The crisis in the US subprime mortgage market has revealed a tangled web of relationships and competing interests between lenders and mortgage brokers, investment bankers and bond investors, and bank trading desks and hedge funds.
One particularly knotty problem has emerged in the derivatives market that tracks bonds backed by subprime mortgages. A key benchmark for this market is the ABX index. Hedge funds that bet on a fall in the ABX have profited handsomely as the index has fallen in value this year.
But a group of more than 25 hedge funds is anxious that investment banks could use their influence in mortgage markets to manipulate the value of the derivatives.
The debate has set powerful hedge funds against a practice favoured by regulators and politicians as a way to keep struggling borrowers in their homes.
The hedge funds are worried about modifications that mortgage administrators, or servicers, sometimes make to home loans for troubled subprime borrowers - for example, changing the interest rate, or extending the repayment term.
Some investment banks are active in the mortgage servicing business as well as being mortgage lenders, underwriters for mortgage-backed securities and derivatives traders.
The hedge funds claim that the banks' ability to modify the terms of individual mortgage loans could go beyond helping borrowers and enable them to profit - or avoid losses - on the derivatives contracts sold to the hedge funds.
"Manipulation is a charged term, but there are concerns that the potential for manipulation is there," said Karen Weaver, global head of securitisation research at Deutsche Bank.
This is because, in contrast to other strategies for managing troubled mortgages, these loan modifications show up in performance reports as no longer in arrears. Loans modified in this way would not trigger writedowns of bonds backed by such mortgages, and in turn, this could mean an investment bank would not have to pay out on derivatives contracts tracking those bonds.
Robert Lacoursiere, research analyst at Bank of America said: "True credit exposure will be masked because worked out loans are considered performing and will no longer be disclosed once they are disseminated into the performing loan pools."
The dealers, meanwhile, argue that the terms of the underlying mortgage-backed securities explicitly permit such loan modifications for the underlying mortgages, provided they are in the best interests of borrowers and investors in the securities.
In recent weeks, Bear Stearns became so concerned that these terms were poorly understood by some derivatives traders that the bank proposed new legal language to the International Swaps and Derivatives Association to clarify the situation. The bank later withdrew it, but stoked debate.
Tom Marano, global head of mortgages at Bear Stearns, said: "We believed that the original ISDA documentation adequately disclosed that investors should look at the provisions in the underlying securities, and that the ability to modify loans was adequately disclosed in the bond documentation. When we saw the debate in the market, we thought it was worthwhile to try to reiterate our position."
Bear Stearns has been particularly active in mortgage servicing through its subsidiary, EMC Mortgage Corporation, which recently launched the "EMC Mod Squad" to help struggling borrowers modify their loans or pursue other options. EMC says loan modifications have increased by more than 300 per cent since February.
Mr Marano emphasises that there is no communication between the bank's derivatives traders and its mortgage servicing arm.
Nevertheless, the hedge funds remain concerned that some loan modifications could mainly benefit the dealers' derivatives traders. One of their arguments is that loan modifications are expensive and often fail, with 40 per cent of borrowers in modified loans back in arrears within a year.
However, Mr Marano argues that, in many cases, loan modification is still the best option to minimise losses because foreclosures can cost even more, with losses of up to 50 per cent of the loan balance in markets with falling house prices.
"We also require the borrower to stay on their repayment plan for three payments before they are treated as current borrowers. If a borrower falls off the plan in that period then we resume the normal foreclosure process," he said.
Ms Weaver at Deutsche Bank said: "The bottom line is that when a servicer modifies a loan, they have to represent that they believe they can maximise the value of the loan by doing a modification as opposed to choosing another option. There's a fiduciary responsibility there."
Moreover, whatever their motivation for modifying loans, dealers can only make changes if borrowers agree.
"A lot of the most problematic mortgages were taken out in late 2005 and 2006, when many borrowers took on huge loans on the belief that house prices were going up," said Ms Weaver. "That hasn't happened and those homes have become albatrosses, so a lot of borrowers may just walk away."
Part of the problem is a lack of specialist knowledge on the part of some hedge funds, one dealer said. "There are participants in the derivatives market that don't understand the servicing process and don't understand the mortgage process. They are great macro players that made a great call on a sector that was going to underperform but they didn't take into account that servicers have options to modify the loans."
Some investors, particularly those active in both the cash and derivative markets, say that the solution is greater disclosure. Mani Sabapathi, portfolio manager at Prudential said: "It may be an unintended consequence that the derivatives are affected, but I doubt it's malicious. What investors really want is better disclosure and reporting of modifications to model how the securities will change, and that's not there yet."