Mark Patterson, co-founder and chairman of distressed investor MatlinPatterson Global Advisors, sounded the alarm on Tuesday morning as a panelist at the Dow Jones Private Equity Analyst Conference 2008. Patterson was part of a discussion titled “Here Comes Trouble: Making Distressed Investments Pay Off.”

Sitting comfortably on the stage with two other panelists and a moderator from Dow Jones in the posh Grand Ballroom in New York’s Waldorf-Astoria, Patterson got the crowd riled up by saying the current economic times, and what is in store for the markets, will be more challenging to investors than anytime since 1929. He said the aftershocks will be felt for the next three years. In fact, he increased his estimate for the chances of there being another Great Depression this year to between 20% and 25%. That is a significant up-tick from what he said is his typical 5% stance.

Who could blame him for such a negative outlook? The markets are still reeling from the Dow Jones Industrial Average plummeting more than 500 points on Monday on the one-two-three punch of Lehman Bros. declaring bankruptcy, Merrill Lynch being acquired by Bank of America and American International Group, the world’s largest insurer with $1 trillion on its balance sheet, on the verge of filing for bankruptcy protection itself.

Patterson said the financial-led depression that could happen because of the challenges of low valuations and “Saharan-like” credit markets could overwhelm the operational challenges of turning around a portfolio company. He said investors doubting what he said were fooling themselves into thinking another depression could not be around the corner.

“In an industry of catching knives, there are a lot of bleeding hands today,” said Patterson.

The fallout from a depression could include a raft of local banks failing. Patterson estimated between 300 and 500 banks would close and as a result absorb all of the FDIC’s pool of funds. That, he said, was assuming that all of the other well known investment banks would survive: something he said “was not such a good assumption.”

Distressed investing, which is a tough business even in good times, has never been harder. Patterson said the leveraged buyout market is “as dead as a doornail” and the IPO market is basically nil. The only significant avenue for exit available to turnaround specialists are strategic buyers. Patterson’s fellow panelists, who were Rodger Krause, co-chief executive officer from Sun Capital Partners; and Harvey Tepner, a principal at WL Ross & Co., agreed with that assessment.

To be sure, Patterson said the tough times have presented a number of opportunities for distressed investors. In the meantime, today’s market could well be looked upon as being one of the best times for turnaround specialists. The problems, according to Tepner, include deciding on which opportunities to jump into.

“It’s like drinking water out of a firehose,” said Tepner.

That is not the only problem that Tepner pointed out. He said there are black-and-white answers to issues of finding leverage for deals and finding the right operators for portfolio companies: either an investor does or does not secure credit as well as finding the right managers, but the real wildcard is the consumer. If people are not buying whatever it is the portfolio company is selling, then distressed investors need to anticipate losses.

Nick Elliott, the managing editor of the Dow Jones Daily Bankruptcy Review who moderated the panel discussion, took everything in stride throughout. Still, if Patterson proves to be right, Elliott could find himself very busy in the foreseeable future.