When Hedges dont work ..

In a trading environment, traders typically hedge their exposure to minimize their exposure to price risk in the event markets turn against them.
The most efficient of all hedges is to have a back-to-back trade (meaning that the trader buys an asset and then sells the off the same asset at a profit) - effectively here, they would have earned a margin without any exposure to any underlying.

For Merrill Lynch, which just reported their 2nd Quarter 2008 results, their results is simply painful to watch. Merrill Lynch is sitting on a pile of Asset-Backed Securities CDOs (hedged position) which they hedged using CDS (Credit default swaps) (hedging instrument). Now, this is not the most effective hedge but it should still offset losses under normal trading environment.
Theoretically, if their CDOs tank, their hedges would make money.
But, as we are now living in unprecedented times, even their hedges lost money, exacerbating the overall losses. This makes for really painful reading. The reason that is that there is a severe deterioration of the creditworthiness of the financial guarantors of their CDS positions, which essentially wipes out all gains made on the position. What this basically means that the counterparty which the CDS were traded against is in a less financially stable position and that there is a higher risk that the trade may not be settled.
Ouch ...