Hypothecation
Encyclopedia
Hypothecation is the practice where a borrower pledges collateral
to secure a debt
. The borrower retains ownership of the collateral, but it is "hypothetically" controlled by the creditor in that he 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 practice that occurs principally in the financial markets, where a bank or other broker-dealer reuses the collateral pledged by its clients as collateral for its own borrowing.
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.
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-dealer
s re-use the collateral posted by clients such as hedge funds to back the broker's own trades and borrowings.
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. Prior to 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 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.
s , 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.
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
to secure a debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
. The borrower retains ownership of the collateral, but it is "hypothetically" controlled by the creditor in that he has the right to seize possession if the borrower defaults. A common example occurs when a consumer enters into a mortgage agreement
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
, 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
Lien
In law, a lien is a form of security interest granted over an item of property to secure the payment of a debt or performance of some other obligation...
.
Rehypothecation is a practice that occurs principally in the financial markets, where a bank or other broker-dealer reuses the collateral pledged by its clients as collateral for its own borrowing.
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 in the hypothetical case that 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.
No creditor's duty of care in India
Since under a strict hypothecation, goods remain in the custody of the borrower or third party, who also enjoys the right to deal with them in the ordinary course of business, the hypothecation itself does not normally impose upon the creditor a duty of care over the hypothecated property. Accordingly, a judgment of the Kerala High Court of India held that where hypothecated property was lost and the banker was not aware of the loss otherwise than in the ordinary course of business, the surety was not discharged.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 creditCredit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
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
Margin Call
Margin Call is a 2011 American independent drama film, written and directed by J.C. Chandor. The film has an ensemble cast that includes Kevin Spacey, Demi Moore, Paul Bettany, Jeremy Irons, Zachary Quinto, Stanley Tucci, Simon Baker, and Penn Badgley...
. 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.
Rehypothecation
Broker-dealer
A broker-dealer is a term used in United States financial services regulations. It is a natural person, a company or other organization that trades securities for its own account or on behalf of its customers....
s re-use the collateral posted by clients such as hedge funds to back the broker's own trades and borrowings.
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
Shadow banking system
The shadow banking system is the infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and Structured investment vehicles...
. Because the collateral is not cash it does not show up on conventional balance sheet accounting. Prior to the Lehman collapse
Bankruptcy of Lehman Brothers
Lehman Brothers filed for Chapter 11 bankruptcy protection on September 15, 2008. The bankruptcy of Lehman Brothers remains the largest bankruptcy filing in U.S...
, the International Monetary Fund
International Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...
(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 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
Gillian Tett
Gillian Tett is a British author and award-winning journalist at the Financial Times, where she is the US managing editor She has written about the financial instruments that were part of the cause of the financial crisis that started in the fourth quarter of 2007, such as CDOs, credit default...
of the Financial Times
Financial Times
The Financial Times is an international business newspaper. It is a morning daily newspaper published in London and printed in 24 cities around the world. Its primary rival is the Wall Street Journal, published in New York City....
drew attention in August 2010 to a paper from Manmohan Singh and James Aitken of the International Monetary Fund
International Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...
which examined the issue.
Rehypothecation in repo agreements
Rehypothecation can be involved in repurchase agreementRepurchase agreement
A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securities together with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively...
s , 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.