Does anyone remember Subordination?

Posted on
20th April 2018
By Travis Miller

Does anyone remember Subordination?

Loss Protection (By Travis Miller, 20th April 2018)

Whilst speaking to a young banker last week and comparing notes on investments, I mentioned an opportunity we were working on with an attractive Risk/Return profile with 35% subordination.  He looked at me with a slightly bewildered  look and asked “What is subordination?”.  

This wasn’t entirely the  response I expected.  On  reflection I realised (aside from getting old) that post GFC, general interest in investing into credit and credit risky assets  has become less cool, particularly when credit spreads are tight and property just goes up right???

Below is a summary of subordination and why it is becoming cool again.

As an investor, subordination can be your friend.  You should learn to embrace it, as in simplistic terms it means someone else is taking losses before you.  The  greater the subordination (or the greater the number of investors that rank below you), the greater the protection to an investor from any losses.

To put subordination into the context, some Investments (often called securitisations) have exposure to a portfolio of underlying loans.  These loans could be  residential property loans, education loans, buy now/pay later loans etc.  Investors can choose how much risk of loss they are prepared to take through selecting the investment closest to their desired level of subordination (loss protection).

That said, like in the advertisement “oils ain’t oils”, “subordination ain’t subordination”.  The quality of the portfolio of loans makes a big difference to an investors expected loss.  

For example, imagine if I had a portfolio of property loans secured against residential property in comparison to a portfolio of buy now / pay later loans secured by “I hope they repay!”.  I  would expect significantly more subordination for a given level of risk from a portfolio of loans based on “hope” than you would on an investment secured over property.

Not only do the type of loans matter, the volume of loans in the portfolio matter!  

Make sense ? 

If a single borrower was to default on their entire loan and the portfolio was made up of 1 loan, it’s a pretty material event as investors would lose all of their money.  If the portfolio was made up of 100 loans, then the loss to the portfolio is only 1%, this is when our friend subordination kicks in to save all investors with greater than 1% subordination.

Lots of other factors matter when considering subordination, excess spread, insurance, recovery, term, maturity, counterparty, read the prospectus etc.  This comes back to the ‘oils aint oils’ thing. 

In summary, the banker I was speaking with did help me understand cryptocurrencies and how he thought block-chain would change the world, so it was not all one way.

All in all, ….subordination ain’t subordination…