By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

If there's one lesson you can take away from this financial crisis, it's this: Whenever the U.S. Federal Reserve squares off against the financial markets, it ends up as the loser.

In recent weeks, I've written several articles suggesting that the credit crisis isn't over and detailed the three indicators that led me to this conclusion – despite what the politicians, the pundits and all the other so-called "experts" would have you believe.

Now, there's a fourth.

It should come as no surprise that there's more distressed debt trading right now than at any other point in history – nearly $184 billion worth. And that's just the "official" tally; we know that the actual total is much higher – it just hasn't been fully tallied and reported, yet.

Historically, large levels of distressed debt have preceded record numbers of bankruptcy filings – including some of the biggest corporate bankruptcy filings in history. Default ratios usually peak 12-24 months after the distressed-securities ratios reach their own apex. In other words, both the level of junk debt and the classification of distressed securities can be viewed as leading indicators.

And what they suggest for 2009 isn't good.

In an era of trillion-dollar problems, a mere $184 billion doesn't sound like much, but that total actually is 11.52% higher than the $165 billion in distressed debt reported immediately after the last bankruptcy boom, according to Moody's Investors Service (MCO).

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Analyst Christopher Garman, former head of high-yield strategies at Merrill Lynch & Co. Inc. (MER) recently told Reuters that the current level of distressed debt suggests nearly $97 billion in defaults could be headed our way next year.

Even now, the problem is so acute that one in every three junk bonds is now trading at "distressed levels" – defined as an interest rate that's 1,000 basis points or more above comparable Treasury securities. That means that 33% of the junk bonds out on the market aren't worth the paper that they're printed on.

At a time when the U.S. economy is struggling with a credit crisis, high energy prices, these distressed-debt issues could end up squeezing profit margins, increasing default rates, and dramatically boosting borrowing costs – any or all of which could feed into a self-repeating cycles.

General Motors Corp. (GM) and Ford Motor Co. (F) lost their investment-grade debt status years ago. But for other companies embroiled in the derivatives markets and the subprime mess, this is an uncomfortably new phenomenon. And that's why their leaders are "shocked" to find that normal financial channels are no longer open to them.

No wonder so may CEOs are sitting behind their finely turned mahogany desks, feeling the waves of panic rising inside themselves as they realize the bond markets are telling them that they won't be around long enough to collect on their gilt-edged retirement plans (Ironically, however, the same signals may be telling those same CEOs that it's increasingly likely they'll be collecting on their "golden parachute").

Obviously, there are two sides to the story here.

On one hand, U.S. Federal Reserve Chairman Ben S. Bernanke, and now U.S. Treasury Secretary Henry M. "Hank" Paulson Jr., have literally pulled out all the stops to keep this from happening. Clearly, this "Dynamic Duo" believes that by saving individual companies via their "bailouts for (almost) all" strategy, they will save the entire economy. So what they've done is to make it possible for firms that are in such deep trouble that they can't obtain loans anywhere else to be able to borrow from the federal government – and on very favorable terms.

Ostensibly, this is a very good thing – or, at least, the feds would have us believe so.

But a super-close inspection suggests the opposite is true.

Of course, in the process the Fed Bailout Brigade has put every U.S. taxpayer in the recovery business to the tune of $10 trillion (or more) – but that's another story for another time.
 
The scramble to save American International Group Inc. (AIG) has resulted in an $85 billion bailout package with terms so onerous that one analyst likened it to a "controlled bankruptcy."

And where there's smoke there's fire. As the assets of Lehman Brothers Holdings Inc. (LEH) and AIG are both sold into a depressed market, the net effect will be a spread of this contagion to the rest of the financial-services sector – which includes investment banks, thrifts, and hedge funds holding similar assets. That will further pressure already-skittish markets.

Unfortunately, history shows that more often than not when the Fed has squared off against the markets, the Fed ends up as the loser. That's why we've been such vocal critics of the central bank's moves since this crisis began, stating that its unprecedented interventions would do nothing more than delay the inevitable pain.

We wish the opposite were true.

News and Related Story Links:

• Wikipedia:
  Distressed securities.

• TheStreet.com:
  Leading Economic Indicators.

• Wikipedia:
  investment-grade

• Wikipedia:
  Golden parachute.

• Wikipedia:
  Henry M. "Hank" Paulson Jr.

• Bloomberg News:
  AIG Falls on Concern Shareholders Will Be Wiped Out.