A group of hedge funds is telling the U.S. Securities and Exchange Commission to be on the lookout for manipulation of bonds backed by subprime mortgages.

Paulson & Co., based in New York, told the SEC that investment banks may pay inflated prices to buy bad loans that are collateral for bonds, said Michael Waldorf, a senior vice president at the hedge fund. Removing delinquent loans may prevent bonds from defaulting and triggering losses in the banks’ investments in derivatives, he said. Waldorf declined to name the other hedge funds that also warned the SEC.

It would be “penny wise and pound foolish” for an issuer to conduct significant buyouts other than to meet contractual requirements to make up for misstated loan characteristics or fraud, because investors would shy away from the company’s future deals, said Peter Cerwin, who runs the portfolio management group at New York-based Credit-Based Asset Servicing and Securitization, or C-Bass, an issuer and servicer.

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