Financial firms are facing a tough choice as they decide how to deal with their hedge funds’ sub-prime woes, says National Bank Financial in a research note.

NBF says that the hedge fund industry is facing a serious stress test, as it contends with trouble in certain illiquid assets. And, it notes that this is occurring at a time when the hedge fund industry has grown by a factor of five (since 2000), to exceed $1.7 trillion in assets under management, without really experiencing a full fledged credit or business cycle.

“Like Bear Stearns a few weeks ago, BNP Paribas decided on Thursday to temporarily suspend some of its hedge funds’ operations, including redemptions, saying that current market conditions make it impossible to value their assets,” NBF notes. “As some investors are beginning to realize, many hedge funds have invested in different risky, and sometimes illiquid, financial instruments (like subprime mortgages) in order to deliver higher returns.”

“As long as investors kept their optimism (home price appreciation, double-digit profit growth, low default rates, etc.), the highly-leveraged hedge fund and private equity industries were able to attract money and keep the bull market rolling. However, as some market participants would realize these days, human nature has not really changed over history about risk perception, shifting sometimes from greed to fear,” it says.

“After spreading the risk everywhere through securitization, banks and brokers are now facing some difficult choices: step in to buy back risk and provide market liquidity on some assets, or stay on the sidelines and proceed with further margin calls, with the risk of exacerbating market turmoil,” NBF observes.

“Credit risk may have been passed along, but it has not evaporated. What goes around eventually comes around!” it concludes.