Kass: Hedge Funds' Dirty Little Debt Secret

Illusory Fund Profits

On a different note, a lot of hedge funds are now trembling -- and I don't mean because Congress wants to raise the tax rate on general partners' carried interest. The big hedge fund secret is that, barring credit downgrades, many leveraged and esoteric investments (such as the collateralized debt obligations that inhabited the Bear Stearns hedge fund) aren't marked to market.

This creates the illusion of profits in a hedge fund, until an outsized event (the subprime mess, Russia's refusal to pay its debt, a terrorist event) occurs. Then the proverbial excrement hits the cooling device.

Regardless, there is likely a large amount of undistributed senior risk sitting in dealers' hands today; that is one of the reasons I recently wrote a cautious piece on the brokerage industry.

The lessons to be learned from this crisis are that market values matter for leveraged portfolios; models sometimes misbehave and must be stress-tested and combined with judgment; liquidity itself is a risk factor; and financial institutions should aggregate exposures to common risk factors.

And portfolios should be marked to market.

Other stocks that may have "mark to market" issues include private-equity-funds-turned-public poweerhouses: Fortress Investment Group (FIG) and Blackstone (BX) BX as well as other banks that mix their own proprietary trading with their banking services, including firms like Goldman Sachs (GS), Lehman (LEH)and JP Morgan (JPM).

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