Volcker

by William L. Silber

  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.

  18. The Rule

  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.

  Speculators in securities behave very differently. They resemble antique-car collectors more than used-car dealers. Antique collectors search for value, like a 1963 Chevy Impala, a 1965 Ford Mustang, or even a 1985 Nissan Maxima, because they expect prices to rise—and they store the cars until they make a profit. Speculators in stocks and bonds do the same thing, buying undervalued securities they think will rise in value, and holding them in inventory until they do.

  But it gets much more complicated. Speculators and market makers can both disguise their intentions like secret agents. At financial institutions, speculators call themselves proprietary traders to sound respectable and often pursue mixed strategies to mask their behavior. They deal with customers when it suits their purpose, serving as ready buyers while accumulating a speculative position. They misrepresent themselves as low-risk market makers to reduce their capital requirements. And market makers often stray into speculation without permission, hoping to earn profits as prices rise by accumulating more inventory than they really need. Market makers speculate because it is more exciting, like buying a Lamborghini, and to earn a bigger bonus.

  Regulators implementing a Volcker Rule that permits market-making and prohibits speculation have their work cut out for them. But they can follow the guidelines of managers at securities firms who monitor trader behavior. For example, when I traded as a market maker (called a scalper) on the futures exchange, I belonged to a clearing firm that guaranteed my transactions with other members of the exchange. The manager of the clearing firm monitored every trader on his watch and would revoke trading privileges for violations of the guidelines. He checked my transactions every day—how often I bought, when I sold, how long I held a position, even the size of my inventory at various points during the day. I did not speculate.

  Volcker sat back in his chair and said nothing after I had confessed to trading for a hedge fund. He then surprised me with “Maybe we can capitalize on your past indiscretions. I’d like you to write an op-ed piece for the Times or the Journal explaining how to distinguish market-making from speculation. They’ll publish it.”

  It was an opportunity and a distraction. “I’m flattered that you ask, but that takes time and I’m trying to write a biography, in case you hadn’t noticed. I was supposed to finish a year ago.”

  He did not hesitate: “The op-ed piece is more important.”

  Volcker’s preference for public over private goals forced a compromise. “I’ll be happy to talk to the committee staffers and to reporters—but no writing. I want to finish this book while you can still criticize it.”

  He ignored the quip. “Okay, I’ll send the rule makers to you—that should be good enough. I’ve got other plans to pressure Congress in the press.”

  “Like what?”

  “I’m solicitin
g support for the Rule from former Treasury secretaries … a letter to one of the national newspapers.”

  “Anyone I know?”

  “Blumenthal … Brady … O’Neill … Shultz … Snow.”4

  “Very nice,” I said. “Lots of Republicans … and I’m sure Milton is turning over in his grave with George Shultz in your corner.”5

  Volcker smiled at the thought of Shultz defying the now-deceased Milton Friedman by supporting increased regulation.6 And then he volunteered: “I called in some chips … Brady owed me.”

  “How is that?”

  “I let him use my name for a horse.”

  “Excuse me?”

  “He owns a racing stable and asked for permission to name a horse after me … I said, which end? When he said the whole animal, I gave my blessing.”

  I laughed. “Is he any good?”

  “He came in second a couple of times at Saratoga … and then he got sick and died.”7

  “Ouch.”

  “I expect to do better.”

  By the end of May 2011, Volcker’s persistence had paid off. He had lobbied personally in Congress for the ban on proprietary trading and then joined forces with Senators Jeff Merkley of Oregon and Carl Levin of Michigan, backing their amendment to the original bill proposed by Senate Banking Committee chairman Christopher Dodd. Volcker wrote a letter for public distribution to the two senators dated May 19, 2010: “Senators Merkley and Levin: I am fully in support of the Merkley-Levin amendment, which will clarify and enhance the proprietary trading restrictions contained within the Dodd bill.”8 Merkley suggested only half jokingly that the legislation should have been called the Merkley-Levin-Volcker amendment.9

  Congressman Barney Frank of Massachusetts, the chairman of the House Financial Services Committee, told a reporter, “When the banks come to me opposing various things [in the financial reform bill], I say to them ‘If I were you, I would go and see Paul Volcker. If you can persuade him, you might have a chance. I think you are not going to see anything in this bill that Paul objects to.’ ”10

  Barney Frank told the truth, with one big exception.

  The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed by President Obama on July 21, 2010, devotes Section 619 to the Volcker Rule.11 This eleven-page prescription adopts the language of the Merkley-Levin amendment, which pleased Volcker, and begins with the two main prohibitions of the Rule, which he liked even more: “A banking entity shall not (A) engage in proprietary trading; or (B) acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund.”12 But the six words preceding these restrictions, “Unless otherwise provided in this section,” gave him cause for concern.

  Volcker had anticipated some exceptions to the Rule but thought the wording offered the bankers a giant escape hatch. None of the prohibitions against trading in Section 619 applied to government bonds, or to reducing risks through hedging, or to helping customers transact in any security, no matter how risky. Bankers would have little difficulty slipping their speculations through the cracks. To clarify the distinctions between permissible and forbidden activities, the Dodd-Frank bill mandated a study “not later than six months after the date of enactment … [by] the Financial Stability Oversight Council … [to] make recommendations on implementing” the statute.13

  Dodd-Frank established the Financial Stability Oversight Council (FSOC), chaired by Treasury Secretary Timothy Geithner, as a permanent committee with broad regulatory authority “to identify risks to the financial stability of the United States.”14 Members of the FSOC included Chairman Ben Bernanke of the Federal Reserve Board, Chairman Mary Schapiro of the Securities and Exchange Commission, and other key federal regulators.15 One of the commission’s earliest responsibilities was to recommend “principles for implementing the Volcker Rule … including an internal compliance regime, quantitative analysis, and reporting and supervisory review.”16

  In October 2010 the FSOC called for comments from the public to guide their recommendations. Volcker prepared as though this were the final battle for financial integrity. He wanted to avoid a last-minute setback.

  “I don’t want to get shafted again,” he said to me as we ate lunch at a corner table in a restaurant overlooking the skating rink in Rockefeller Center. He had just introduced me to David Rockefeller, seated at the adjacent table. The ninety-five-year-old retired chairman of Chase Manhattan Bank and grandson of Standard Oil founder John D. Rockefeller had been Volcker’s boss during Paul’s Chase Manhattan days, and had just congratulated him on the recent legislation.

  “He didn’t seem to think you got shafted,” I said, nodding toward Rocke feller.

  “But he doesn’t know how close to perfection we came.”

  A congressional conference committee reconciling the House and Senate versions of the Dodd-Frank bill on the final night of deliberation had diluted the restriction against banks owning and sponsoring hedge funds. After the negotiations, banks could invest up to 3 percent of their Tier 1 capital in hedge funds, rather than the $500 million maximum that Volcker had conceded.17 JPMorgan Chase, for example, could invest about $3.9 billion, Citicorp $3.6 billion, and Goldman Sachs $2.1 billion without violating the law.18

  “Well, perfection is a high standard,” I said, “but compared with your prospects last February, you cannot complain.” I showed him a Wall Street Journal article dated February 3, 2010, with the headline “Volcker and Reform Defeated.”19

  He laughed. “They miscalculated.”

  “Besides,” I said, “I’ve always thought that the ban on proprietary trading was more important—and that went through unscathed.”

  “I agree.” Volcker smiled like a litigator sensing an opening. “And that is why I want you to provide guidance to the committee on how to separate market-making from speculation. I’ve written a four-page letter in response to their call for public comments and added a footnote indicating they should expect a submission from you.”20

  “You don’t give up, do you?”

  “I may be old but I am persistent.”

  “Are there any other surprises?”

  Volcker smiled. “Maybe.”

  “I can’t wait.”

  On Tuesday, January 18, 2011, the FSOC released an eighty-one-page report with detailed recommendations for regulators, but the exodus of proprietary traders from banks had already begun. The press reported as far back as August 2010 that JPMorgan Chase had begun “dismantling its stand-alone proprietary trading desk and is now preparing to wind down One Equity Partners, its internal private equity business,” to meet anticipated regulations, and Citigroup had sold “its Skybridge Capital hedge fund group” to comply with provisions of the new law.21 On January 11, 2011, the Wall Street Journal reported that Morgan Stanley, the brokerage giant that had become a bank holding company during 2008, “reached an agreement with proprietary-trading chief Peter Muller … to form a new firm … About 60 employees are likely to follow Mr. Muller out the door.”22

  The voluntary compliance with the Volcker Rule met with praise and skepticism. Brad Hintz, an analyst at the brokerage firm Sanford C. Bernstein, said, “This is the real stuff … we really are squeezing Wall Street. Their business models are changing.”23 But most observers thought traders could sell the Volcker Rule short with impunity. Jeffrey Harris, the former chief economist at the Commodity Futures Trading Commission, said, “The line between providing liquidity and proprietary trading is very thin. If people want to trade on prop accounts, they are going to find a way to do it.”24 And the Bloomberg columnist and best-selling author Michael Lewis wrote, “Wall Street insiders [say] … The banks have no intention of ceasing their prop trading. They are merely disguising the activity, by giving it another name.”25

  The FSOC recognized the problem and introduced its report with a warning to institutions planning to hide speculators behind market makers. “Although ‘bright line’ proprietary trading desks are readily iden
tifiable, in current practice, significant proprietary trading activity can take place in the context of activities that would otherwise be permitted by the statute. Therefore, an essential part of implementing the statute is the creation of rules and a supervisory framework that effectively prohibit proprietary trading activities throughout a banking entity—not just within certain business units.”26

  The attention to detail pleased Volcker as he reviewed the FSOC report, especially the precise metrics recommended to regulators to separate market makers from speculators. High inventory turnover, frequent transactions with customers, and consistent profits on a daily basis, would classify a trader more like a market maker than a speculator.27 Low scores on these metrics would not prove that a trader had violated the Volcker Rule, but they would flash a warning like the Check Engine light on a car’s dashboard, and require further investigation by the regulator. The report pointed out that regulators such as the Federal Reserve System would need “significant new and specialized resources” to implement the law.28

  The need for more resources had concerned Volcker all along. In February 2010 he testified, “The banks are all going to have a lot of twenty-six-year-olds … [with] a lot of fancy mathematical training and all the rest. The supervisors need a few twenty-eight-year-olds that have had the same kind of training.”29 But he knew that talent flows to the highest pay scale, so that traders at Goldman Sachs, JPMorgan Chase, and Morgan Stanley could usually outsmart the regulators at the Federal Reserve Bank of New York. He had racked his brain to turn the tables—and had hit upon a solution only after the Dodd-Frank legislation had passed.

  Volcker waited until the request for public comments by the FSOC to present his idea. It appeared as the first substantive paragraph of his October 29, 2010, letter and focused on the role of a bank’s chief executive officer (CEO): “In my view, effective compliance must start with clear understanding at the top of the regulated institution. As I have repeatedly stated both in public and in conversations with banking leaders, the relevant banking supervisor’s first step in their examination and enforcement process should be the ‘corner office.’ The CEO’s understanding and his instructions to other executives and staff regarding the prohibition on proprietary trading and compliance procedures for the new rules should be carefully reviewed … to insure effective procedures for compliance with Section 619.”30