Lending 101 - Subordinations

For my dear colleagues in the credit risk field, this is a common lingo used in credit adjudication, namely, assessing if a loan should be approved.

One question that credit adjudicator often asks is, who is the borrower? When we ask who, not only do we mean who the entity is, but also where the entity is in its corporate ecosystem.

Subordinations signal one aspect that typical corporate credit adjudicators don't like - the loan is not ranking first in the corporate ecosystem - which means that when push comes to shove and the borrower's asset freezes, our loan won't get paid out first. In other words, our loan is ranking "below" or "behind".

There are two ways that the loan obligations can be subordinated: Contractually, or Structurally. When a loan is contractually subordinated, it can be either due to the ranking or as a result of security. For example, when a borrower enters into two loans, one loan is secured and the other one is not. The unsecured loan is contractually subordinated to the other one.

Structural subordination is just a tad bit more complicated. When the borrower is a holding company (Holdco) and there are existing loans at the operating company (Opco) level, our Holdco loan is "structurally" subordinated to the Opco loan. This has something to do with where the repayment cash flow is derived from. Holding companies usually rely on upstream dividends from operating companies. When the cash flow is first used in repaying loans at the Opco level, Holdco debts get paid second.

Of course, there is a market for being subordinated debts or even "mezzanine" debts, and the pricing of these debts reflect the associated higher risks. The availability of these products all depends on the financial institution's risk appetite.