Hypothecation is the practice where a borrower pledges collateral 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. If a borrower does default on a loan , that to secure a debt Debt is that which is owed; usually referencing assets owed, but the term can also cover moral obligations and other interactions not requiring money. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned. Some companies and corporations use debt as a part of their overall. The borrower retains ownership of the collateral, but it is "hypothetically" controlled by the creditor in that they have the right to seize possession if the borrower defaults. A common example occurs when consumers enter into a mortgage agreemnent, where their house becomes collateral untill 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 classed as a 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. The owner of the property, who grants the lien, is referred to as the lienor and the person who has the benefit of the lien is referred to as the lienee.
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.
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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. [1] If a consumer takes out an additional loan secured against the value of their mortgage (the current value of the house minus outstanding repayments) they are then hypothecating the mortgage itself - the creditor can still seize the house but in this case they then become 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 size 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[2] 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 credit Credit is the provision of resources by one party to another party where that second party does not reimburse the first party immediately, thereby generating a debt, and instead arranges either to repay or return those resources (or material(s) of equal value) at a later date. It is any form of deferred payment. The first party is called a repayments the broker can sell some of the securities A security is a fungible, negotiable instrument representing financial value. Securities are broadly categorized into debt securities and equity securities, e.g., common stocks; and derivative contracts, such as forwards, futures, options and swaps. The company or other entity issuing the security is called the issuer. A country's regulatory. [1] The broker can also sell the securities if they drop in value and the investor fails to respond to a Margin call In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of his counterparty . This risk can arise if the holder has done any of the following:. 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 doesnt 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 Prime brokerage is the generic name for a bundled package of services offered by investment banks and securities firms to hedge funds and other professional investors needing the ability to borrow securities and cash to be able to invest on a netted basis and achieve an absolute return. The business advantage to a hedge fund of using a Prime services are able to expand their trading operations by re-using collateral belonging to their counter-parties.Re-hypothecation occurs when banks or broker-dealers A broker-dealer is a term used in United States financial services regulations. It is a company or other organization that trades securities for its own account or on behalf of its customers 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 [3], 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. [4] [5] [6]
In 2007, rehypothecation accounted for about 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 IMF calculate that US banks were receiving over $4 trillion worth of funding by rehypothecation, much of it sourced from the UK where there are no statuary limits governing the reuse of clients collateral. Its estimated that only about $1 trillion of original collateral was being used, meaning that collateral was being rehypothecated several times over, with an estimated churn factor of 4. [5]
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 than can be reposted, or even prohibit rehypothecation completely. In 2009 the IMF estimate that the funds available to US banks due to rehypothecated had declined by more than half to about £2trillion - due to both less original collateral being available for rehypothecation in the first place, and due to a lower churn factor. [5] [6]
The possible role of rehypothecation in the Financial crisis of 2007–2010 and in the shadow banking system was largely overlooked by mainstream financial press and commentators, until Dr. Gillian Tett of the Financial Times The Financial Times is a British international business newspaper. It is a morning daily newspaper published in the Borough of Southwark, London and printed at 22 sites. Its primary rival is New York City-based The Wall Street Journal drew attention in August 2010 [6] to a paper from Manmohan Singh and James Aitken of the International Monetary Fund that examined the issues Manmohan Singh and James Aitken. [5]
Rehypothecation in repo agreements
Rehypothecation can be involved in repurchase agreements A Repurchase agreement allows a borrower to use a financial security as collateral for a cash loan at a fixed rate of interest. In a repo, the borrower agrees to sell immediately a security to a lender and also agrees to buy the same security from the lender at a fixed price at some later date. A repo is equivalent to a cash transaction combined , commonly called repos. In a two-party repurchase agreement, one party sells the other a security at a specified price with a commitment to buy the security back at a later date for another specified 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 several 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.
See also
Notes and References
- ^ a b "Hypothecation explained at the financial dictionary". http://financial-dictionary.thefreedictionary.com/Hypothecation. Retrieved 2010-08-31.
- ^ Union Bank of India v. M.P. Sreedharan AIR 1993 Ker. 285
- ^ 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 the 140% limit does in many cases considerably reduce their exposure to rehypothecation.
- ^ a b c d Manmohan Singh and James Aitken (2010-07-01). "The (sizable) Role of Rehypothecation in the Shadow Banking System". IMF The International Monetary Fund is the intergovernmental organization that oversees the global financial system by following the macroeconomic policies of its member countries, in particular those with an impact on exchange rate and the balance of payments. It is an organization formed with a stated objective of stabilizing international exchange. http://www.imf.org/external/pubs/ft/wp/2010/wp10172.pdf. Retrieved 2010-08-31.
- ^ a b c Gillian Tett (2010-08-12). "Web of shadow banking must be unravelled". The Financial Times. http://www.ft.com/cms/s/0/112ff210-a62b-11df-9cb9-00144feabdc0.html. Retrieved 2010-08-31.
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