Rehypothecation

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.

The main purpose of hypothecation is to mitigate the creditor's 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 seize 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 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.

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.

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Wikipedia