Reuters reported today on a Wall Street Journal story that said hedge fund investors are up in arms over moves made at Bear Stearns, which critics say are evidence that the Wall Street giant is trying to manipulate a large part of the secondary market for residential mortgages. A few excerpts would seem to summarize the issue:

Hedge funds that had sold short such securities [subprime] made profits when an index tied to a basket of subprime bonds was falling. But the index has recovered in recent weeks, leading to howls of protest from hedge funds, according to the report. The chief critic, John Paulson of Paulson & Co., a $12 billion fund, says Bear Stearns 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, the Journal reported.

So the issue is loan purchases, right? Maybe. Here’s another Reuters story on the row, published later today. This story contained the following gem from Tom Marano, global head of mortgages and asset-backed securities at Bear Stearns:

Marano added that decisions made by the bank in servicing its mortgage loans do not take into consideration their potential impact on CDS prices. “Our servicing decisions — such as modifying loans when people can’t pay their mortgage, or buying out loans when rep & warranty issues are involved in the underwriting process — stand on their own,” Marano said. “None of the servicing decisions we make are driven by any activity or outstanding positions in the CDS market.”

This story makes it look like the issue is loan servicing, not loan purchases. And if I understand Marano’s claim, he’s making it sound like Bear Stearns services its loans with no concerns regarding its Wall Street position whatsoever. If you’ve ever worked in loan adminstration and dealt directly with phone calls from hyped-up bond traders at a trading desk, you’d know that is simply not true. So which is it? Was Paulson alleging that Bear Stearns was looking to “prop up faltering mortgages-backed securities by purchasing individual mortgages that were rapidly losing value to avoid doling out billions in swap payments,” as the first Reuters story says? Or was Paulson alleging that Bear Stearns was engaging in loan modifications during servicing solely to prop up CDS prices, as the second Reuters story suggests? Or is it both? Loan purchases notwithstanding, it looks like Paulson seems to be most concerned about how Bear Stearns’ servicing arm, EMC, has engaged in loan modifications — at least according to this story in the New York Post:

At issue is the motivation behind efforts by Bear’s EMC Mortgage unit to renegotiate subprime home loans, and whether it’s solely to prevent homeowners from losing their houses, or, as Paulson’s general partner John Paulson told The Post, simply “to artificially inflate the value of derivative securities.” Paulson said that he strongly supported loan modification when valid, but that some of these “second chances” appear to be just “market manipulation” from Bear.

The same NYP article lays out more detail that seems to clarify what’s going on here:

For Paulson, this is no mere academic debate. His funds have a multibillion-dollar bet on the decline of the subprime mortgage market, using trading strategies. The first involves short-selling the ABX index, a key subprime mortgage market benchmark that tanked in February and March as mortgage defaults skyrocketed, earning Paulson and other funds billions of dollars in profits. Another Paulson strategy involved using credit default swaps, complex securities that act as an insurance policy against a drop in the value of subprime securities. Paulson bought about $1 billion worth of this “insurance” as bonds, backed by subprime mortgages, declined in value, and he locked in a home run, collecting an amount roughly equal to those declines. But the alleged $1 billion in paper profits that Paulson’s fund has made is being jeopardized as the ABX index has begun to march upward, rallying to 83 from a low of 73 in February.

I think I get it now, but the above now begs an interesting question: now some Wall Street investors want to see defaults? And are willing to accuse firms like Bear Stearns of market manipulation if they don’t get them? Update: To say I was unduly confused by all of this earlier would be an understatement. Calculated Risk has a great thread on this issue, and you’ll note some pretty silly comments over there by yours truly while I was trying to figure this out. (I usually try to work my confusion out in less public places, but in my defense, it’s not as if the media initially reported on this clearly, which led to part of my confusion.)