The Lie That Will Kill Hedge Funds

But the strategy isn't risk-free. Only Treasuries are risk-free.

Now I am showing a really consistent rate of return because of that trade and dozens like them -- regardless of the stock market. So funds of funds drool and throw money at me and I keep buying more mortgage-backed securities and borrowing Treasuries. I can handle trillions!

Houses go up in value, mortgages get paid, employment's strong; that's all that matters. The bonds pay.

But housing stops going up in 2006. I keep buying the bonds, but I keep reading there are defaults. I don't see it. My traders don't see it. Everything's seems very ethereal.

And then in June, Bear Stearns (BSC Quote), doing this strategy at its funds, gets told the bonds are moving down in value and it must put up more collateral. But it doesn't have much cash and all of it is deployed. So it sells some bonds to meet the call. But nobody wants the bonds; everyone reads the papers and knows that defaults are mounting. So by the time it finishes selling the bonds, which now have no natural buyers, the collateral is gone. The funds close.

That happens in June. In July, the funds of funds get their reports and they see that, let's say, one of the funds is down 10%. They immediately put two and two together and they figure, "Wow, we could have a Bear on our hands." They go to the manager with redemptions.

But things are much worse than they seem. The "marks" -- meaning what the bonds in their portfolio are marked or priced at -- is some last sale price, presumably around par because they don't trade.

A redemption notice forces the trade. There are no buyers. That's how a Sowood could be down 10% at the end of June and 50% a few weeks later.