Hypothecation

This article is about debt financing. For the ring-fencing of a tax, see Hypothecation (taxation).

See also: hypothec

Hypothecation is the practice where (usually through a letter of hypothecation) a debtor pledges collateral to secure a debt or as a condition precedent to the debt, or a third party pledges collateral for the debtor. A common example occurs when a debtor enters into a mortgage agreement, in which the debtor's house becomes collateral until the mortgage loan is paid off.

The debtor retains ownership of the collateral, but the creditor has the right to seize ownership if the debtor defaults. In a possessory hypothecation (e.g. if the collateral is a financial asset), the creditor possesses the collateral; in a non-possessory hypothecation (e.g. if the collateral is a house) the creditor cannot possess the collateral (because the debtor lives in the house).

The main purpose of hypothecation is to mitigate the creditors credit risk. If the debtor cannot pay, the creditor possesses the collateral and therefore can claim its ownership, sell it and thus compensate the lacking cash inflows. In a default of the obligor without previous hypothecation, the creditor cannot be sure that it can size sufficient assets of the debtor. Because hypothecation makes it easier to get the debt and potentially decreases its price; the debtor wants to hypothecate as much debt as possible - but the isolation of 'good assets' for the collateral worsens the quality of the rest of the debtor's balance sheet and thus its credit quality.

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 occurs mainly in the financial markets, where financial firms re-use the collateral to secure their own borrowing. For the creditor the collateral does not only mitigate the credit risk but also allows to refinance more easily or at lower rates; in initial hypothecation contract however, the debtor can restrict such re-use of the collateral.

Hypothecation in consumer and business finance

Hypothecation is a common feature of consumer contracts involving mortgages – the debtor legally owns the house, but until the mortgage is paid off, the creditor has the right to take ownership (and possibly also possession) - but only if the debtor 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 financial industry

The most common form of hypothecation is a repo transaction: the creditor gives a loan to the debtor and receives in return the possession (not the ownership) of a financial asset until the maturity of the loan. A reverse repo is a hypothecation 'in the reverse direction': creditor and debtor swap roles.

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.

Rehypothecation

Goldman Sachs Tower – banks that provide prime brokerage services are able to expand their trading operations by re-using collateral belonging to their counter-parties.

Re-hypothecation occurs when the creditor (a bank or broker-dealer) re-uses the collateral posted by the debtor (a client such as a hedge fund) 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 any different to 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 re-sells 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.

See also

• Security interest - hypothecation

Notes and references

• 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.

• • As Hypothicated RE: A developer/lot owner may hypothicate the lot for use by a builder to facilitate action against a line of credit whereas both parties will benefit from the hypotication of the collateral. Gregory Yurco, Lead Lending Officer Geauga Savings Bank, Newbury Ohio.

External links

• Collateral Management article on Financial-edu.com