Hedge funds warn SEC on bonds

A group of hedge funds has asked the Securities and Exchange Commission to be on the lookout for manipulation of bonds backed by sub-prime mortgages.

Paulson & Co., based in New York, told the SEC that investment banks might pay inflated prices to buy delinquent loans that are collateral for bonds, said Michael Waldorf, a senior vice president at the hedge fund. Doing so could keep the bonds from going into default and triggering losses in the banks’ investments in derivatives, he said.

The hedge funds have used derivatives to bet against mortgage bonds and would profit from defaults.

Waldorf declined to name the other hedge funds that joined Paulson last month in sending a letter about the issue to the SEC.

An SEC spokesman declined to comment on the letter.

More than $800 billion of bonds are backed by loans to homeowners with poor or limited credit histories, according to Credit Suisse Group. Holders of such bonds stand to lose as much as $75 billion because of a rise in mortgage defaults, Newport Beach-based Pacific Investment Management Co. estimated in April.

Some of the investment banks that gather mortgages and package them into bonds also own companies that make and service home loans and therefore can in some cases buy loans from the pool of mortgages.

Thomas Marano, head of Bear Stearns’ mortgage business, said in an e-mailed statement that none of its decisions regarding whether to buy loans were driven by any holdings it might have of derivatives.

Peter Cerwin, head of portfolio management at Credit-Based Asset Servicing and Securitization in New York, an issuer and servicer, said it would be “penny wise and pound foolish” for an issuer of mortgage-backed bonds to buy a significant amount of loans from an issue, except when it is contractually required to do so, because investors would shy away from the firm’s future deals.