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Subordination and Substitution of Collateral With Other Assets
When a party places a lien on a property, it has a legal claim on it or it’s proceeds in event of an enforced sale.
It is most commonly observed when a lender agrees to a mortgage signed up by a home buyer.
In this case, assuming that there are no other liens, the mortgager (lender) becomes the first in line.
The simple reason why liens are placed by lenders on a property for mortgages is to prevent homeowners from selling the property without paying off the loan with the proceeds of sale.
Subordination is requesting someone or an entity who holds a deed of trust (mortgage) on the property to subordinate to second in line.
The reason why a homeowner might want to ask a lender with the first mortgage to agree a subordination is that he is seeking a second mortgage on the property.
Because loaning a second mortgage to a homeowner would effectively place the new lender’s lien as second in line behind the first mortgager, it means that the new lender would be taking on a higher risk for approving this loan.
And because any business would demand higher returns to compensate for higher risks, the new lender would demand a higher interest and/or better terms for being owner of the second mortgage.
If the second lender is flexible, it might agree on a much lower mortgage rate with better terms on condition that it’s lien which will be placed on the property becomes the first in line.
For more advanced real estate investors, subordination can also be a method of cashing out of properties they already own.
For example, this can occur when seller financing is used and the buyer is willing to make cash payments or make a lump sum payment towards the the mortgage principal. In exchange the existing owner of the first lien is place as a second lien with a new party as first in line.
Substitution of collateral
Closely related to subordination is the substitution of collateral.
This refers to transferring a lien from one collateral, in this case the property, to another.
While real estate will be the preferred asset of choice by lenders maybe through a blanket mortgage, they can also be receptive to other types of assets or personal property of significant market value.
While items such as boats, art, antiques, cars, stocks, etc, have been observed to become collateral in the industry, the most common substitutes of collateral are bonds.
A bond is a debt instrument that can be traded on the equity markets. It is basically a loan to the issuer of the bond with a promise to repay a specified interest rate (coupon rate) and full repayment in future.
Various types of bonds including municipal and government bonds have a cash value based on it’s present value and maturity date.
Treasury bonds for example are considered some of the safest and secure financial assets to hold. And they can be bought and sold in the open market… and used as collateral.
If there is a need, one might be able to convince a mortgager to substitute a collateral on the loan from property to bonds.