Explanation:
In Malz's standard securitization model, a typical "high-default" scenario assumes a cumulative default rate of 15% over the life of the assets. Assuming a standard 40% recovery rate, the total loss on a $100 million portfolio would be $9 million ($100M × 15% × (1 - 0.40) = $9M).
The capital structure consists of a $5 million equity tranche, a $10 million mezzanine (junior) tranche, and an $85 million senior tranche. The losses are applied from the bottom up. The equity tranche absorbs the first $5 million of losses, being wiped out completely. The remaining $4 million of losses are absorbed by the mezzanine tranche, causing the junior bondholders to suffer a principal and interest shortfall. Since the total losses ($9 million) do not exceed the combined $15 million protection provided by the equity and mezzanine tranches, the senior bondholders are fully shielded and experience no principal or interest shortfall. Therefore, the junior tranche is impaired while the senior tranche is paid in full.
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Under this high-default scenario, which of the following statements is TRUE?
A
There is never a year in which either the junior or senior bonds are paid their full interest
B
Both bondholders (senior and junior) realize all of their interest payments in the first four years, but neither recovers their entire obligation in the fifth year (i.e., shortfall for both bondholders)
C
Junior bondholders suffer interest payment shortfalls and a principal shortfall, but senior bondholders receive all of their interest and experience no principal shortfall
D
Both bondholders realize all of their interest payments in full and get back the entirety of their principal