Kass: Hedge Funds' Dirty Little Debt Secret

This column was originally published on Street Insight on June 26 at 8:01 a.m. EDT. It's being republished as a bonus for TheStreet.com and RealMoney.com readers.

The downside of the leveraged and carried trade, mainly through the Bear Stearns (BSC) High-Grade Structured Credit Strategies Fund, has been opened up like a Pandora's box of inflated hedge fund valuations, impotent credit ratings and other risk issues.

It all started with the erosion in subprime credits, as delinquencies and foreclosures in late 2005 skyrocketed after housing affordability was stretched by a sustained period of low interest rates, which encouraged housing's speculative activity (the outgrowth of which was record buying of non-owner-occupied investment properties) and the insensibilities of lenders.

The culprits and sinners of this cycle are plentiful. They include a too-easy Federal Reserve, loosely regulated and heedless housing lenders, avaricious home speculators, funds of funds that encouraged hedge fund investors to leverage, greedy hedge fund investors -- you would have thought that they learned from the demise of John Meriwether's Long Term Capital Management -- irresponsible ratings agencies that were reluctant or ill-equipped to downgrade credits, brokerages that packaged these complicated products and, of course, hedge fund managers who have the temptation of large compensation incentives to take undue risk. (They participate in at least 20% of the fund's profitability.)

Reckless lending and the egregious use of leveraged capital has permeated our financial system, raising the risk that the subprime disaster is the leading edge of a deteriorating credit cycle and that its effect will be chilling.

The key to the ultimate impact will be the slope of the economic cycle. If the bulls are correct and a sustained period of economic growth (free of inflationary pressures) is in the cards, credit problems will likely be contained. If I am correct that we are moving toward a recession in early 2008, the subprime mess will be only the tip of the iceberg, and problems will move up the credit ladder.