CDO investors have varying views on how managed investment-grade (IG) CDO vehicles should have handled and should continue handling their exposure to recently fallen angel WorldCom, Inc. (Ba2/BB). Some analysts speculate a 50/50 likelihood of default, as exemplified by its 11-year debt trading between 40 cents to 42 cents during the middle of last week.

"These WorldCom-type situations rarely get better, and asset managers can see the rating drops coming often months ahead of time," said one seasoned investor in distressed CDOs.

One arbitrage managed synthetic investment-grade CDO manager was advised by its managers, at least one month ago, to buy credit default swap protection on its WorldCom exposure. The asset manager, however, opted to wait things out.

"In general, many CDO managers' transactions become severely damaged because they are not willing to take the pain on declining credits early, often due to fear of missing an equity payment because of putting a hedge on the credit or selling," said the investor.

"However, as a result of not taking that pain early, what often happens is that the credit goes to triple-C or into default, and not only does the CDO vehicle miss equity payments anyway, but it also hurts the debt investors as well," the investor added. "I've seen this happen over and over."

Traders say that currently there is virtually no market for WorldCom credit default protection, as "no one wants to take that risk." Around April 9, when Moody's Investors Service lowered the senior unsecured debt rating on WorldCom to Ba2' from Baa2' (still on watch), the five-year credit default swap protection on the name had a bid/offer spread of 710 to 780. Currently there is no credit default swap protection available, but only theoretical offers in the 27.5% area for a five-year credit default swap (discounting back to present value), which is very similar to the lowest recovery scenario offered by Lehman Brothers high yield research.

"At this point it's not worth a manager locking in a loss using a costly hedge, when the recoveries on this real' company could be as high as 60% to 70%," said one source, using a back of the envelope analysis: 100 minus a 27% annual default swap premium for 5-year credit default protection equals an approximate 63% recovery rate, if you make the simplifying assumption that WorldCom defaults in the next 12 months.

"This is not Enron," the source explained. "A 60% to 70% recovery rate was typical for most of the high profile investment grade bankruptcies last year: Railtrack, Swissair... though not Enron. So if you believe - as is probably the case - that the greatest probability of a WorldCom bankruptcy is within the next 12 months given debt refinancing requirements, then you can still argue a case for a recovery rate in the 60-70% range on a cash basis."

However, a manager taking this view must have a clear valuation rationale for holding the credit, rather than a simple aversion to taking the loss.

According to a May 14 Lehman Brothers high yield report, Lehman has three recovery scenarios if WorldCom files for protection under Chapter 11. In two of their workout scenarios, the present value range of expected recoveries was 40% to 60% and 36% to 58%, respectively. In a third scenario (where $5 billion of bank debt is fully drawn WorldCom files for Chapter 11 in 2004), the PV range of Lehman's expected recoveries is 28% to 42%, including coupons.

The question is: how widely held WorldCom is in IG CDOs? According to Nik Khakee, Standard & Poor's director of synthetic CDO ratings, it is unlikely that WorldCom is nearly as widely held in investment-grade CDOs as Enron's 83% number (for S&P-rated CDOs), considering the market has been bearish on telecom for some time. Khakee adds that recovery rates on investment-grade companies should not be looked at via averages that smooth out highs and lows, but on a company and asset-specific basis.

Year to date, fallen angels have added $52.4 billion to the high-yield market, compared to $27.2 billion YTD last year. For the full year of 2001, $66.4 billion in fallen angels joined the high-yield market.

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