I think I was reading Veryan's latest post about the Bear Stearns "hedge fund" blowup when it occurred to me that the problem became one of correlation. (I mean, the technical reasons a varied and all, and I'm no expert, but in the end it came down to correlation, as I see it.)
Lets say that both funds were long CDOs and possibly had synthetic exposure as well (wrote CDSes against the CDOs, etc.) and short the ABX indices, which is the description I've read. Now, both of these instruments are tied, fundamentally, to the mortgage market. Correct me if I'm mistaken, but the point of the hedge should be to offset the moves in the long position, with hopefully enough leverage applied to make a difference. You have to be careful with the leverage however, because too much in the wrong direction would offset the gains on the other side (which, again, mirrors the description I've heard of the Bear Stearns funds).
In the configuration described above, when these positions start heading south, there is no place to hide. Both of them are tied to mortgage instruments. Shouldn't the hedge have been in instruments with negative correlations to the CDOs and other instruments in the long portfolio? Even worse, the positions they needed to get out of the most quickly were the least liquid (which makes so little sense to me!).
Now, I would imagine someone is going to point out something I've missed. There's some assumption that I have overlooked that SHOULD have allowed this magic to work. However, the fact is that the magic DID NOT work.
So what we appear to have here, fundamentally, are two positions which are too positively correlated to be tied to each other. Had the hedge been in anything other than other mortgage related securities (Zimbabwean stocks?), then there might have been a chance. Too much positive correlation and too much leverage applied in the wrong place seems, to me, to have doomed these funds.
Now, what lesson can be learned from this? Diversification maybe? That seems like a big one. But even in such a concentrated portfolio, it would have made sense to have more diversification of credit securities. I could imagine less or no leverage on the long positions and mild leverage on the shorts, with the hedge being mildly levered purchases of mortgage CDSes. The fund weren't (aren't) short credit funds, right? So I can't imagine them positioning negatively in the credit markets, which is probably the best place to have been this year.