Bought and Paid For (33 page)

Election years bring lots of surprises, and none bigger for Wall Street than the resurrection of Paul Volcker as the 2010 midterms approached. The aged former chairman of the Federal Reserve was supposed to serve as nothing more than window dressing for the Obama administration—his early support had given Obama much-needed assurance in economic circles that the candidate wasn't the flaming liberal that his detractors tried to portray him as.

Volcker, a committed Democrat, had, after all, first been appointed as Fed chairman by president Jimmy Carter, had been reappointed to run the Fed in the early 1980s by conservative icon Ronald Reagan, and is credited with taming the economic malaise of the late 1970s and early 1980s—so-called stagflation, the lethal combination of high unemployment and high inflation. Volcker squeezed inflation by raising interest rates to historic highs, and he did it with brass balls. When called before Congress to answer for the 20 percent interest rate he had imposed and the consequent economic despair it was causing, he rolled a cheap cigar in his mouth and calmly but firmly explained that it was the necessary medicine for years of excess. And he was right. The short-term pain of high unemployment ultimately gave way to long-term economic gain. Once inflation fell, so did interest rates, and when combined with the Reagan tax cuts the economy took off on a decadelong boom.

Volcker had since left the Fed and continued on as a consultant, but one that was decidedly anti-Wall Street. Unlike his successor, Alan Greenspan, he hated the newfangled financial alchemy that spread though the banking system in the 1990s, the newfangled bonds, and most of all the newfangled banks—and he constantly and continuously let the world know it. He showed particular contempt for Citigroup. By commingling investment banking, risk-taking traders, and customer deposits under one roof, Volcker thought Citi had become a disaster waiting to happen, no matter how much its founders, Sandy Weill and Bob Rubin, were initially celebrated. And based on the events of 2007 and 2008, he was right.

For being right about the financial crisis, Volcker was offered what was thought to be an easy job with the Obama administration, something that was more or less a “thank you” for his early support for the young and economically inexperienced candidate. The president's economic inner circle of Geithner and Summers and their senior staff regarded Volcker as someone who had to be tolerated but not taken seriously.

There was only one problem: Paul Volcker didn't see it that way.

“I hear about these wonderful innovations in the financial markets, and they sure as hell need a lot of innovation,” Volcker said in his trademark no-nonsense, almost monotonic style of speech, “and I can tell you of two—credit-default swaps and collateralized debt obligations—which took us right to the brink of disaster. Were they wonderful innovations that we want to create more of?”

Volcker was speaking at a December 2009
Wall Street Journal
conference that focused on the banking crisis and Wall Street's role in creating the massive risk that upended the financial system. During his speech and in answering questions, Volcker attacked Wall Street on everything from its massive compensation packages based on short-term trades to its corporate governance system, where boards of directors barely understood the business of risk that the banks had adopted.

Despite the creation of all those funky derivatives, CDOs, and the like, Wall Street actually lacked innovation, Volcker claimed. The massive amounts of derivatives designed to limit risk only caused more of it. Many of the high-tech companies the firms brought public paid them massive investment-banking fees to downplay their shortcomings in research to investors and ultimately became insolvent. In fact, the greatest innovation that he could come up with from the banks over the past two decades was the ATM—the automatic teller machine, because it “really helps people and prevents visits to the bank and is a real convenience.”

“More of the same,” was how one banking executive who heard of the speech described it to me. That's because for years Volcker had attacked big banks like Citigroup and JPMorgan Chase as “bundles of conflicts,” in other words, for being so big that they often served the interests of corporations at the expense of depositors and people who bought stock through their brokerage channels.

What made Volcker's commentary so searing and accurate was that he couldn't be bought, and wouldn't be. His post-Fed job was with a small but prestigious investment advisory firm rather than a large bank. He didn't engage in the corrupt and conflicted banking practices that were so lucrative and evil at the big firms. As a result, he was free to opine on Wall Street's aberrant behavior, particularly when it came to the business model du jour, the large universal bank where millions of small investors, many of them buying stocks for the first time to save for retirement as 401(k) plans replaced old pension funds, constantly got the shaft because they were prodded by the firms' brokers to buy shares of companies that the banks had underwritten. The stocks of these companies were further enhanced by conflicted analyst research reports issued by people like Henry Blodget of Merrill Lynch and Jack Grubman of Citigroup. Critics charge that these analysts promoted the shares of the companies they analyzed because they weren't necessarily paid to steer clients to the best investment but rather to help their firms get more underwriting business from those same companies. Paul Volcker was one of those critics.

Now Volcker wanted to rein in what he saw as Wall Street's other sin, namely its addiction to risk. But for a guy who wasn't supposed to have much sway inside the Obama administration, Volcker worked as if he had a lot of it. I ran into more than a few former top executives at Wall Street firms who told me in mid- to late 2009 that they had spoken to Volcker, who was planning something big to reduce Wall Street risk taking once and for all. For a time Volcker toyed with the idea of bringing back Glass-Steagall, which would have forced a separation of JPMorgan, Citigroup, and Bank of America into separate investment and commerical banks. Based on what I know about these meetings, I believe he decided against that measure because putting the genie back in the bottle was much more difficult than it appeared. Moreover, not even the great Paul Volcker was prepared to tell Jamie Dimon that he had to spin off his commercial banking business.

So in the end, Volcker called for some pretty inconsequential reforms—soon to be collectively dubbed the Volcker rule—which would prevent all banks, from Goldman Sachs to those that handle customer deposits and are thus protected by the FDIC, from risking it all by speculating in the markets with company capital. No more so-called proprietary trading, no more hedge funds or private-equity funds for banks, if the federal government was to back up their deposits in the event of massive losses.

And now, as the public outrage over Wall Street profits grew louder amid burgeoning unemployment, the president began to listen to his most anti-Wall Street economist. Had Obama come to understand that the massive protections he continued to offer the banks while they gambled should finally come to an end? Probably not. Did he understand that the public was beginning to associate him and his administration with the fat-cat bankers? More likely.

The wake-up call for Obama was when Republican Scott Brown, a little-known state legislator, won the Senate seat held by liberal icon Teddy Kennedy, even after Obama spent time in Massachusetts campaigning for the Democrat, Martha Coakley. Obama, the man who made women swoon when he ran for president and packed stadiums filled with admirers to hear his pearls of wisdom, was getting a taste of reality. Americans loved his personal story but had begun to hate his policies. His poll numbers were now cruising lower, mostly the result of the struggling economy but also because the public was fully digesting the inequity of Obamanomics: Bankers make bundles while everyone else suffers.

Amid this tailspin, Obama began to embrace the original anti-Wall Street economist, Paul Volcker, and the Volcker rule got a new lease on life in a new financial reform law Obama promised to get done before the end of 2010. As Obama began to unveil his plan to reform the financial markets, which included new proposals to limit risk Volcker had advocated, there was the six-foot-six-inch Volcker standing right to his side, hovering over the president like a giant tower while the diminutive Geithner stood meekly in the background.

The spectacle sent a chill through Wall Street. The consequences for JPMorgan Chase of the “new Volcker rule,” as it became known on Wall Street, were not life threatening though they were still pretty stark and they made Jamie Dimon seethe: Depending on the final language, the firm might have to spin off its massive hedge fund, known as Highbridge Capital, which had $21 billion in assets under management. Goldman Sachs not only owned a bank in Utah (not the biggest part of its operations but a nice moneymaker) but the firm was officially designated as a bank, meaning the rule would squeeze its lucrative business of “proprietary trading.” (It turned out not to be that easy for Goldman, since the firm had been deemed a bank after the 2008 financial collapse.) Who knew how Citigroup would be affected, as the bank traded commodities all across the world even in its current shape as a near basket case.

Blankfein, of course, never saw it coming. The Volcker proposal appeared on its face to hit the banks hard, but Citigroup and JPMorgan had somewhat curtailed their proprietary trading activities. Goldman, on the other hand, was in essence one large hedge fund that was only technically a bank; it didn't matter whether or not it offered checking deposits; the Fed still regulated the firm as it did Citi and JPMorgan
.

As one JPMorgan executive put it, “Goldman is now in the roach motel with the rest of us, and the poison will be worse for them than anyone else.”

When news hit that the rule was being strongly considered as part of the legislation, Goldman's lobbyists, many of them former legislative staffers who had worked for key Democratic lawmakers like Barney Frank, fanned out across Capitol Hill. David Viniar, the firm's CFO, scheduled a conference call and assured analysts that the rule was no biggie; proprietary trading accounted for just 10 percent of the firm's revenues, he said. Dimon's flacks offered the same spin—the rule would get modified down to almost nothing, they told reporters, even as Dimon privately worried that JPMorgan might have to spin off its massive private equity holdings and hedge funds when he read the fine print of the Volcker rule.

One of the ironies of the rule is that neither proprietary (“prop”) trading nor hedge fund investing was the major cause of the 2008 financial collapse. Wall Street's massive losses largely stemmed from the firms' creating mortgage bonds and other complex investments for clients, so in essence the Volcker rule was meaningless. It did nothing to prevent the possibility of another financial collapse and it still allowed the banks to be “too big to fail.”

“Volcker has no idea how the financial crisis began,” Larry Fink remarked after he heard that the president was beginning to take Volcker seriously. Fink, as we've seen, had made a killing from the various bailouts and mechanisms offered during the postbailout months. And yet by early 2010 he had begun telling friends that he was no longer a fan of the president. Obama, Fink complained, had lost his way. Not only was the president listening more to Volcker, whom he considered misguided, but the Wall Street-loving guy he knew on the campaign trail had morphed into a class warrior. Fink told people he had voted for Obama as a change toward moderation—change from the big-spending ways of George W. Bush and the nation's cowboy image overseas, particularly in the Middle East, where BlackRock managed money for wealthy Arabs—and because he couldn't bear to vote for a ticket that included the superconservative and, in his eyes, incompetent Sarah Palin.