With the

S&P 500

falling through 1000 and the

Nasdaq

plunging below 1500 for a spell Wednesday, it's no surprise that most investors' eyes are on stocks. But when trying to comprehend the malaise following the terrorist strikes of Sept. 11, don't ignore the extreme stress in the corporate bond market, the chief source of funds for America's largest companies.

The current credit market debacle poses a severe challenge to the nation's economy and its central bank, the

Federal Reserve

, which is doling out billions of dollars of cheap funds in an effort to keep markets and investors afloat.

According to bond investors, the credit market is experiencing its worst crisis since 1998, when the near-collapse of the gargantuan hedge fund Long Term Capital Management caused widespread market paralysis and threatened to bring down several investment banks.

Here's the damage: Corporate bond prices are down sharply in many sectors -- like airlines -- since last week's terrorist strikes. Meanwhile, liquidity is drying up in higher-risk and longer-term bonds. This is partly due to a lack of buyers and partly because of disruption to market infrastructure caused by the attacks.

Large sections of the corporate market haven't yet responded to emergency actions by the Fed, including a big cut in the fed funds target rate Monday and an enormous injection of low-cost funds into the financial system since the atrocities of Sept. 11.

"After the '98 crisis, this is the next-worst period in the bond market," says the head of investments at an insurance company. He notes that in 1998 the new issue market almost completely dried up for a month and reliable pricing in the secondary market was very sparse. Now, he notes that some deals have gotten done, like new bond issues from

Disney

(DIS) - Get Report

and

GE Capital

Monday and

Canadian National Railway

and

Nevada Power

Wednesday.

Providing more perspective, this investor adds that the price declines were worse in the 1994 selloff that followed a raft of interest rate hikes by the Fed. But he says liquidity was better back then and market was less disrupted.

So what's gone on, and is the Fed doing the right thing in response? Greenspan's aim is to head off the chances of a liquidity drought that would deprive companies and financial firms of funds. By providing short-term funds to banks, the Fed appears to have avoided a Wall Street-centered collapse. Brokerages appear to be functioning.

But what about Main Street? Meeting short-term needs of a few finance houses is a lot different from ensuring that corporations, many of them debt-laden after years of ill-advised expansion, acquisitions and stock buybacks, have access to long-term borrowing. Here, the Fed so far has had little success. The average interest rate on a seven-to-10-year bond of a single-A rated industrial company is exactly where it was before the assaults -- at 6.30%. Ideally, that should've come down. Now, those corporate bonds trade at 1.65 percentage points over similar-maturity government bonds, compared with 1.54 points before Sept. 11.

In essence, by lowering rates, the Fed intends to make holding cash extremely unattractive. It wants investors to return to normal buying habits, even though risks have intensified. This is the problem with Greenspan's ploy. Investors are probably wise to avoid some corporate bonds at the yields they're currently trading at, given the economic uncertainty the country is facing.

People poured scorn on calls by some players to buy stocks for patriotic reasons Monday. But the Fed's urging something equally wrong. It's using its power to make cash yield less to try to force people into riskier assets. Government suppression of the price of money through lower-than-warranted interest rates always causes misallocation of capital, which, in turn, sets the stage for intense market pain when the mistakes get corrected.

Greenspan's current actions are a direct departure from the sound advice of Walter Bagehot, whose work on central banking,

Lombard Street: A Description of the Money Market,

counsels a very different type of policy. Bagehot says central banks need to lend in times of stress, but when "the exigency has passed it might let the offending banks suffer." No brokerage suffered after LTCM; in fact, they all went on to fuel, and profit from, the most egregious bubble in history.

While the brokerage industry deserves support right now because it was a blameless victim of the terrorists, many Wall Street firms were facing an extremely tough future before last week's events. The same applies to other sectors of corporate America.

When the dust settles, the Fed should be careful not to prop up businesses that were failing even before the strikes. Doing so will only delay the recovery America needs.

Know any companies that the market may be misvaluing? Detox would like to hear about them. Please send all feedback to

peavis@thestreet.com.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.

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