On Tuesday, February 2, 2010, Paul Volcker arrived at the Dirksen Senate Office Building to testify before the Senate Banking Committee on the rule that bore his name, courtesy of President Obama. Volcker had proposed a regulation that would allow commercial banks to trade securities to serve customers but prevent the type of reckless transactions accompanying the World Financial Crisis that began in 2007.1 The Volcker Rule would permit commercial banks to buy and sell securities with clients but prohibit high-risk speculation either directly or by the banks’ owning hedge funds. It was a noble idea that displeased the bankers.
Volcker had had less than ten days to prepare his remarks after Obama’s announcement on January 21, 2010, supporting his initiative, but he had testified in Congress more than forty times since his departure from the Fed in 1987 and had not lost his touch. He was still a commanding presence at age eighty-two, as tall as during his Princeton basketball days, despite carrying extra inches around the midsection, with a slight loss of hearing his main infirmity.
Two days later, on February 4, Jerry Corrigan, Volcker’s former colleague and now a managing director at investment giant Goldman Sachs, would appear before the same committee to comment on the proposed legislation. Volcker had mentored Corrigan, teaching him fly-fishing and recommending him as president of the Federal Reserve Bank of New York, the powerful branch of the central bank located in the heart of Wall Street, where Corrigan grew the Rolodex that nurtured his new career. Corrigan had served Volcker as a loyal knight, protecting his back and defending his honor. But now their interests diverged, and Corrigan served a new master.
Goldman Sachs was an investment bank, also called a securities firm or broker-dealer, offering the full spectrum of financial services. Like some of its Wall Street peers, it had become a commercial bank holding company after Lehman Brothers, Goldman’s smaller sister, declared bankruptcy on Monday, September 15, 2008.2 The collapse of Lehman, the largest bankruptcy in U.S. history, triggered a run on banks and other financial firms reminiscent of those of the Great Depression, and forced the government to rescue a system on the verge of collapse. It was the darkest hour of the ongoing financial crisis that began on Thursday, August 9, 2007.
The crisis started when BNP Paribas, the French equivalent of Bank of America, suspended withdrawals from three of its investment funds because it could not value the mortgage-backed securities held in their portfolios. The shock of the suspension, and the suspicion that this was not an isolated event, forced the European Central Bank (ECB) and the Federal Reserve to provide unprecedented liquidity to financial institutions in Europe and America to restore market order. We know now that these loans by the ECB and the Fed could not correct the deterioration in the value of mortgages, especially on subprime credits, that came with declining home prices. The collapse of two major investment banks, Bear Stearns and Lehman Brothers, with too little capital and too much real estate exposure, followed in 2008.3
Goldman Sachs became a commercial bank holding company immediately after September 15, 2008, because it wanted the privilege of borrowing at the discount window of the Federal Reserve Bank of New York to guard against Lehman’s fate. Volcker had commented to anyone who would listen, “They’re just trying to hide behind Uncle Sam’s skirts … How can we let Goldman Sachs profit from speculation until something goes horribly wrong, and then force the taxpayers to foot the bill.”4
Goldman lit the fuse for the Volcker Rule, but Volcker had made that same point almost twenty years earlier, with the following quotation from Adam Smith, the eighteenth-century Scottish philosopher who invented economics: “Though the principles of the banking trade may appear abstruse, the practice is capable of being reduced to strict rules. To depart upon any occasion from those rules, in consequence of some flattering speculation of extraordinary gain, is almost always extremely dangerous and frequently fatal to the banking company which attempts it.”5 The Volcker Rule labeled all bank speculation unflattering.
In April 1995, more than ten years before the onset of the World Financial Crisis, Volcker foresaw the tranquil origins of the biggest financial upheaval since the 1930s. He testified before the House Banking and Financial Services Committee exploring financial reform: “It is a sheer fact of human nature that if you went along for ten or twenty years without problems, that is going to create an atmosphere in which people will go to the edge. And the regulator will not be as strict and sooner or later you will have a crisis.”6
The Great Moderation in inflation and unemployment that began in the mid-1980s had calmed the economic atmosphere, and the congressional repeal in 1999 of the separation between commercial and investment banking sanctioned earlier Federal Reserve permissiveness in expanding bank powers.7 Stable growth during the first few years of the twenty-first century masked fundamental risks, especially in mortgage-backed securities, and the regulatory laxity encouraged reckless speculation in housing-related investments.8 The combination fit Volcker’s script for a crisis.
But Volcker had gone even further in April 1995, describing with eerie precision the dilemma that would follow deregulation: “I will not refer to Goldman Sachs … but I think it is obvious that if you had a large investment bank allied with a large [commercial] bank, the possibility of a systemic risk arising is evident … It may be even evident with the investment bank alone. We are trying to keep them out of the so-called safety net now, but certainly you cannot keep them out if they are combined with a banking institution.”9
Volcker was no longer the banking watchdog in 1995, and although he warned against excessive regulatory leniency, his focus lay elsewhere. He was the chairman of James D. Wolfensohn and Company, a boutique investment firm that offered strategic advice to companies such as American Express and Daimler-Benz.10 Volcker had joined the company in 1988, a few years after it was founded by the investment banker James D. Wolfensohn, and during his tenure as chairman it grew from two to ten partners.
In March 1995 he took over as chief executive when Wolfensohn was nominated as president of the World Bank. And a year later his partners negotiated the sale of the firm to Bankers Trust Company. Volcker wanted it to remain independent and small, but they saw an opportunity to cash out, which they did. According to the press, “Perhaps the most important acquisition for Bankers Trust is the services of Paul A. Volcker … [He] is expected to bolster the reputation of Bankers Trust, which has been tarnished in recent years.”11
The multimillion-dollar windfall gave Paul the opportunity to do something that was long overdue: pay tribute to Barbara, who was bedridden from complications of diabetes and arthritis. The couple endowed the Barbara Volcker Center for Women and Rheumatic Diseases at the Hospital for Special Surgery in New York City in 1996. The gift allowed the hospital to recruit Barbara’s longtime physician Michael Lockshin as head of the center.12 Paul recalls, “This was one of the few sources of comfort to Barbara before she died in 1998. She deserved it.”13
Volcker withdrew from operating responsibilities when Wolfensohn and Company was sold to Bankers Trust, agreeing only to serve on the bank’s board of directors, but his reputation for honesty and integrity drew numerous requests to rent his seal of approval. He could not refuse Fritz Leutwiler, the former head of the Swiss National Bank who had been so helpful during the Mexican crisis.
In the spring of 1996, Leutwiler asked his old friend to chair an “Independent Committee of Eminent Persons” to oversee the return of assets deposited in Switzerland by victims of the Holocaust. Swiss banks had a public relations problem that rivaled al-Qaeda’s. The New York Times editorialized, “For decades the Swiss banking industry arrogantly thwarted inquiries about its role in the Nazi period, and effectively discouraged the relatives of Holocaust victims searching for long-dormant accounts.”14 Volcker promised justice before an investigating congressional committee.15 “We are meeting more than fifty years after the end of the Holocaust, certainly one of the most shameful and brutal episodes in human history … The time has surely come for a full accounting.”
Volcker’s willingness to tackle incendiary material brought another request for help, this one in 2002 from Arthur Andersen, the accounting firm that had certified the fraudulent financial statements of the bankrupt Enron Corporation. According to the press, Andersen turned to Volcker because he “may be one of the few public figures with enough prestige and moral authority in the world of finance to bring the giant accounting firm back to reputable standing.”16 And in 2005, Volcker was asked by the United Nations to investigate the oil-for-food scandal that involved the son of Kofi Annan, the UN secretary-general.17 They needed to cleanse the record and knew that only Volcker’s independence could overcome the potential conflict of interest. And besides, they had heard that the price was right: Volcker charged a one-dollar fee in such cases.
Volcker avoided shades of gray and expected others to do the same, but he was usually disappointed. He had learned during his career at the Fed that color-coded signals gave bankers trouble—they understood that green means go and red says no, but they had great difficulty with yellow. And that is why he bristled when Goldman Sachs became a bank in September 2008. “The lines differentiating financial institutions had been blurred, but if Goldman wanted the commercial banking safety net it should look more like a bank, specializing in taking deposits and making loans, rather than like a hedge fund, geared to speculating on mispriced securities.”18 His opportunity to change the rules would come after the 2008 presidential election.
Volcker’s presence in Washington grew when Barack Obama defeated John McCain in November 2008. Paul had endorsed the Illinois senator in February 2008, while Obama battled Hillary Clinton for the Democratic nomination. “After thirty years in government … I have been reluctant to engage in political campaigns. The time has come to overcome that reluctance … It is not the current turmoil in markets … that [has] impelled my decision. Rather, it is the breadth and depth of challenges that face our nation … Among all the candidates, it is Barack Obama who has most clearly recognized those needs.”19
Obama capitalized on Volcker’s stature during the campaign, seating the financial strongman immediately to his right, as photographers captured the moment, during a roundtable discussion in October 2008 with voters in Lake Worth, Florida.20 Other photos followed, but Obama invoked the Volcker seal most effectively during the final presidential debate, when McCain raised questions about some of Obama’s associates. The Illinois senator shot back, “Let me tell you who I associate with. On economic policy I associate with Warren Buffett and former Fed chairman Paul Volcker … who have shaped my ideas and who will be surrounding me in the White House.”21
But the election changed the pecking order, despite the efforts of Austan Goolsbee, a friendly thirty-nine-year-old professor from the University of Chicago business school who had advised Obama during his 2004 Senate campaign and would eventually become chairman of the president’s Council of Economic Advisers. Goolsbee, who made the trim president-elect look a little overweight, had successfully urged Obama to bring Volcker into the inner circle during the campaign and pressed for more of the same after the victory. “Immediately after the election, I urged Obama to appoint Volcker as treasury secretary, even for only a few years. He would have given us instant credibility both at home and abroad. But the transition team had been taken over by Clinton’s people, and that hurt his chances.”22
Volcker’s candidacy for treasury secretary had been rumored in the press and made considerable sense, despite his age.23 The Lehman bankruptcy in September 2008 had plunged America into a financial crisis that demanded bold initiatives, as when Jimmy Carter appointed Volcker as Fed chairman in 1979. And Volcker worked as though he were a thirty-year-old, spending nine-hour days in his Rockefeller Center office in New York City when he was not traveling the world like a financial Gandhi preaching monetary reform. When Warren Buffett recommended Volcker as treasury secretary to Obama’s transition team, a young man replied, “He may be a little too old.” Buffett responded, “I think he’s about my age.”24
Obama raised the topic with Volcker in a telephone conversation after the election.25 “Paul, I’d like your reaction to some names for the top job at Treasury.”
“Okay,” Volcker answered, knowing this was either a courtesy call or a presidential probe of his availability. He doubted that Obama had time for courtesy calls.
“What about Tim Geithner?”
“He could do the job, but he might need some seasoning. Besides, that would leave the New York Fed without a president, and that is a big hole, especially now.”
“And Larry Summers?”
“He’s already shown he can run Treasury, but we both know he may have a problem getting confirmed in Congress. And that’s a diversion you certainly do not need, Mr. President.”
Obama then got to the point. “Would you serve for one or two years if I asked?”
Volcker relished the opportunity to confront the greatest crisis since the Great Depression and believed that “you never refuse a president’s request to serve your country,” even at age eighty-one. He said: “Yes, but it’s probably best to keep the time limit between us.”
“Of course,” the president-elect concurred, “and thanks.”
Volcker had said yes, but he knew that an offer was as likely as rain in San Diego. Both Geithner and Summers had worked at the Treasury in the Clinton administration, Summers eventually becoming treasury secretary with Geithner as his deputy. And Obama’s transition team, which vetted all job candidates for the new administration, had become a Clinton outpost.
John Podesta, President Clinton’s former chief of staff, who had joined the Obama campaign after Hillary Clinton had withdrawn from the race, served as cochairman of Obama’s transition team. His staff included influential alumni from the Clinton Treasury, most prominently Michael Froman, a Harvard Law School classmate of Obama’s who had been chief of staff for Robert Rubin, Clinton’s treasury secretary.26
During his stay in Washington, Rubin, a former cochairman of Goldman Sachs, had championed financial deregulation to promote the globalization of American finance, first as a White House adviser on economic policy and then as treasury secretary, where he groomed both Summers and Geithner. His son James S. Rubin was also on Obama’s transition team.
The announcements on Monday, November 24, 2008, brought no surprises. Geithner, the forty-seven-year-old career civil servant, was appointed treasury secretary, and Summers, the fifty-four-year-old former president of Harvard University, was named head of the White House National Economic Council. They had been the front-runners and were young enough to play basketball with Obama. Volcker did not fit, and not just because he was too old to compete on the court and thought deregulation had gone too far. He scared them.
Volcker’s independence conferred credibility but came with a price. He would speak his mind rather than spout the party line. The press called it “straying off message,” but it meant the same thing.27 Obama echoed that sentiment: “Paul … is held in the highest esteem for his sound and independent judgment. He pulls no punches. He seems to be fairly opinionated.”28
Volcker had been bypassed for the job of treasury secretary before, for the same reason, when Bill Clinton defeated George H. W. Bush in 1992. The post went to seventy-one-year-old Texas senator Lloyd Bentsen, who was later succeeded by Rubin. The New York Times commented that Volcker lost out because he was “unlikely to subordinate [his] own strong philosophies and ideas to the new President’s.”29
Clinton could afford to reject Volcker without great consequence; there was no crisis of confidence threatening the American financial system then. But Obama faced a far more dangerous circumstance, certainly comparable in severity to Carter’s in 1979, and exceeding Reagan’s problem in 1983. And yet both Jimmy Carter and Ronald Reagan swallowed the entire Volcker package rather than succumb to political expediency.
Obama chose the easy way out.
The president-elect kept Volcker close by naming him chairman of a new structure, the President’s Economic Recovery Advisory Board, designed to give Obama “expert advice outside the normal bureaucratic channels.”30 Stan Collender, a former staffer in the House and Senate Budget committees and partner in a public relations firm, said, “It also rents some of Volcker’s credibility until the president-elect can further establish some of his own.”31
The PERAB, as it was called, reported directly to Obama but had no resources or staff of its own. Volcker’s office (which he never used) was in the Treasury Building, and his chief economist, Austan Goolsbee, had a full-time job on the Council of Economic Advisers in addition to his PERAB duties (perhaps a punishment to Goolsbee for straying off message with Volcker). Nevertheless, Volcker succeeded, with the help of Vice President Joseph Biden, in promoting the Rule that brought him before the Senate Banking Committee in February 2010.
Congress would test his resolve.
Volcker’s proposed ban on commercial bank proprietary trading, a polite euphemism for speculation, almost died at 2:45 P.M. on Tuesday, February 2, 2010, while he sat before the microphone waiting to testify. Democratic senator Christopher Dodd, chairman of the Senate Banking Committee, who would eventually cosponsor the Dodd-Frank financial reform bill that would become law in July 2010, greeted Volcker.32 “We have a lot of work left to be done, so this debate is an important one and we welcome you today to share your thoughts.”33 He then turned the floor over to the ranking minority member of the committee, Republican senator Richard Shelby of Alabama.
Senator Shelby welcomed Volcker by recalling his own debut in the Senate in 1986, “when you were Chairman of the Federal Reserve.” Shelby then lobbed a Republican hand grenade. “I am quite disturbed by the manner in which the Administration has gone about introducing their latest proposals for consideration. We are more than a year into our deliberation on regulatory reform … [And now] seven months after the Administration first introduced [its] broad recommendations … this concept that we have before us today has been air-dropped into the debate.”34
Volcker swallowed hard and suppressed a grimace, knowing that he had proposed the ban on proprietary trading the previous June, more than eight months before, in a memo to the president.35 He had fought with Geithner and Summers since then to get his way. Shelby, like almost all Republicans, and some Democrats, too, viewed Obama’s embrace of the Volcker Rule as a political affair, an attack on the evils of speculation that would please everyone but the bankers on Wall Street. And the bankers would lobby their favorite members of Congress to avoid the proposed regulation.
Volcker knew that the Rule would need Republican support, so he took Shelby’s tirade as an opportunity to push a wider perspective. “I want to emphasize … that the proposed restrictions … [are] a part of the broader effort … designed to help deal with the problem of ‘too big to fail’ and the related moral hazard that looms so large as an aftermath of the emergency rescues of financial institutions.”36
The New York Times had featured the comprehensive plan two days earlier, in an op-ed article Volcker wrote touting increased capital requirements and a so-called living will, or resolution authority, for large financial institutions.37 More capital was designed to prevent failure at the beginning, and the living will was aimed at containing the spillover damage in the event of bankruptcy at the end.
Volcker recalls: “I had thought that the decision to let Lehman go in September, 2008, was understandable at the time, to undo the moral hazard of the Bear Stearns rescue six months earlier. But it backfired almost immediately and forced the Fed to rescue AIG … an insurance company! After that, no systemically important institution would worry about bankruptcy … they knew the government would come to the rescue. And that meant they could take even more risk than before without suffering any consequence—which is exactly what we mean by moral hazard. This unfortunate reality required a radical change in financial regulation.”38
Increased capital formed the centerpiece of the U.S. Treasury’s plan to prevent future bailouts.39 All banks and insurance companies borrow money to buy assets, leveraging their capital to enhance their returns but simultaneously laying the groundwork for bankruptcy because lenders must be repaid. Leverage—the use of borrowed funds to invest—can be toxic when asset prices decline.40 More capital reduces the risk of insolvency by enhancing a company’s ability to meet its obligations.
Senator Robert Corker of Tennessee, a Republican who had joined the Senate Banking Committee a few years earlier, wanted to know why the Volcker Rule was needed on top of more capital. The bankers wanted neither, of course, but more capital was less onerous than more regulation. “If we have a bill that … says that if you are going to [speculate] in these risky areas of activity, that higher capital is going to be required … would … this type of legislation even be necessary?”41
Volcker had argued with Geithner and Summers over precisely this point, and conceded that in theory more capital would work, even though there was never enough to eliminate all risk. But as a practical matter, he did not trust the bankers to comply with the regulations. “Over time, they will reallocate that capital the way they want to.”42 And he did not trust the regulators to remain vigilant. “Congress is [not] going to specify precisely what the capital requirement is, but they are going to give the supervisor the [necessary] authority … [and] it is very hard to maintain very tough restrictions when nothing [bad] is happening.”43 The facts supported Volcker’s skepticism.
Bankers had been minimizing their capital requirements to enhance their profitability ever since balance sheets were invented, perfecting their methods with mathematical flair in the twenty-first century. Banks created subsidiaries called structured investment vehicles (SIVs) to house assets such as subprime mortgages that were partitioned into packages with impeccable credit ratings.44 These bank subsidiaries eliminated the need for capital in the parent company but continued to draw on a bank’s reputation and liquidity, a fact that regulators ignored before 2007. All this changed after losses on the mortgages parked in SIVs forced bank holding companies, such as the then giant Citigroup, to swallow the damaged assets, impairing what seemed like enough capital beforehand.45
A second line of attack on the Volcker Rule came from Republican senator Mike Johanns of Nebraska, who dispensed with the pleasantries: “I must admit I have sat through this hearing and I get more confused as you testify … Tell me the evil that you are trying to wrestle out of the system by this rule?”46
Volcker was taken aback. “I feel that I have failed you if you are more confused than before.”
“That is all right.”
“What I want to get out of the system is taxpayer support for speculative activity, and I want to look ahead … It is going to become bigger and bigger, and … add to what is already a risky business.” Volcker had emphasized looking ahead because he knew what Johanns was going to ask.
“But here is the problem, Mr. Chairman,” Johanns said, using Volcker’s old title to soften the sting, “and here is where I am struggling to follow your logic … How would this have prevented all the taxpayer money going to AIG? … Would we have solved the problems with Lehman had the Volcker rule been in place?’
Volcker knew that this was not the case.47 Lehman was an investment bank that had purchased risky assets, including commercial real estate and subprime mortgages, and had financed many of its investments by borrowing money that had to be repaid overnight.48 The mismatch between the maturity of assets and liabilities made Lehman resemble Continental Illinois a generation earlier—both survived by renewing their borrowings in the marketplace on a daily basis. Lehman declared bankruptcy when investors lost confidence in the firm’s ability to repay its debts and refused to renew their loans.
Volcker conceded the point to the senator from Nebraska: “It certainly would not have solved the problem at AIG or … Lehman alone. It was not designed to solve those particular problems.”
“Exactly. That is the point,” Johanns interjected. “You know, this kind of reminds me of what … [Obama’s] Chief of Staff said, ‘never let a good crisis go to waste.’ What we are doing here is we are taking this financial reform and we are expanding it beyond where we should be. And I just question the wisdom of that.”
Volcker, of course, had exploited crises long before Obama’s gatekeeper, Rahm Emanuel, had even thought of the phrase, much less spoken it. And that perspective contained more truth than he would admit, as when Senator John Heinz accused him of crisis-mongering in 1984 to fix the deficit. But he believed that guarding against the last conflagration is as fruitless in finance as it was in combat. “I would emphasize that the problem today is [to] look ahead and try to anticipate … And I tell you, sure as I am sitting here, that if banking institutions are protected by the taxpayer and they are given free rein to speculate, I may not live long enough to see the crisis, but my soul is going to come back and haunt you.”
Johanns found this amusing: “That may be. There will be a lot of people. You would have to stand in line maybe.”
Everyone laughed, including Volcker, but he knew that the risks of speculation remained mostly submerged, like an alligator waiting to strike, and with the same devastating consequences when they surfaced. Speculation by Nick Leeson, a trader for the two-hundred-year-old Barings Bank, had forced the company into bankruptcy in 1995, and trading losses of $7 billion by Jérôme Kerviel in 2008 had impaired the credit rating of Société Général, the second-largest French bank.
Volcker recognized that neither of those massive speculations had unleashed a financial tsunami, because they were considered isolated events. But speculators, despite their secretive nature, often pursue the same strategies, like the famous carry trade. Traders borrow in a low-interest-rate currency, like Japan’s, and lend in a high-interest-rate currency, like Australia’s, and assume foreign exchange risk while trying to capture the interest rate differential. It works until losses force them to abandon the strategy, as during 2007 and 2008.49
Herding by speculators risks a stampede to safety, the signature of a crisis.
The most powerful Republican challenge to the Volcker Rule came toward the end of the day on February 2, 2010, when Senator Mike Crapo of Idaho, a member of the Senate since 1998, returned to Senator Shelby’s opening theme: “The Administration submitted a significant proposal last summer about how to approach reform … [and] the Volcker rule was not in that proposal … I assume that part of the reason … was because … we do not have the … the legislation language … And my question, Chairman Volcker, is [can you distinguish] … between the permissible and impermissible [trading] activities … Some people say [it is] impossible.”50
Volcker knew this called for applying Justice Potter Stewart’s methodology—speculation is like pornography, you know it when you see it—but he had already blurted out that analogy, and gotten a laugh, in response to an earlier question from Shelby.51 Now he could only say, “Bankers know what proprietary trading is and what it is not, and do not let them tell you anything different.”52
Volcker was right, and Crapo agreed, in part. “Well … I suspect that that may be true, to some extent, although … we could find different points of view among bankers as to exactly what we are talking about.”
“I agree … [but] I do not think it is so hard to set forward the law that establishes the general principle.”
“I understand the point you are making, but … this Committee and this Congress need some level of specificity on which to act … because if we get them wrong, I think that we could be doing as much harm as good.”
The Volcker Rule needed greater precision to win congressional support.