# Defaults and Loss Handling

In the event that borrowers fail to meet their repayment obligations, Pencil Finance employs a clear and transparent loss allocation process designed to maintain capital integrity and protect senior investors.

### **How Defaults Are Recognized**

A default is triggered when a borrower fails to make a scheduled repayment within a **45-day grace period**. During this time, the loan is monitored but not yet flagged as delinquent. If repayment is not received after 45 days, the loan becomes delinquent and enters a monitoring period.

If the loan remains unpaid and reaches **90 days past due**, it is formally classified as defaulted. Lending partners are responsible for updating loan statuses in real time, but Pencil’s smart contracts are also equipped to detect and flag delinquency events automatically, using on-chain payment data.

### **Write-Down and Write-Off Mechanics**

Once a loan is marked as defaulted, the protocol initiates a **write-down**, adjusting the estimated repayment value in internal accounting. This marks a partial loss that reflects reduced expectations of recovery:

* A partial write-down occurs if some recovery is still expected (e.g., legal recovery or borrower negotiations).
* A **write-off** occurs when a loan is deemed unrecoverable—due to insolvency, prolonged delinquency, fraud, or confirmed inability to repay.
* Written-off loans are removed from future repayment flows and NAV calculations.

If a written-down or delinquent loan is later **partially or fully repaid**, the protocol updates the loan status and reflects the recovered amount in the bundle’s **Net Asset Value (NAV)**. Recovered funds are distributed according to the standard repayment waterfall, prioritizing outstanding Senior obligations.

### **Loss Allocation**

Losses from written-down or written-off loans are allocated according to the **tranche waterfall**:

1. **Junior Tranche** fully absorbs the initial loss amount.
2. If Junior capital is depleted, remaining losses impact the **Senior Tranche**.

This structure ensures the **Senior Pool is shielded** from early-stage loan defaults and encourages responsible lending and monitoring behavior by lending partners, who are exposed to first-loss through mandatory participation in the Junior Tranche.


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