"Fixed Income":bankruptcy reorganization

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Questions 1:

The absolute priority rule is most likely violated in a:

A 、bankruptcy liquidation.

B 、special purpose entity securitization.

C 、bankruptcy reorganization.

Questions 2:

Which statement best describes the risk to senior tranche investors in a collateralized debt obligation (CDO)?

A 、There are no triggers that require the payoff of the principal to investors.

B 、In default, the manager will not earn a return sufficient to payoff investors.

C、 Leverage inherent in the CDO transaction results in higher risk.

View answer resolution

【Answer to question 1】C

【analysis】

C is correct. When a company is reorganized, the strict absolute priority has not always been upheld by the courts.

A is incorrect because in liquidations, the absolute priority rule generally holds.

B is incorrect because in the case of a SPV securitization, the courts (in most jurisdictions) have no discretion to change absolute priority because the bankruptcy of a company does not affect the SPV. The SPV is considered bankruptcy remote.

【Answer to question 2】B

【analysis】

B is correct. In the case of defaults in collateral, there is a risk that the CDO manager will not earn a sufficient return to pay off the investors in the senior and mezzanine tranches. This will result in losses to these classes of bondholders.

A is incorrect because if the CDO manager fails to meet certain pre-specified tests, a provision is triggered that requires the payoff of the principal to the senior bond classes until the tests are satisfied.

C is incorrect because the CDO manager is using leverage to generate a return above the funding cost for the equity tranche holders. If certain pre-specified tests are not met by the CDO manager, a provision is triggered that requires the payoff of the principal to the senior bond classes until the tests are satisfied, thus deleveraging the CDO.

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