Hypothecation is the practice where (usually through a letter of hypothecation) a borrower pledges collateral to secure a debt or a borrower, as a condition precedent to a loan, or has a third party (usually an affiliate) pledge collateral for the borrower. The borrower retains ownership of the collateral, but the creditor has the right to seize possession if the borrower defaults. A common example occurs when a consumer enters into a mortgage agreement, in which the consumer's house becomes collateral until the mortgage loan is paid off.
The detailed practice and rules regulating hypothecation vary depending on context and on the jurisdiction where it takes place. In the US, the legal right for the creditor to take ownership of the collateral if the debtor defaults is classified as a lien.
Rehypothecation is a professional financial market practice, where counterparty reuses a security pledged as a collateral for its own use. It is how the hypothecation mechanism fundamentally works in the security market, replacing the overhead of liens through actual title transfer against cash with the promise of an opposite transaction in the future (repo). Counterparties receiving the security can use it freely.
Hypothecation in consumer and business finance
Hypothecation is a common feature of consumer contracts involving mortgages – the borrower legally owns the house, but until the mortgage is paid off, the creditor has the right to take possession if the borrower fails to keep up with repayments. If a consumer takes out an additional loan secured against the value of his mortgage (approximately the current value of the house minus outstanding repayments) the consumer is then hypothecating the mortgage itself – the creditor can still seize the house but in this case the creditor then becomes responsible for the outstanding mortgage debt. Sometimes consumer goods and business equipment can be bought on credit agreements involving hypothecation – the goods are legally owned by the borrower, but once again the creditor can seize them if required.
Hypothecation in the investment markets
When an investor asks a broker to purchase securities on margin, hypothecation can occur in two senses. The purchased assets can be hypothecated so that, if the investor fails to keep up credit repayments, the broker can sell some of the securities. The broker can also sell the securities if they drop in value and the investor fails to respond to a margin call. The second sense is that the original deposit the investor puts down for the margin account can itself be in the form of securities rather than a cash deposit, and again the securities belong to the investor but can be sold by the creditor in the case of a default. In both cases, unlike with consumer or business finance, the borrower does not typically have possession of the securities as they will be in accounts controlled by the broker, however, the borrower does still retain legal ownership.
Re-hypothecation occurs when banks or broker-dealers re-use the collateral posted by clients such as hedge funds to back the broker's own trades and borrowing.
In the UK, there is no limit on the amount of a clients assets that can be rehypothecated, except if the client has negotiated an agreement with their broker that includes a limit or prohibition. In the US, re-hypothecation is capped at 140% of a client's debit balance.
In 2007, rehypothecation accounted for half the activity in the shadow banking system. Because the collateral is not cash it does not show up on conventional balance sheet accounting. Before the Lehman collapse, the International Monetary Fund (IMF) calculated that US banks were receiving over $4 trillion worth of funding by rehypothecation, much of it sourced from the UK where there are no statutory limits governing the reuse of a client's collateral. It is estimated that only $1 trillion of original collateral was being used, meaning that collateral was being rehypothecated several times over, with an estimated churn factor of 4.
Following the Lehman collapse, large hedge funds in particular became more wary of allowing their collateral to be rehypothecated, and even in the UK they would insist on contracts that limit the amount of their assets that can be reposted, or even prohibit rehypothecation completely. In 2009 the IMF estimated that the funds available to US banks due to rehypothecation had declined by more than half to $2.1 trillion - due to both less original collateral being available for rehypothecation in the first place and a lower churn factor.
The possible role of rehypothecation in the financial crisis of 2007–2010 and in the shadow banking system was largely overlooked by the mainstream financial press, until Dr. Gillian Tett of the Financial Times drew attention in August 2010  to a paper from Manmohan Singh and James Aitken of the International Monetary Fund which examined the issue.
Rehypothecation in repo agreements
Rehypothecation can be involved in repurchase agreements, commonly called repos. In a two-party repurchase agreement, one party sells to the other a security at a price with a commitment to buy the security back at a later date for another price. Overnight repurchase agreements, the most commonly used form of this arrangement, comprise a sale which takes place the first day and a repurchase that reverses the transaction the next day. Term repurchase agreements, less commonly used, extend for a fixed period of time that may be as long as three months. Open-ended term repurchase agreements are also possible. A so-called reverse repo is not actually different than a repo; it merely describes the opposite side of the transaction. The seller of the security who later repurchases it is entering into a repurchase agreement; the purchaser who later resells the security enters into a reverse repurchase agreement. Notwithstanding its nominal form as a sale and subsequent repurchase of a security, the economic effect of a repurchase agreement is that of a secured loan.
Notes and references
- "Hypothecation explained at the financial dictionary". Retrieved 2010-08-31.
- Though of course a bank can only rehypothecate the assets the client has posted as collateral
- Hedge funds often have a considerably higher amount of securities pledged as collateral than their current borrowings – they continue to receive the normal income stream from the securities and it gives them the flexibility to quickly execute trades if an opportunity arises – the 140% limit does in many cases considerably reduce their exposure to rehypothecation.
- Manmohan Singh and James Aitken (2010-07-01). "The (sizable) Role of Rehypothecation in the Shadow Banking System". International Monetary Fund. Retrieved 2010-08-31.
- Gillian Tett (2010-08-12). "Web of shadow banking must be unravelled". The Financial Times. Retrieved 2010-08-31.
- California Civil Code Section §2920. (a) A mortgage is a contract by which specific property,including an estate for years in real property, is hypothecated for the performance of an act, without the necessity of a change of possession.
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