Wall Street Civil War

There’s a tendency, in the endless discussions about the economic crisis, to think of the entire financial industry as a single, ultra-powerful actor. Big commercial banks, nimble hedge funds, even the odd insurance company all get lumped together under the heading “Wall Street,” with its sinister, Death-Star connotations. In a recent story about relations between the financial world and Obamaland, no less a populist organ than The Wall Street Journal offered up such a conflation, noting that the administration, “after months of criticizing Wall Street, has been scrambling to woo top bankers and financiers to back its latest bailout plan.”

In fact, there are real differences among these species of moneymen. Top executives at large commercial banks tend to be a little older, a little stodgier, a little more politically conservative than their counterparts at hedge funds and other money-management firms. Traditionally, the bankers have also been far more sophisticated about navigating Capitol Hill. That’s especially relevant in the current crisis, when the interests of the two groups increasingly diverge and Washington is being forced to adjudicate. And perhaps no episode better illustrates the gap in political savvy than the battle over housing legislation now boiling over in the Senate.

Ever since 2007, Congress has been grappling with a way to ease the millions of foreclosures piling up in the wake of the housing bust. Any solution needs to accommodate the fact that banks don’t keep most of the loans they originate. Instead, they sell them off for repackaging as securities, which investors buy. But the banks continue to service the mortgages--collecting payments from homeowners each month--and it falls to them to work out a modification. Which is to say, while the banks have the authority to modify a loan, they often don’t have a strong financial interest in doing so, since they no longer have a stake in the mortgages. Worse, the banks actually face a huge disincentive: investors irate that they lowered their returns.

Among the Democrats’ preferred solutions to this problem is something called “cram-down”--that is, allowing bankruptcy judges to modify a mortgage and unilaterally impose the new terms. When Obama unveiled his own housing plan in February, he asked Congress to revive the cram-down idea as part of a carrot-and-stick approach to helping borrowers. The carrot would be cash incentives--a series of $1,000 payments--for banks to perform modifications. Cram-down would serve as the stick.

Almost immediately, investors and banks joined forces to snap that stick like a twig. Investors hated the cram-down idea because they worried judges would force them to accept, say, lower interest payments for the sake of distressed borrowers. The big banks had similar worries for the mortgages they keep. Many also hold on to second liens (basically, second mortgages) after they sell off the first and worried judges would wipe those out entirely. And both groups generally feared the arbitrary ways judges might wield their power.

But a funny thing happened while the big banks and investors were uniting against the cram-down push: The banks cut their own deal. Top executives at four large banks--Citigroup, Bank of America, J.P. Morgan, and Wells Fargo--descended on Congress to proclaim they’d love nothing more than to modify mortgages, just like the president wants. It’s just that, with all those greedy investors out there, you never know who’s going to sue. The solution, they argued, was a “safe harbor” provision: Give us legal immunity, and we’ll modify all the loans you send us. “They said it’s necessary to protect them from lawsuits,” recalls one House Democratic aide. “Our position was, to the extent there are barriers to modifications, let’s erase those barriers.” (Spokesmen for J.P. Morgan and Wells Fargo declined to comment; the other banks did not return calls.)

From the banks’ perspective, the beauty of legal immunity was that it would give them a free hand to modify mortgages owned by investors while collecting cash incentives from the government and protecting their second liens--a proposition potentially worth billions. From the investors’ perspective, it meant the cost of modifications would come entirely out of their pockets. If the fight in Congress was essentially over who would eat hundreds of billions of dollars in housing market losses, the genius of the banks was to realize early on that, given the political environment, it wasn’t going to be homeowners. That left them duking it out with investors, even if the latter weren’t aware of it.

And so, while the investors droned on to glassy-eyed congressmen about the sanctity of their contracts, the banks waxed expansive about all they wanted to do for the man on the street. “The investors don’t make a sympathetic case. The banks positioned themselves as happy to help modify the loans,” says one neutral finance industry lobbyist. “By essentially throwing investors under the bus, they created a glide path for loan modifications.”

When the House passed its bill in early March, the investors were stunned to see that it contained the safe harbor provision they feared and loathed. They’d hardly realized it was even on the table and had made no attempt to fight it. Their only consolation was the belief that safe harbor was joined at the hip to the cram-down measure, so the banks would work with them to defeat the entire package in the Senate. But it soon became clear that Senator Dick Durbin, who was spearheading the cram-down legislation, had no intention of letting it torpedo the overall bill--which, in addition to safe harbor, also included a larger credit line for the FDIC. (Durbin eventually decided to slice off cram-down for a separate vote.)

The investors realized they’d been had. They quickly pulled out of the broader lobbying effort and formed their own group--called the Mortgage Investors Coalition--which spent most of April frantically pleading their case. They argued that, even without safe harbor, the lenders had all the legal protection they needed. They insisted the only thing safe harbor would accomplish is to protect banks who made fraudulent loans, which they’d essentially be able to launder through modification.

The investors also finally adopted the universal language of Washington lobbying: the fight for the little guy--in this case, homeowners. “The borrower and investor have aligned interests here,” Micah Green, head of the Mortgage Investors Coalition, recently told me. “The goal of this whole process should be to get the homeowner in a position where they not only can stay in homes, if at all possible, but where they want to stay in their home.” True, a modification might lower monthly payments, Green conceded. But he said it wouldn’t change the fact that many mortgages are underwater--that is, the borrower owes more on the mortgage than the house is worth--a scenario that leads people to walk away. (Administration officials disagree, citing extensive research showing that when modifications actually lower payments, people living in homes they own tend to stay put even if they’re underwater.)

Alas, it may be too little, too late. Pressed by the big banks, the Senate defeated cram-down yesterday and is on the verge of passing safe harbor as early as Monday. (J.P. Morgan CEO Jamie Dimon was spotted in the chamber on Wednesday.) “We’re trying to cram six-to-eight months of education into three-to-four week period,” bleats one beleaguered investor lobbyist.

In the end, the problem for investors was largely sociological. Banking is a heavily regulated industry; in order to succeed, a bank’s top executives must be as deft at navigating Washington as they are at lending money. But, with a few important exceptions, most hedge funds live by a meritocratic credo: You make money by having the more sophisticated computer model or arbitrage strategy. “Traditionally, investors aren’t lobbyists, they don’t have an eye toward Washington,” says the finance industry lobbyist. “They have an eye on deal-making.” That helps explain the irony that, even though Obama himself is closer to more hedge fund managers than bank executives, the banks look to have won this fight. (The administration did finally work out a compromise between investors and banks on the second-lien issue, though.)

From the public’s perspective, it’s not a bad thing that private investment firms are belatedly emerging as a separate interest group on K Street. Yes, the investor arguments about the dangers of mortgage modifications are self-serving. And, other things being equal, it’s hard to see why the average person should care whether banks or hedge funds end up shouldering a bigger share of housing-market losses.

But, given the banks’ central role in causing the financial crisis and their outsize influence in Congress, investors could serve as a needed counterweight. For example, it’s far from clear that banks won’t abuse the safe-harbor provision they’ve lobbied for; if it passes, the investors could push to prevent them from using it as a shield against liability for peddling fraudulent mortgages. Investors could also play a constructive role on other issues, such as the attempt by banks to return their bailout money quickly in order to wriggle free of pay restrictions. Investors who own the banks’ bonds aren’t likely to be keen on this, because the bailout money insulates them from potential losses. Think of the new dynamic as a kind of Iran-Iraq war come to Capitol Hill: Where there are no obvious good guys, the next best thing may be two powerful rivals beating each other to a pulp.

Noam Scheiber is a senior editor of The New Republic.