There are several threads addressing this issue that have been marked as resolved, when they are clearly not.
WP Smush it is all about reducing image file size so your pages load faster, as suggested by Google and Yslow etc. Serving images from a subdomain also allows for faster file download.
Since the update to this plugin from 1.6.5 to 126.96.36.199, the ability to smush images that are in fact in the worpdress directory, but served from a subdomain is no longer possible.
For example, WordPress recognises the images in the media library and the content is in fact in wp-content/uploads, even though the Settings in Setting > Media > Full URL path to files links to a subdomain, i.e. http://images.website.com
So, for those that are looking for a solution until this is actually fixed, roll back to 1.6.5 by downloading here. I rolled back and I'm now serving images from a subdomain that have been smushed. Including Bulk Smush.