It is a perverse fact of life in the market for financial instruments that the well-intentioned quest for safety very often leads to the worst sort of dangers.

Almost 20 years ago, the great crash of 1987 came about in large part as a result of stock market participants' purchase of a kind of portfolio insurance that paradoxically caused the very type of volatility it was intended to prevent.

About seven years ago, the Long Term Capital Management hedge-fund crisis sprang from a wrongheaded theory by prize-winning economists that tons of money could be made with little risk by betting that the sovereign debt of various European countries would converge.

And now we learn that one or more major hedge funds may have suffered substantial losses this month -- and potentially ignited a "contagion" -- as a result of blown-up trades related to U.S. automakers in esoteric risk-avoidance instruments called collateralized debt obligations and credit-default swaps.

The trouble this time is unlikely to be as deeply pervasive as the first two, in which a passion for risk-aversion by well-capitalized institutional investors heaped billions of dollars of losses on the public. But because these instruments have never been stressed in a real-time crisis, it's hard to know exactly how they will act. We may discover that they could ultimately batter the public just as soundly.

Why should you care? It's tempting to view hedge funds harshly for any misjudgments they may have made. After all, in the popular imagination they are cowboys on the risk-taking fringe, only out for themselves.

Yet the reality is quite different. The hedge funds at the root of the problem may actually have been working on your behalf -- and at any rate they were tripped up by pretty conservative trades that went terribly wrong. The trouble that they encountered was the investment equivalent of getting hit by a truck while crossing the street at a well-marked intersection. Maybe you didn't look both ways, but the fact that you got crushed is more bad luck than bad karma.

The Emergence of Hedge Funds

To understand what happened, let's dial back and consider what hedge funds are and the background of their transactions.

From the time of their invention through the mid-1990s, hedge funds were primarily partnerships limited to investments by rich people that focused on profiting from both positive and negative moves in stocks, bonds, currencies and commodities. There are dozens of different types of specialist funds, but the purpose of most is to provide steadfast returns uncorrelated with the trend of the market on which they focus. The funds' members, or limited partners, pay managers up to a third of the profit for annually delivering the holy grail of investing: great results in good times or bad.

In the early part of this decade, amid a raging bear market, a handful of major corporations -- led by

General Motors

(GM) - Get Report

, ironically enough -- grew concerned that their pension funds would never meet their investment goals if they continued to focus strictly on long-only stock-and-bond strategies. So they directed their pension managers to put billions of dollars on behalf of their retired blue-collar workers into "alternative investments," which is a term of art for hedge funds.

Broadly speaking, pension funds try to maintain a balanced allocation of 60% stocks and 40% bonds. The idea of that split is that they'll get more bang for their buck out of stocks -- and yet if equities are soft, returns will be cushioned by nice, safe bond yields. The problem has been that the

Federal Reserve's

expansive money policy of the past few years created a financial regime in which bond yields were extremely low -- and yet stock returns haven't been too hot, either.

Bundling Up Bonds

So what's a pension manager to do? Well, in pursuit of returns of 8% to 10% in a negative or flat market, many sought out bond hedge funds that promised to use new mathematical modeling techniques to seemingly manufacture money out of thin air.

When you hear the word "bond," you probably think of a U.S. government or corporate debt instrument that pays holders an annual interest payment whose size is related to risk and duration. Short-term U.S. Treasury bills backed by the government's taxing power pay the smallest amount of interest, while the long-dated obligations of iffy companies with poor credit -- known as "junk" bonds -- pay the most.

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But between those two extremes is a wide range of debt products. To make it simpler to buy and sell them, investment banks came up with the idea to "securitize," or bundle up, a lot of different types of bonds into instruments called "collateralized debt obligations," or CDOs. These are in turn sliced up by banks into smaller pieces, generally categorized by risk, that are known by the French word "tranches."

Something like 90% of all corporate bonds are securitized and resold in this way -- spreading out the risk in a way that helps issuers get financed and grow.

New Financial Models

Now enter the hedge funds seeking to provide dependable returns to pension managers. A new breed of math geniuses entered the scene not too long ago with financial models that they believe help them understand when certain tranches are undervalued relative to other tranches. The big idea is that if you can figure out which ones are overpriced and likely to lose value, and which ones are underpriced and likely to gain in value, you can short one and buy the other and make a few bucks as their prices converge.

One of the big trades that hedge fund managers working on behalf of your pension put on in recent years has been to buy the "mezzanine," or medium-risk bond tranche of CDOs, and short the equivalent amount of money in the equity tranche or equity of the company. The amount of money involved in these trades is quite enormous; because the trading environment was so tame up until quite recently, the equity tranches were leveraged by as much as 17 to 1, according to Peter Petas, research director at the corporate capital-structure research firm CreditSights in New York.

Automakers are among the biggest sellers of bonds in the U.S., so they are overrepresented in even the most diverse CDOs. And now we get to the heart of the matter.

Enter Kirk Kerkorian

What happened last week that imperiled a number of hedge funds' carefully constructed credit-spread compression strategies was the very unusual span of two days in which Los Angeles financier Kirk Kerkorian first announced a significant bid for General Motors stock at a premium, and then debt-rating agency Standard & Poor's downgraded GM bonds to junk status. As you might recall, GM shares went straight up and then its bonds went straight down -- blowing up a trade that was leveraged to the hilt. In the space of a few hours, an unknown amount of highly leveraged hedge-fund money that probably totaled well into billions of dollars went


No hedge fund has admitted yet that it was on the wrong side of this trade, but it will eventually come out. And the reason that it can have a "contagion" effect is that the funds at risk will undoubtedly face a large number of redemption requests from their members -- and failure of a fund could have a combustible impact on its counterparties and prime brokers, which are big investment banks.

Fallout -- and Bankruptcy?

Funds are required by contract to provide "liquidity" -- that is, cash -- to members either at the end of a month or a quarter. So, many in the investment community are holding their breath now, waiting to see how many funds need to liquidate stock and bond portfolios in order to meet a flood of redemptions.

One serious issue is that CDOs may be widely sold, but they are not terribly liquid. There is no easy market for these things, and they can typically only be sold back to the organization from which they were purchased. Plus, since they are just sitting on the funds' books for long periods of time, they are usually not marked to market, or priced, until the time of sale. And that is why no one really knows how much money is at stake.

"We have seen that these sorts of trades only work until they stop working," said Peter Petas, of the capital structure research firm CreditSights. "It is not the most tested market, but guys are taking these trades anyway to get yield in a low-volatility environment."

If we see big up days in the market followed by big down days, you can be sure that funds are using every uptick to unload inventory to meet their obligation and avoid bankruptcy. At times like this, the Federal Reserve and other central banks have learned to flood the system with money to avoid big disruptions. So from now until the end of the month, or quarter, there may be an interesting battle between the private forces of fear and the public forces of balance. Stay tuned: It could be your money.

Jon Markman, writer of Value Investor, is the senior investment strategist and portfolio manager at Greenbook Investment Management, a division of Greenbook Financial Services. Separately, he is publisher of StockTactics Advisor, an independent weekly investment research service. While Markman cannot provide personalized investment advice or recommendations, he appreciates your feedback;

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