Volcker (44 page)

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.
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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.
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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.

I came to Volcker's Rockefeller Center office on Monday afternoon, February 8, 2010, for an interview—we had been meeting twice monthly since I started this biography in mid-2008. Volcker sat in a high-backed leather chair behind his desk, as always, and wore a gray double-breasted suit, white shirt, and dull tie. He looked more unhappy than usual, perhaps because the international press had memorialized his testimony of February 2 at the Senate Banking Committee with the headline “Risky Banking Like Pornography, Volcker Tells Senate.”
¹

He stared at me for a moment and then tossed a familiar-looking document across the granite desktop in my direction. “Now, why the devil didn't you show this thing to me before last week? I could have waved it in front of the Committee instead of offering up salacious material. I would have made it required reading.”

I smiled at the thought. “I did not know you were going to testify, but after I read the newspaper accounts, I sent it up by messenger.”

“If memory serves me correctly, we discussed trading many times and you never mentioned it.”

“Well, I told you that I traded, both as a market maker and as a speculator, and that I worked for a hedge fund for a while. You didn't seem to care.”

“I must have blocked out the hedge fund connection … But you never said you wrote an article on how to distinguish between market-making and speculation.”
²

“It's been a while,” I answered.

“The publication date is 2003—that's only seven years ago.”

“But I began thinking about it in 1983, when I worked for Dick Fuld. That's almost thirty years ago.”

Volcker looked at me as though I had just confessed to a felony. “You mean the CEO of Lehman?”

“Yes, although that was not his job back then. Lewis Glucksman was the chief executive officer and he had just put Dick in charge of all trading.”

“What did you do?”

“He hired me as risk manager.”

Volcker furrowed his brow. “I didn't think they had that position back then.”

“They didn't,” I said, and told him the story. “It was mostly seat-of-the-pants risk controls, but Glucksman wanted to create a system because he worried about trading losses—with good reason. I'll never forget my first day. Fuld and I sat in a glass-walled booth overlooking a trading floor as big as a football field, with more than a hundred traders positioned before rows of computer terminals that extended the length of the room. I could hear the roar of muffled conversations, some spoken into headsets and others shouted across the room, with phrases like ‘how many,' ‘how much,' and ‘you're done' rising above the confusion. Fuld said, ‘Are you ready to start?' I answered, ‘Sure, but what are all these people doing out there?' He raised his voice in mock anger: ‘What the fuck do you think I hired you for?' ”

Volcker laughed. “I guess he never found out.”

“It wasn't his fault, at least not then,” I said. “I left Lehman a year later, before I understood that the two varieties of trading—market-making and speculation—are very different businesses. I learned the hard way, trading for myself on the futures exchange as a market maker and then trading for a hedge fund as a speculator. I lost money only when I confused the two lines of work.”
³
Market-making in securities is like the used-car business. A used-car dealer buys Chevrolets and Hondas from owners wanting to sell and then turns around and sells those cars to drivers wanting to buy, providing a ready market for secondhand cars to its customers. Dealers make money on the price markup, the difference between the buying and selling prices, and on rapid turnover. They try to avoid a buildup of unsold cars. Market makers in stocks and bonds are also called dealers, securities dealers, because they do the same thing. They buy Microsoft stock or General Electric bonds from investors wanting to sell and then turn around and sell those same securities to others wanting to buy, providing a ready market—liquidity—to investors. They avoid holding inventory for too long because their markup, the difference between their bid (at which they buy) and offer (at which they sell) is relatively small compared with the normal price fluctuations in stocks and bonds. Inventory is risky.