According to a recent article in the Economist 1,000 hedge funds are estimated to have used "mark to model" techniques to smooth out returns according to Risk DATA. This is a dangerous and foolhardy game. Many buyers could argue (legally) that the "risk" component of their investment was mis-represented by this smoothing.
My own opinion is that funds should report results on a mark to market, mark to model, VaR and Cost basis. If they can't mark to market, then mark to cost or provide data for others to make their own conclusions. Many managers complain this would tip their hands to competitors. My own belief is that the hedge fund universe will be contracting a bit in the future as too many entrants pursued it as a compensation class and not an asset class. Hopefully a little economic Darwinism makes things better for everyone else. We can also hope this is a "wall street" issue and not a "main street" issue.
The CDS and CDO market are just the most visible areas of abuse, but may actually have performed their function of transferring real estate default risk away from overly concentrated poor geographic neighborhoods. Now if Greenwich and Manhattan can just take the economic heat from these poor investments.
Soros among other doesn't like barrier options and some of the other more esoteric instruments that are more about taking a bet than really transferring risk or providing some useful economic function. My own bias is to keep it simple, if you have to call higher powers than algebra or a black scholes (Thorpe Bachelier ask Taleb) model to price something, you may have entered voodoo economics.