Bear's Benighted Bearish Bear-Market Bet

What's causing the losses at Bear Stearns's High-Grade Structured Credit Strategies Enhanced Leverage Fund? On Saturday, Kate Kelly of the WSJ reported that the fund was short subprime indices:

The Bear fund has different bets on the health of subprime mortgages, both positive and negative, but has been hurt particularly by a negative bet after a rebound on a key index that tracks the sector...
The fund bet a popular index that tracks subprime mortgages, the ABX, would fall. Late last year and early this year, those moves bore good returns, says a person familiar with the matter. Then the tide began to turn. After reaching a low of 62 late in February, amid rising numbers of defaults and delinquencies in the subprime market, the ABX unexpectedly recovered in the months that followed, reaching 72 in mid-May. It has since gone back down to 61. This led to losses for Mr. Cioffi.

I can see how someone who was short the ABX would suffer on its way up from 62 to 72. But why is the fund suffering now, when the ABX is at an all-time low? There are a few different answers.

First, hedge fund strategies are very complicated things. Journalists love to be able to sum them up in a clean sentence: LTCM bet that credit spreads would narrow, or Amaranth bet that the spread between two gas futures contracts would rise. But in fact most hedge-fund strategies are more complicated than that, and a "short" bet on subprime mortgages can go very sour even when the ABX index is falling.

That's especially true in the world of subprime, where the ABX index is more of a trading vehicle than an actual index of how the subprime market more generally is doing. It should certainly not be thought of as an index like, say, the S&P 500, which impartially reflects the performance of underlying securities. Given the illiquidity of most subprime securities, that wouldn't be possible: that's why most traders prefer to trade the ABX instead. But that does mean the ABX has something of a life of its own, and that anybody using it to extrapolate wider subprime woes should tread very carefully.

Finally, of course, there's the possibility that Bear's Cioffi was forced to cover his short positions on the way up from 62 to 72, and incurred a lot of losses in May, rather than during the more recent move back south. With his ABX short covered, he found himself long the market at its highs, just as the market was set to take another tumble. And with his short-covering losses spurring redemptions, he found himself unable to get out of his long positions in a bear market without suffering even bigger losses. In other words, he lost money on the way up and then lost even more money on the way down.

This is all speculation, of course, and even Bear Stearns itself is probably unclear on some of this: otherwise it wouldn't have had to alter its official April results from a loss of 6.5% to a loss of 19%. Besides, officials at Bear probably have bigger problems on their hands right now than explaining to journalists exactly what went wrong and how. Still, this is already a salutary case: a hedge fund seems to have managed to go bust by making bearish bets in a down market. Leverage can have that effect, if you're not careful, or if you're unlucky.