Financial Crisis Inquiry Commission Hearing: Testimony of Peter J. Solomon

Date: 13-Jan-2010

Peter J. Solomon, Chairman                           

Testimony of Peter J. Solomon

Thank you for asking me to appear before the Commission.  Before I begin, I want to commend the
leadership of the House and Senate for creating this bi-partisan Commission to examine the causes
of the current financial and economic crisis in the United States.
When I entered Wall Street in the early 1960s, securities firms and commercial banks had not
changed much since the 1930s. Stock ownership was not widespread. Public pension funds and
endowments did not invest broadly.  The average daily volume on the NYSE was about the same as 40
years earlier. There wasn't a large public bond market.  The business of commercial banks was
lending. The securities firms were usually private partnerships.  Investment funds and trading were
separate from banks and securities firms.

I have been afforded the opportunity over 50 years to observe the dramatic changes in the financial
world from a number of perspectives. My career at Lehman Brothers spanned 29 years.  I rose to Vice
Chairman of the firm in the 1980s and was the Co-Chairman of the Investment Banking and Chairman
of the Merchant Banking divisions.  I have held financial positions in the public sector as Deputy
Mayor of the City of New York during the financial crisis of the late 1970s and as Counselor to the
Secretary of the Treasury in the Carter Administration.  I have been active on corporate,
not-for-profit and foundation boards where I have been involved in investment decisions.

For the past 21 years, I have been the Chairman of the Peter J. Solomon Company, a private
independent investment bank and member of the FINRA. Our firm is a throw-back to the era of the
early 1960s when investment banks functioned as agents and fiduciaries advising their corporate
clients on strategic and financial matters such as mergers and the raising of debt and equity capital. 
Unlike today’s diversified banks, we do not act as principals or take proprietary positions.  We do
not trade and we do not lend.

For a moment, let me set the scene of the 1960s investment bank. The important partners of Lehman
Brothers sat in one large room on the 3rd floor of Number One William Street – the Firm’s
headquarters.  The partners congregated there, not because they were eager to socialize. An open
room enabled the partners to overhear, interact and monitor the activities and particularly the
commitments of their partners.  Each partner could commit the entire assets of the partnership.
Lehman’s capital at the time of incorporation in 1970 was about $10 million.  The wealth and, thus
the liability, of the partners like Robert Lehman exceeded the Firm’s stated capital by multiples. 
Since they were personally liable as partners, they took risk very seriously.

The financial community changed dramatically beginning in the 1980s.  Incorporation and public
ownership by securities firms enabled them to compete with commercial banks. Innovations like junk
bonds, for example, allowed securities firms to lend to non-investment-grade companies.  All the
firms accelerated the push into global markets, far-flung operations, mathematical modeling,
proprietary dealings in debt and equity, and the growing use of leverage and derivatives to hedge
risk.

As the Commission investigates the causes of the 2007-2009 crisis, it is important to remember that
market crises occur periodically.  To name a few, in the last 20 years the markets have been roiled
by Asian, Russian and Mexican crises; the crash of ’87; the collapse of Long-Term Capital; the 2000
dot-com bubble collapse and Enron’s bankruptcy.

The question before the Commission is:  What events or actions occurred within the capital markets
or the environment which allowed this crisis to become a debacle?

First, every legislative and regulatory move in the last 20 years has been towards obliterating the
distinctions between providers of financial services and freeing the capital markets.  The shining
example, of course, is the Gramm-Leach-Bliley Act of 1999 which removed the last vestiges of the
Glass-Steagall barriers.

Second, financial institutions used the more lenient regulatory environment to build scale and to
extend scope.  Citigroup, Bank of America, JP Morgan and Lehman Brothers, for instance, acquired
competitors and expanded their operations into new fields. Concentration created institutions “too
big to fail”.  Government regulation, in terms of oversight and coherence, did not keep pace with
innovation, leverage and the expanded scope of the banks.

Third, access to new capital permitted the banks and securities firms to shift the nature of their
businesses away from agency transactions and more towards proprietary trading that took positions
in marketable and less liquid securities and assets such as commercial real estate.  Combined with
greater leverage, earnings volatility increased.

Fourth, scale, scope and innovation created an inter-dependency, most noticeably in Credit Default
Swaps, disproportionate to the equity capital of all banks. Managements misjudged the capabilities
of their elaborate risk management systems, like VAR, to keep their institutions solvent.  Even for
insiders, transparency diminished so much that firms were not prepared for the extraordinary –
so-called BLACK SWAN – event.

Given these changes affecting the banking system, what fundamental issues might the Commission probe?

1.  The lack of coherent regulation by agencies where the application of existing regulation could
have provided more transparency and forestalled a meltdown. The Commission might examine the role
of campaign contributions as they relate to Federal Government’s regulatory structure.  The
financial community has become increasingly active in Washington and is now one of the largest
contributors to Federal political campaigns.  Even today, one can see the detrimental effects of
its lobbying on Government action to create transparent, accountable and efficient markets.

2.  The Commission might consider whether the legal structure of banks contributed to undertaking
excessive risk.  The mixture of unlimited capital, limited liability and incentive compensation
inevitably led to testing the levels of risk.  It might be argued that public ownership and the
compulsion to increase earnings per share propels employees towards greater risk.  The experience
of Lehman Brothers and Bear Stearns indicates that large stock ownership by employees was not by
itself a barrier to imprudent risk.

3.  It is time to examine whether it is appropriate to have proprietary trading and investments,
essentially hedge fund activities, within the same bank as lending and other agency transactions. 
The Commission might explore how these proprietary activities affect the stability of the markets
and whether Congress should limit the scope of banks.

Paul Volcker has suggested that financial firms might be categorized between activities with
ongoing relationship businesses such as lending, and transactional interactions such as trading. 
He has proposed that these functions be separated.

A corollary question is whether it would be preferable from a public policy perspective and
adequate from a capital markets point of view to require proprietary investing to be in private
partnerships. Until it went public, Goldman Sachs, for example, remained a private partnership and
was able to attract sufficient capital and weather a series of large losses.

In closing, my hope is that the Commission will determine whether the 21st Century model is
consistent with the need for stable banks and capital markets sufficient to finance the world
economy.  The Commission has an opportunity to approach this challenge in a bi-partisan manner and
produce unanimous recommendations.  These conclusions can have a profound effect on
legislation as did the recommendations of the 911 Commission.  In doing so, the Commission
will make a major contribution to the stability of the financial markets and we will have a chance
to mitigate future crises.

Thank you.