What is 'Rehypothecation'
Rehypothecation is the practice by banks and brokers of using, for their own purposes, assets that have been posted as collateral by their clients. Clients who permit rehypothecation of their collateral may be compensated either through a lower cost of borrowing or a rebate on fees. In a typical example of rehypothecation, securities that have been posted with a prime brokerage as collateral by a hedge fund are used by the brokerage to back its own transactions and trades.
BREAKING DOWN 'Rehypothecation'While rehypothecation was a common practice until 2007, hedge funds became much more wary about it in the wake of the Lehman Brothers collapse and subsequent credit crunch in 2008-09.
In the United States, rehypothecation of collateral by broker-dealers is limited to 140% of the loan amount to a client, under Rule 15c3-3 of the SEC.
Rehypothecation occurs when a lender uses an asset, supplied as collateral on a debt by a borrower, and applies its value to cover its own obligations. In order to do so, the lender may have access to a variety of assets promised as collateral including tangible assets and various securities.
Hypothecation and Rehypothecation
Hypothecation occurs when a borrower promises the right to an asset as a form of collateral in exchange for funds. One common example occurs in the primary housing market, where a borrower uses the home he is purchasing as collateral for a mortgage loan. Even though the borrower asserts a level of ownership over the property, the lender can seize the asset if payments are not made as required. Similar situations occur in other collateralized loans, such as a vehicle loan, as well as with the setup of margin accounts to support other trading actions.
Rehypothecation occurs when the lender uses its rights to the collateral to participate in its own transactions, often with the hopes of financial gain. For example, if a customer leaves a number of securities with a broker as a deposit, most often in a margin account, and the broker then uses the securities as a pledge for the margin on his own margin account or as backing for a loan, rehypothecation has occurred.
Risks of Rehypothecation
With rehypothecation, the asset in question has been promised to an institution outside of the borrower’s original intent. For example, if a piece of real estate functions as collateral on a mortgage loan, and the lender pledges the asset to another financial institution in exchange for a loan, if the mortgage lender fails, the second financial institution may make a claim on the real estate.