Kass: Hedge Funds' Dirty Little Debt Secret

Their investments are creating an illusion of profits. Which stocks could be at risk.
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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.

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) - Get Report

BX as well as other banks that mix their own proprietary trading with their banking services, including firms like

Goldman Sachs

(GS) - Get Report

,

Lehman

(LEH)

and

JP Morgan

(JPM) - Get Report

.

At time of publication, Kass and/or his funds had no positions in stocks mentioned, although holdings can change at any time.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd. Until 1996, he was senior portfolio manager at Omega Advisors, a $4 billion investment partnership. Before that he was executive senior vice president and director of institutional equities of First Albany Corporation and JW Charles/CSG. He also was a General Partner of Glickenhaus & Co., and held various positions with Putnam Management and Kidder, Peabody. Kass received his bachelor's from Alfred University, and received a master's of business administration in finance from the University of Pennsylvania's Wharton School in 1972. He co-authored "Citibank: The Ralph Nader Report" with Nader and the Center for the Study of Responsive Law and currently serves as a guest host on CNBC's "Squawk Box."

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