Mortgage market manipulation

From the Wall Street Journal:

The Sure Bet Turns Bad
Funds Howl As Bear Stearns Buys Mortgages
By KATE KELLY and SERENA NG
June 7, 2007; Page C3

Just a few months ago, bets against securities backed by shaky subprime-mortgage loans were among the most alluring trades on Wall Street.

But the market for those securities has since stabilized, potentially hurting those who bet against it, and left a messy squabble in its wake.

A band of hedge-fund managers accuse Wall Street’s Bear Stearns Cos. of attempting to manipulate the market for securities backed by subprime loans by purchasing shaky mortgages. Bear retorts that it has the right to repurchase mortgages and that sometimes it can help a struggling borrower. Meanwhile, an industry association that oversees derivatives trading has been drawn into the middle of the matter.
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Back in February, the shorts looked like they were making a great trade. Many hedge funds had been shorting a derivative index called the ABX that is tied to a basket of subprime bonds with weak credit ratings. The index had a value of 100 when it was launched this past July.

By late February it had plunged to a low of 63, bringing millions of dollars in paper profits to the short-sellers. The plunge also caused ripples of worry through the stock and bond investors about the broader health of the U.S. economy. The index has since turned around, reaching 77 in mid-May before sinking back to 73, according to its administrator Markit Group.

Back in January, at a Las Vegas industry conference, Bear’s head mortgage trader, Scott Eichel, talked with a small group of traders over drinks in the Venetian hotel about propping up the ABX index by buying and rescuing some struggling subprime bonds, say two people who were there. A Bear Stearns spokesman said Mr. Eichel disagrees with the account, but wouldn’t elaborate with any details.

The recovery of the ABX index has led to howls from hedge funds which are short subprime, including Mr. Paulson, who manages a $12 billion hedge fund. Mr. Paulson says Bear wanted to prop up faltering mortgages-backed securities by purchasing individual mortgages that were rapidly losing value to avoid doling out billions in swap payments.

Bear denies the allegations. “None of the [mortgage] servicing decisions we make are driven by any activity or outstanding positions in the CDS market,” says Tom Marano, who runs Bear’s mortgage business.
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In April, when the ABX was trading at about 74, Paulson executives called Mr. Eichel to ask whether he was contemplating a plan to repurchase mortgage-backed securities. “Maybe we are, maybe we’re not,” Mr. Eichel replied, according to two Paulson executives, who say he added they should call him if they were interested. A Bear spokesman said the Paulson executives’ recollection of the conversation is inaccurate.

The prior day, Bear’s mortgage desk had sent Paulson a copy of new language it was proposing to the International Swaps and Derivatives Association, the industry group that represents traders of swaps and other complex market instruments.

It exacerbated the controversy. The proposed rules would codify its right to prop up a faltering pool of home loans in a mortgage security, even if it knew its clients bet those loans wouldn’t perform.

“We were shocked,” says Paulson vice president Michael Waldorf, that a firm “like Bear would introduce language that would try to give cover to market manipulation.” Also on his mind: With a big bearish bet on the ABX, his firm stood to lose a lot if the index didn’t fall.