the Capital Committee, which focuses on credit extension; and the Business Practices Committee, which reviews operational and reputational risk. These committees create a system of checks and balances that encourage communication between people in both control and business positions and, when necessary, the speedy escalation of a potential issue. Over one-half of the members of our firmwide committees have worked in two or more divisions. And the average tenure at the firm of committee members is 17 years.

More broadly, we place great importance on communication between revenue and control areas. This translates into a constant flow of risk reports, and the end result is a better understanding of the risks we are taking.

Closely related to communication and escalation is accountability. People have to feel responsible for the decisions they make, and for the decisions their subordinates make. If we suffer a credit loss, the relevant business is not absolved of the consequences simply because the risk was approved by the Credit department. Taken together, all flow into one another: communication encourages escalation and escalation reinforces accountability.

Because we are in the business of assuming risk on behalf of our clients, we know we will have losses from time to time. That’s why it is important to give people the confidence and support to stay committed to those businesses during difficult times. Our appetite for risk taking is central to our ability to accomplish our clients’ objectives and to be profitable. But our appetite is calibrated by balancing potential risk and reward as market conditions shift and evolve and meaningful opportunities ebb and flow. Clearly, market conditions can change abruptly. We must never forget that risk is just that — risk, with all its consequences.

Goldman Sachs Gives

Another important part of our culture is philanthropy and service. We are proud that so many of our people support hundreds of non-profit organizations around the world, serving on the boards of educational institutions, charities and environmental organizations.

Earlier this year, building on Goldman Sachs’ long tradition of philanthropy, we announced one of our most significant philanthropic initiatives to date.

In launching Goldman Sachs Gives, a donor-advised fund, the firm’s partners agreed to commit a part of their overall compensation to charitable organizations. Individual accounts have been established within Goldman Sachs Gives for participating partners, who will recommend charitable organizations as recipients, thereby diversifying the overall philanthropy of our firm and our people. In addition, the firm made a separate contribution to Goldman Sachs Gives.

Through the collective generosity of our people, we expect that Goldman Sachs Gives will grow to more than $1 billion over the next few years and will become a significant source of dedicated charitable funds. This important initiative will provide a meaningful way for our people to increase their current support of non-profit organizations around the world.

Looking Ahead

Some may characterize culture and the attributes we described above as soft issues. To us, our culture sustains our client franchise and reputation. In that sense, it is a tangible driver of our performance. The relative strength of our franchise can sometimes be masked by generally favorable markets. The second half of the year’s more difficult conditions, we believe, highlighted the depth and breadth of our client franchise.

Conditions across various markets remain challenging. Our industry is a cyclical one with little predictability in the short term. As a firm that operates in the center of the global economy, we grow at a multiple of GDP growth and are directly affected by the macroeconomic environment. It is important to remember that, given our stake in the global economy, the recent pace of earnings growth simply is not sustainable.

However, over the longer term, we remain optimistic that secular growth trends, notably the rise of the BRICs and the evolution of markets and instruments, will play to the strengths of our businesses and allow us to grow our franchise.

Behind the hard numbers of financial performance is an internal set of shared values at Goldman Sachs. These values fuel a culture of teamwork and the rigor of our risk management. We will make our fair share of mistakes and we will experience losses.

Guaranteed. However, we manage our business over the long term and we believe that the cultural attributes of Goldman Sachs will continue to enable us to generate strong returns for our shareholders.

Lloyd C. Blankfein
Chairman and Chief Executive Officer
Jon Winkelried
President and Co-Chief Operating Officer
Gary D. Cohn
President and Co-Chief Operating Officer

View Goldman Sachs 2007 Annual Report

We See Opportunity.

Download Goldman Sachs 2007 Annual Report

PDF format, 4.5MB, 154 Pages.

We see opportunity
In extending our reach

In 2007, Goldman Sachs made a series of significant commitments to building our presence in Brazil. We established a bank and supported the management team with important new hires and transfers. We have built upon our long history as one of the country’s premier M&A advisors to become a diversified provider of products and services, including Fixed Income, Currency and Commodities, Asset Management, Research, Principal Investing, Corporate Finance and Equities.

In 2007, we participated as the lead bookrunner in the country’s largest recorded IPO for Bovespa Holding, which controls the São Paulo Stock Exchange. The IPO was the culmination of over a year of working as an exclusive advisor to Bovespa Holding during its demutualization and preparation to become a publicly traded entity.

In preparation for the IPO, Goldman Sachs worked with the Bovespa Holding management board to develop a profile that would appeal to a broad base of international investors. Key to the success of the offering was helping them demonstrate how their evolving culture supported the financial disclosure, compliance and independent board oversight practices expected by the global investment community. Our commitment throughout the process, from the demutualization to the pricing of the IPO, is an important factor in our efforts to grow our franchise in new markets through strong client relationships and innovative services.

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