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 insti
tutions 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
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