Hypothecation

Hypothecation occurs when an asset is pledged as collateral to secure a loan, without giving up title, possession or ownership rights, such as income generated by the asset. However, the lender can seize the asset if the terms of the agreement are not met.

Hypothecation occurs most commonly in mortgage lending. The borrower technically owns the house, but as the house is pledged as collateral, the mortgage lender has the right to seize the house if the borrower cannot meet the repayment terms of the loan agreement – which occurred during the foreclosure crisis. Auto loans are similarly secured by the underlying vehicle.

As hypothecation provides security to the lender because of the collateral pledged by the borrower, it is easier to secure a loan, and the lender may offer a lower interest rate than on an unsecured loan.

Margin lending in brokerage accounts is another common form of hypothecation. When an investor chooses to buy on margin or sell-short, they are agreeing that those securities can be sold if necessary if there is a margin call. The investor owns the securities in their account, but the broker can sell them if they issue a margin call that the investor cannot meet, to cover the investors’ losses.

When banks and brokers use hypothecated collateral as collateral to back their own transactions and trades with their client’s agreement, in order to secure a lower cost of borrowing or a rebate on fees — this is called rehypothecation. While certain types of rehypothecation can contribute to market functioning, if collateral collected to protect against the risk of counterparty default has been rehypothecated, it may not be available in the event of a default. This, in turn, may increase systemic risk and amplify market stresses by causing a chain reaction of asset sales. So, when collateral is rehypothecated, investors need to understand how long the collateral chain is.