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Explanation:
In this scenario, the total terminal available funds ($86.356 million) are less than the total owed to the bond tranches ($100.675 million). Because senior bondholders have priority in the capital structure (waterfall payment structure), they are paid their interest and principal first. Since the senior tranche size is typically large but well within the available funds (e.g., $80 million principal + interest), the $86.356 million is sufficient to fully cover the senior bonds' principal and interest without any shortfall. The remaining funds are insufficient to completely cover the junior bondholders' claims, meaning the junior bondholders must absorb the losses, resulting in a shortfall for them. Therefore, senior bondholders are made whole, while junior bondholders suffer a shortfall.
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313.2. The following structure is identical to the previous (and to Malz's illustration in section 9.2)¹¹ but with one difference: in this scenario, the default rate has been dramatically increased to 10.0% per annum:
| (1) | (2) | (3) | (4) | (5) | (6) | (7) | (8) | (9) | (10) | (11) | (12) |
|---|---|---|---|---|---|---|---|---|---|---|---|
| Defaults | |||||||||||
| t | Annual | Cum'l | Survived | Loan Interest | Excess Spread | Over-collater | Recovery | OC + Recovery | Equity Flow | Results | OC a/c |
| d(t) | L(t) | L(t)-B | OC(t) | R(t) | OC(t) +R(t) | ||||||
| 0 | (5.00) | ||||||||||
| 1 | 10.0 | 10.0 | 90.0 | $7.650 | $1.975 | $1.750 | $4.000 | $5.750 | $0.225 | Y | $5.750 |
| 2 | 9.0 | 19.0 | 81.0 | 6.885 | 1.210 | 1.210 | 3.600 | 4.810 | - | Y | 10.848 |
| 3 | 8.0 | 27.0 | 73.0 | 6.205 | 0.530 | 0.530 | 3.200 | 3.730 | - | Y | 15.120 |
| 4 | 7.0 | 34.0 | 66.0 | 5.610 | (0.065) | (0.065) | 2.800 | 2.735 | - | Y | 18.611 |
| 5 | 7.0 | 41.0 | 59.0 | 64.015 | 2.800 | - | 19.541 |
Total terminal avai funds = L(5) + R(5) + OC a/c (final) 86.356
Owed to bond tranches 100.675
Equity terminal cash flow -
Note: except for defaults/survive, all amounts in $millions
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