It's the bonds (silly), and the story isn't over.

Judging by

yesterday's recovery and this morning's early gains, the stock market seems of the mindset that the

WorldCom

(WCOME)

fallout has been contained. But WorldCom's $30 billion of outstanding debt is the nuclear waste in this saga.

"Everyone is focused on

tech and telecom, but we should get our eyes off TNT and look at the banks," said Diane Garnick, global equity strategist at State Street Global Advisors in Boston. "Somebody's got to absorb all the debt from the ex-Arthur Andersen clients."

More than 25 banks would be on the hook for over $4.5 billion if WorldCom defaults or goes bankrupt, including Germany's Deutsche Bank, ABN AMRO of the Netherlands and Japan's Bank of Tokyo-Mitsubishi,

Reuters

reported. Obviously some folks were

looking at the banks yesterday and worried about their exposure to WorldCom: As major averages recovered to finish near break-even, the Philadelphia Stock Exchange/KBW Bank Index fell 2.7% while WorldCom's lead banker,

Citigroup

(C) - Get Report

, shed 5.4%.

J.P. Morgan Chase

(JPM) - Get Report

fell 4.4%, and

Bank of America

(BAC) - Get Report

shed 3.4%; along with Citi, J.P. Morgan and BoA were co-lead managers of a $2.65 billion line of credit facility drawn by WorldCom last month.

Still, that line of credit was syndicated (i.e., spread out) among 25 banks, and J.P. Morgan said yesterday that its exposure to WorldCom is "very small" and would have "no material effect on earnings." Bank of America didn't give details, but analysts estimate their WorldCom exposure wouldn't affect earnings by more than 5 cents per share this year, in a worst-case scenario.

Mellon Financial

(MEL)

said it has $100 million in exposure.

Today, Citigroup put its exposure to WorldCom at around $375 million, mainly through holdings of WorldCom debt. Still, the company expects the financial impact to Citigroup will be "relatively modest," according to a statement.

Because bank loans are spread across a large number of participants, "bondholders, not banks, are the big losers on WorldCom debt," commented Kathy Shanley, who follows finance at Gimme Credit, the independent credit-rating agency. Shares of General Electric

(GE) - Get Report

, for example, were lately down 1.3% after the firm said it lost $110 million on WorldCom bonds. Still, some of those bondholders are banks, including many of WorldCom's financiers.

Indeed,

The Wall Street Journal

reported today that many hedge funds that recently bought the "distressed debt" of companies such as WorldCom and

Adelphia

-- including some funds created expressly for that purpose -- were feeling the strain of yesterday's big losses, during which WorldCom bonds tumbled to 12 cents on the dollar from 70 cents Tuesday. (Overall, corporate bond prices were recovering early Thursday, although spreads for General Motors'

(GM) - Get Report

financing arm, GMAC, widened noticeably amid rumors of accounting irregularities, which the firm denied.)

Marty Fridson, chief high-yield strategist at Merrill Lynch, disputed the notion that all of WorldCom's paper is in the hands of high-yield managers. WorldCom's debt became junk status only in early May, and he argued that "a lot of that

paper is sitting where it was," i.e., with investment grade and more traditional bond funds. (For those curious, PIMCO -- which not long ago publicly raised its view of high-yield bonds, including telecom -- declined to comment.)

Still, "even if the immediate damage to bank balance sheets is muted, we wouldn't downplay the second order risks," Gimme Credit's Shanley said. "Citigroup and J.P. Morgan Chase are already under fire for acting as enablers for Enron's partnership agreements." Furthermore, many investors are also recalling how the banks kept upping their exposure to Enron after initially trying to downplay the impact.

"Who can blame foreign investors for figuring that maybe the differences between emerging market economies and the U.S. market are not as big as had been advertised?," Shanley mused. "We are not optimistic about the prospects for a rapid turnaround in activity in the capital markets."

Who, indeed?

WorldCom and Beyond

Longer term, the effects of WorldCom's scandal is that "another tier of companies is likely to get excluded from the new issue market for a while," said Merrill's Fridson. That's in addition to the "early stage telecoms already unable to raise money" in the high-yield market.

Fridson quipped that it "isn't such a bad thing if capital is steered toward more constructive purposes." Still, that scenario suggests an increase in default rates and bankruptcies, and that isn't such a good thing for investors.

The Merrill strategist wouldn't specify beyond "more mainstream telecom and energy companies" where there's "concern about the legitimacy of financial engineering."

In a separate report this morning, Gimme Credit's Carol Levenson did name names:

Qwest Communications

(Q)

,

Tyco

(TYC)

and

Dynegy

(DYN)

"leap to mind" among companies that are "likely to suffer from a further deteriorating in market confidence -- especially if it's accounting-related."

AOL Time Warner

(AOL)

is another potential victim of such concerns, she said.

Recalling that "Enron's peer group experienced a delayed reaction to its troubles," Levenson advised that investors should "re-evaluate" Qwest,

Sprint

(FON)

and

AT&T

(T) - Get Report

, as well as equipment suppliers

Lucent

(LU)

,

Corning

(GLW) - Get Report

and

Nortel

(NT)

.

Gimme Credit is "already negative" on the aforementioned but "believe

s their riskiness has increased with these events."

Levenson's comments refer to the debt of those companies. But if it isn't obvious that developments in the corporate bond market

often presage those in equities, you haven't been paying very close attention.

In sum, the WorldCom blow-up is "too big an event to ignore," said Merrill's Fridon, which pretty much summed up the mindset of Jeffrey Saut, chief equity strategist at Raymond James.

Before the open yesterday, Saut suggested the "pornographic plunge" he'd discussed previously was likely to occur. He recommended buying one-third positions (or 1,000 shares each) in the

Merrill Lynch Semiconductor HOLDRs

(SMH) - Get Report

SMH,

Dow Diamonds

(DIA) - Get Report

,

Merrill Lynch Biotech HOLDRs

(BBH) - Get Report

and "big names that institutions will trust," like

IBM

(IBM) - Get Report

. He recommending buying another one-third position on the expected "secondary decline" midday and the final one-third at the close, if the market was firm. (P.S., I found out about this

after

the close yesterday, so spare the

"why'd you tell me now?"

emails.)

After the close Wednesday, Saut said he made those initial one-third purchases but "didn't have the

cojones

to complete them," because of concerns about the impact of WorldCom's implosion on the bond market.

"I hope that's the reversal, but this bond thing has got me worried," he said. "You're going to start hearing about counter-party trades, which bank lent to whom and what."

As Enron's case demonstrated, sometimes those relationships are so Byzantine it takes a while for even those involved in the transactions to figure it all out. In other words: Stay tuned

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.