The Wall Street Journal Thursday reported that no less than 71% of companies with Standard and Poor’s credit ratings had junk-quality ratings – BB and below—in 2006, up from 32% in 1980. An astounding 42% of companies with credit ratings were rated single B, the lowest possible credit rating that isn’t vulnerable to immediate default. Only 7% of rated companies were single B in 1980. So does B stand for Bankruptcy – or just for harmless, profitable Bubble?

The modern corporate finance fetish for debt originated with the Modigliani-Miller Theorem of 1958, which said that the value of a firm was unaffected by its capital structure, so that it didn’t matter how much of its capital was debt, how much equity. Modigliani/Miller and its corollary the Efficient Market Hypothesis both made assumptions that aren’t remotely true in the real world, but they quickly became popular with non-practitioner academics, because they appeared explanatory and subtly downgraded conventional financial skills. Academics thus promoted the theories vigorously among their students, so like many well marketed academic nostrums, they eventually became fashionable among practitioners as well as theorists.

Prior to 1958 and for some years afterward, U.S. financial managers, in those days with experience of the Great Depression, limited their debt to the amount on which interest and principal amortization could be paid even in the bottom of a severe recession, when operating revenues were at the nadir. This led to very low leverage ratios; generally debt was no more than 20-25% of total capital.

Since debt payments were tax-deductible and dividends weren’t, it followed from Modigliani/Miller that a rational company would maximize the amount of debt on its balance sheet, subject only to the constraint that actual bankruptcy imposes additional costs on all parties. The advent of inflation in the late 1960s made debt financing seem even more attractive. Then the sloppy Jimmy Carter-era Bankruptcy Code of 1978 introduced the Chapter 11 provision, whereby in a debt default management could control a corporate reorganization themselves and remain in office, with only the unfortunate shareholders losing out. From that point, turbo-leverage was off to the races.

As the junk bond market exploded in the 1980s, it was expected to lead to an enormous number of defaults, which would in turn lead to a retreat from the market and a rebalancing of credit appetite by investors. In 1990-91 and again in 2000-01 there were a lot of defaults (the latter concentrated primarily in telecoms) but not the level that had been anticipated. There were two reasons for this.

First, much of the junk debt had been raised in the period of very high interest rates in the early and middle 1980s. Hence the secular bull bond market of 1981-2004, in which long term interest rates dropped by over 8%, while inflation continued significant and the U.S. economy remained generally strong, made the leverage in the borrowing companies diminish as cash flow improved and interest rates declined.

Second, except for a modest squeeze in the early 1990s there has not since 1980-82 been a period of tight liquidity. Instead the Federal Reserve has since 1993 been increasing M3 money supply by close to 10% per annum. In such an environment, unless the borrowing company’s operations have truly deteriorated (which happens only occasionally if there is no recession) it can always indulge in take-out refinancing, borrowing more money to cover its cash flow deficits.

This is the ugly secret about B rated bonds: if monetary conditions remain easy, then increased investor appetite allows potential defaulters to refinance instead of defaulting, which in turn keeps default rates low and increases investor appetite. This has particularly been the case in the last few years, when hedge funds have been able to raise almost unlimited capital from foolish institutional investors, leverage themselves to the hilt, possibly in yen, from foolish banks and then invest the gigantic proceeds in junk bonds, for their modest additional yield above U.S. Treasuries.

Provided the junk bond market doesn’t crash, so refinancing of all but the worst rubbish is still readily available, hedge funds can in any given year achieve with almost complete certainty a satisfactory return, at least 20% of which will flow to the hedge fund managers personally. Thus the normal corrective mechanism of rising default rates ceases to work, and the market spirals towards bond-market nirvana. Essentially the safety valve on the engine of speculative financing has been jammed shut.

This is even more the case internationally. The only thing that ever causes countries to default is a refusal by the bond markets to finance their deficits. Since in an easy money period, with generally declining spreads, the bond market is open to all borrowers, no defaults ever occur. That’s why there has not been a sovereign default since Argentina went in December 2001. The IMF and World Bank and the Bush administration can hold conference after conference congratulating themselves on their superb management of the international financial system, which has caused the world to be free from “crises” for half a decade. In reality the lack of crises is nothing whatever to do with good management, but is simply a function of excess liquidity.

The perverse incentives in emerging market junk bonds can be illustrated by the case of Argentina. Having defaulted on its international debt, forcing tens of thousands of middle class Italian savers (the main buyers of its bonds, presumably because of family connections) to accept only 30 cents on the dollar, having stiffed several foreign banks with local operations and a number of foreign utility companies foolish enough to invest there, Argentina is now living high on the hog. Four years of rapid economic growth, temporarily freed from onerous foreign obligations have produced a real estate boom so extreme that the government has ceased issuing construction permits, and have made the country one of the world’s most attractive markets for luxury goods retailers.

This is the difference between corporate and national credits. If Enron had been a country, “Enronia, Queen of the Pampas” lenders and investors would be showering money on it today, and Jeff Skilling, rather than facing a 24 year jail sentence, would be seen, blonde on each arm, happily campaigning for triumphant re-election.

The market for emerging market bonds is as distorted as any market in history. Both spreads and interest rates are low, so that the J.P. Morgan EMBI+ emerging market bond index yields well under 2% above Treasuries, thus providing investors in some of the world’s dodgier credits with returns of a princely 6% or so. Oddly enough, emerging market stocks are not particularly overvalued; the Morgan Stanley Capital International Emerging Markets Index is on a price/earnings ratio of about 14.

Moreover a portfolio of emerging market stocks that matches the MSCI Index gets you largely Asia, with particular concentrations in the rapidly growing economies of South Korea and Taiwan. Conversely an EMBI+ portfolio of emerging markets bonds dumps more than half your assets in the dodgy kleptocracies of Latin America, with another sixth subjected to the tender mercies of Vladimir Putin’s Russia. If ever a market was subject to extraordinary popular delusions and the madness of hedge fund crowds, it’s this one.

One day, the Fed will notice that inflation hasn’t disappeared, and will raise the Federal Funds rate, probably by a wimpy ¼%. At that point, panic will ensue in the junk bond markets, domestic and international. With higher interest rates and tighter money, junk borrowers will find all their comforting arithmetic thrown out of whack, as their cash drains increase in size, and the bond markets begin to close for them.

At this point, a wave of defaults worse than we have ever seen will sweep over these markets. It will probably be worse than the 1930s in terms of percentage defaulting, even if any economic downturn is initially mild. The worst classes of 1930s debt issuance, those of 1930-32, lost 4.72% of principal for AAA credits and 12.25% of principal for AA. However this time very few of the defaulters will be AA credits, let alone AAA. The actual loss rates on the 42% of companies with B ratings, or even the 25% with BB ratings is likely to be a substantial multiple of 12.25%, in the B case possibly more than half.

Internationally, it is likely that when times get tough the countries of Latin America (plus probably Russia) will follow Argentina’s happy example and default en masse, daring international investors to do anything about it and looking forward to the inevitable domestic real estate boom. The new Ecuadorian government, indeed, has already hinted that it proposes to take this course. The country is oil rich, and thus currently isn’t short of money, but for a populist Latin American regime, default to rich Western capitalists is a thoroughly cathartic experience, which can now be enjoyed without worrying unduly about the consequences. The days when gunboats bombarded the defaulting country’s Presidential palace are regrettably long gone.

In all probability, investors in defaulting emerging market bonds will go no further than complaining feebly to the IMF, which will send a mission down to the countries in question to give them a stern lecture. Unpleasant though it is to be lectured by the IMF, the thought of ripping off all those foreign capitalists probably makes it worth it. After all if the IMF officials get too censorious you can always throw them in jail!

Domestically, there’s no question that a massive default experience, while unpleasant, would be cathartic. After it, the remaining solvent corporations would throw their modern financial theory textbooks in the bin, return to the sound borrowing practices of the 1950s and 1960s, and take much better care of their relationships with the debt and equity investors who provide them with the money to operate.

Internationally, it’s a different story. Mass defaults by emerging market borrowers could damage the international financial system irretrievably, making trade credit and foreign investment very hard to come by, even for those countries that hadn’t defaulted. Unlike in the domestic markets the virtuous countries, open to international trade and not overleveraged, would be at least as badly damaged as the defaulters. Among the defaulters there would be actual beneficiaries — the large exporters of primary products, like Argentina and Russia, with only modest manufactured goods sectors. Such countries are not dependent on foreign know-how, and so would be able to live for many years from the proceeds of defaulting on their debt and stealing all their country’s inward foreign investments.

I’m not sure how you work an international economic system which rewards the most dishonest and spendthrift while penalizing those who play by the rules. Probably you can’t, and so following a mass emerging market debt default international trade will go into a period of autarky similar to the 1930s.

We can send a gunboat to Buenos Aires or Guyaquil (though not Quito) but how do you get a gunboat to Moscow?

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)