This is the latest story to get all those bears out their excited (from DealBreaker.com)…

In case you missed it this weekend, Merrill seized $400mm in assets from a Bear Stearns hedge fund and is auctioning them off starting today. The Ralph Cioffi led fund scrambled to avoid liquidation late last week, auctioning off over $4bn worth of bonds Thursday morning alone, culminating a protracted struggle to sell assets to stay afloat. The fund has sold $7bn worth of bonds since May and frozen redemption requests.

Also, pay attention to the last line in this little news story….

The Bear fund originally raised $600mm in investor capital and borrowed $6bn from banks to bet the wrong way on the ABX.

When you are leveraged 10 to 1 making a mistake hurts. But it hurts your bankers more. After all, guys running the fund have already been paid and investors only invested 600 million. But the banks are on hook for 6 billion dollars.

That is why I think Merrill moved to pull the plug. They probably hoped that if got out first they could leave the banks holding bag. But it has not turned out to be that simple for Merrill (this from Reuters)…

Merrill is delaying selling the assets until it hears the troubled hedge fund’s plan to recapitalize, the network reported. Merrill and Bear are expected to discuss the plan on Monday or Tuesday, CNBC said.

Calculated Risk speculated over in the comments on his blog that Merrill did not like the price that they were going to get if they sold the Bear collateral at a fire sale. He thinks that this is why they are having second thoughts.

Myself, I wonder if this does not have more to do with one division of Merrill saying to the other, “hey, if you make Bear go down you are going to take us down with them.” After all, it was just this February that Merrill was spending big money trying to catch up with Bear Stearns (this from Bloomberg this February)….

Merrill Lynch & Co. Chief Executive Officer Stanley O’Neal was willing to lose $230 million to catch Bear Stearns Cos. and the shakeout is just beginning.

That’s because Merrill is determined to capture a dominant share of trading in bonds backed by home loans, the fastest- growing debt market since 1995 and this year’s most troubled. O’Neal’s enthusiasm for mortgages to potentially delinquent borrowers coincides with the highest default rate in more than six years, a record contraction in demand for so-called subprime loans and descending bond prices.

Merrill already has bankrolled two home lenders that subsequently failed and purchased a third, First Franklin Financial Corp., for $1.3 billion, just before HSBC Holdings Plc disclosed that its bad-loan provisions increased 20 percent because of the unraveling U.S. subprime market.

Now running hedge fund that bets on a bond market is different then trading bonds on the market. Still, I can imagine a scenario where some Merrill bond traders might be telling their bosses that if the Bear’s hedge fund goes down, they go down. That is the fun of modern financial markets. Everyone is dependent on everyone else, even their rivals.

Of course, all that is only speculation. In fact, nobody even seems to no for sure why or how the Bear hedge fund got into trouble or even how much trouble they are really in (though if you are facing margin calls, you obviously have problems). Felix has a good overview of the problem over at his blog. I will only quote the last to paragraphs because they are the most deliciously ironic….

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.

Edit 6/19/07: Merrill listened to Bear’s plan to get out of their troubles and—drum roll please– decided to sell Bear’s collateral anyway. See this blog post from Calculated Risk.