Rehypothecation is the re-use of collateral from one lending transaction to finance additional loans. It creates a type of financial derivative and can be dangerous if abused.
Rehypothecation an obscure investing topic. It's one that many investors and traders don't encounter in day-to-day conversations. But changes in regulations around its use could lead to devastating consequences in the wrong situation.
Be sure you understand rehypothecation, the risks it poses; this will help you protect your assets.
What Is Hypothecation?
Before you can understand rehypothecation, you have to understand hypothecation. This refers to taking certain assets and pledging them as collateral for a debt. That means it's collateral that can be seized in the event of a default.
This is quite common in lending. For instance, if you buy a home and take out a mortgage, you are entering into a hypothecation agreement. While you retain the title to the house, failure to pay the mortgage can result in the bank or the lender seizing it.
Different types of hypothecation agreements are regulated in different ways. In the U.S., it's often easier to seize a car than it is a home.
What Is Rehypothecation?
Rehypothecation, then, is what happens when a lender takes the collateral from that original loan and uses it as collateral for a new debt. This new debt is now a derivative financial product; it's based on the original debt agreement between you and your lender.
This process increases liquidity in the market while also increasing uncertainty. The more assets are re-used in this way, the less clear it is who owns the asset and who has the right to payment if someone in the chain defaults.
- Alternate name: Collateral re-use
How Rehypothecation Works
Let's say that you borrow money and hand over the collateral. The original lender then turns around and borrows money, repledging your collateral. Your lender no longer enjoys ultimate control over the collateral or what can be done with it; their lender now does.
This is made possible by something known as "Federal Reserve Board Regulation T", or 12 CFR §220—Code of Federal Regulations, Title 12, Chapter II, Subchapter A, Part 220 (Credit by Brokers and Dealers).
The arrangement can result in big problems if things go wrong. That's even more true, thanks to something known as "regulatory arbitrage." In such a case, a brokerage house plays by the rules of the U.S. or the UK. It can effectively remove any or all limits to a number of rehypothecated assets to which it has access. It does that in order to borrow money and fund its own risky bets—on stocks, bonds, commodities, options, or derivatives. When this happens, it's known as hyper-hypothecation.
A Hypothetical Example of Rehypothecation
Imagine you have $100,000 worth of Coca-Cola shares parked in a brokerage account. You have opted for a margin account. That means you can borrow against your stock if you want, either to make a withdrawal without having to sell shares or to purchase additional investments.
You decide you want to buy $100,000 worth of Procter and Gamble on top of your Coke shares. You figure you'll be able to come up with the money over the next three or four months, paying off the margin debt that is created.
After you put in the trade order, your account now consists of $200,000 in assets ($100,000 in Coke and $100,000 in P&G). You also have a $100,000 margin debt owed to the broker. You will pay interest on the margin loan in accordance with the account agreement governing your account and the thin-margin rates in effect for the size of the debt.
Your brokerage firm had to come up with the $100,000 in case you wanted to borrow in order to settle the trade when you bought P&G. In exchange, you've pledged 100% of the assets in your brokerage account, as well as your entire net worth, to back the loan as you've given a personal guarantee. That is, you and your broker have entered into an arrangement and your shares have been hypothecated. They are the collateral for the debt and you've given an effective lien on the shares.
How Brokers Get Margin Lending Funds
In some cases, the broker might fund the trade out of its own net worth or resources. Perhaps it is conservatively capitalized and has a lot of current assets with little to no debt sitting around on the balance sheet.
Maybe your broker issued corporate bonds, knowing it can earn a spread between its interest expense rate and what it charges its clients. Regardless of how the broker funds the loan, there is a good chance that, at some point, it will need working capital in excess of what its book value alone can provide.
For instance, many brokerage houses work out a deal with a clearing agent, such as the Bank of New York Mellon. They have the bank lend them money to clear transactions, with the broker settling up with the bank later, making the whole system more efficient.
To protect its depositors and shareholders, the bank needs collateral. So the broker takes the P&G and Coca-Cola shares you pledged to it; then, the broker re-pledges it, or rehypothecates them, to Bank of New York Mellon as collateral for the loan.
Seizing Rehypothecated Assets
Let's say something happens that causes the brokerage house to fail. Maybe management loads up on leveraged bets. This happens more often than you may think. There were financial institutions that collapsed in 2008–2009. And there were more than a few that came close; they were saved by huge equity infusions that severely diluted stockholders.
One major discount broker had borrowed lots of money to invest in collateralized debt obligations, making leveraged gambles on mortgages that went bad. It survived, but not before clients defected en masse. The business had to bring in a specialist to stabilize operations through the crisis.
In such a situation, the Bank of New York Mellon or another party to whom the assets have been rehypothecated will have first dibs on the collateral. This was reinforced by a series of court rulings since 2012; they put these entities' interests above the interests of clients.
In your case, these entities are would seize the shares of Coca-Cola and P&G to repay the money the broker borrowed. That means you're going to log in to your account and find some—if not all—of your cash, stocks, bonds, and other assets gone.
In this case, the lost assets would not be protected by SIPC insurance. While partial recovery may be possible through bankruptcy courts, there are no guarantees. The process would take years, and it could be very stressful.
From Account Holder to Creditor
At this point, you are merely a creditor in the bankruptcy hierarchy. You have to hope there is enough money recovered during the court cases to reimburse you. But this whole setup is perfectly legal—you end up paying someone else's bills.
Under the regulations of the U.S., it should be possible for clients with margin accounts to know that their potential exposure to a rehypothecation disaster is limited. For instance, if you have an account with $100,000 and only $10,000 in margin debt to fund the outright purchase of a long-equity position, you shouldn't be exposed for more than $10,000.
In reality, that's not always possible. Certain restrictions requiring segregation of fully paid client assets in place in the U.S. (following the Great Depression) are not in place in the UK.
Aggressive brokers can move money through foreign affiliates, subsidiaries, or other parties. It can be done in a way that allows them to effectively remove the limits on rehypothecation. That means it's not just the assets you have borrowed against that could be seized. They can go after all of your assets.
Notable Happenings: MF Global Bankruptcy
MF Global was a major publicly traded financial and commodities broker with more than $42 billion in assets and nearly 3,300 employees. It was run by Jon Corzine, the 54th Governor of New Jersey, a U.S. senator, and the former CEO of Goldman Sachs.
Beginning of the Problems
In 2011, MF Global decided to make a speculative bet by investing $6.2 billion in its own trading account in bonds issued by European sovereign nations, which had been hit hard by the credit crisis. The year before, the company had reported a net worth of roughly $1.5 billion. This meant small changes in the position would result in large fluctuations in book value.
Combined with a type of off-balance-sheet financing arrangement known as a repurchase agreement, MF Global experienced a catastrophic liquidity disaster due to a confluence of events. This disaster forced the company to come up with large amounts of cash to meet its collateral and other requirements.
Pulling From Client Accounts
Management raided the assets in client accounts, part of which included making a $175 million loan to the firm's subsidiary in the UK to pony up collateral to third-parties (i.e., rehypothecation).
When the whole thing fell apart and the company was forced to seek bankruptcy protection, clients discovered that the cash and assets in their account—money they thought belonged to them and secured by debts on which they hadn't defaulted—were gone. MF Global's creditors had seized them, including the rehypothecated collateral.
After the Chips Fell
By the time all was said and done, the clients of MF Global had lost $1.6 billion of their assets. Clients revolted, suddenly caring a great deal about the fine print in their account agreements. They were able to get a sympathetic judge who ultimately approved a settlement of the bankruptcy estate. This resulted in an initial recovery and return of 93% of customer assets.
Many clients who held out through the multi-year legal process ended up getting 100% of their money back; this was in no small part due to the media and political scrutiny. They were lucky. In the meantime, they missed out on one of the strongest bull markets in the past few centuries, with their money tied up in legal fights as they held their breath to see if it would be restored.
How to Protect Against Rehypothecation
The best way to protect yourself against rehypothecation within an ordinary brokerage account is to refuse to hypothecate your holdings in the first place. Doing that is simple: Don't open a margin account. Instead, simply open what is known as a "cash account," or in some places, a "Type 1 account." Some brokerage houses will add margin capability by default unless otherwise specified. Don't allow them to do it.
This will make placing stock trades or other buy or sell orders, including derivatives such as stock options, a bit more inconvenient at times. That's because you must have sufficient cash levels within the account to cover settlements and any potential liabilities. But it is worth putting up with the inconvenience for the peace of mind. On top of that, you'll have the comfort of knowing you'll never face a margin call or risk more funds than you have on hand at the moment.
- Rehypothecation is the re-use of previously pledged collateral as the collateral for a new loan.
- It improves liquidity in the market while also increasing risk to everyone in the chain touching that piece of collateral.
- If an asset is rehypothecated many times, it can send shockwaves through the market, leaving many without their original investment.
- The best way to avoid the dangers of rehypothecation is to avoid buying margin accounts and instead only purchase cash investment accounts.