Keith Fitz-Gerald

The Fed Will Drown Swimming Against the Tide

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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.

The Storm Before the Storm

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 to 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).

Analyst Christopher Garman, former head of high-yield strategies at Merrill Lynch (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 and 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 self-repeating cycles.