Receiving 5% on one US Government Bond and paying 2.5% on another US Government Bond with the same maturity is an obvious winner, but many hedge funds went bust in 2008 because they were unable to hold their trades to fruition.
I don't know this market so I can't explain what happened to this trade back then. But having done many, many equity pairs trade in 2008-2009, I can spell out some of the issues in a such long-short arbitrage.
1) You pay out the yield on the short position. This isn't a problem if you're shorting the low yield and buying the high yield.
2) You pay out the borrow rate on the short position. It can be nominal or if there's an extreme amount of subsequent shorting, it can rise significantly.
3) When there's panic (see 2008), brokers can increase the margin rate, requiring more collateral.
4) If the pair isn't highly correlated and market participants rush to buy your short leg (flight to safety?), price diverges and your collateral requirement increases.
Now imagine the guy (or firm) that is margined to the gills and some combination of these events increases his margin required. He can't sustain the trade. The paragraph following your excerpt states:
We hold about 50% of our fund as unencumbered collateral, precisely for situations like this. At our low point (end of October 2008), we still held 36% of our fund as excess collateral. We were able to hold this trade through the chaos. Despite entering the trade way too early and suffering initial losses as well as losses from other trades around the world, our collateral was sufficient to maintain our positions.
It required 14% of their collateral to hold onto the trade. The over margined guy was toast.