What is ‘Rehypothecation’
Rehypothecation is the practice of banks and brokers using, for their own purposes, funds that have been posted as collateral by their clients. Clients who permit rehypothecation of their collateral may be compensated either by reducing the cost of borrowing or a rebate on fees. In a typical example of rehypothecation, securities that have been placed with the Prime broker as collateral hedge Fund used a broker back its own operations and transactions.
Breaking Down The ‘Rehypothecation’
Rehypothecation was a common practice until 2007, but hedge funds have become much more cautious about it after the collapse of Lehman Brothers and subsequent credit crisis in 2008-09.
In the United States, rehypothecation of collateral broker-dealers is limited to 140% of the loan amount for a client, under rule 15c3-3 sec.
Rehypothecation occurs when a lender uses the asset delivered as collateral on a debt obligation of the borrower, and applies its value to cover their commitments. In order to do so, the creditor can have access to various assets promised as collateral, including fixed assets and various securities.
The loan and Rehypothecation
A pledge arises when the borrower promises the right to the asset in the form of collateral in exchange for funds. One common example occurs on the primary housing market, when the borrower uses the house, he buys as collateral for a mortgage loan. Even if the borrower confirms the level of ownership of the property, the lender may seize the asset if payments are not made as required. A similar situation is observed in other secured loans, such as loans vehicle and with the installation of a margin account to support other trading activities.
Rehypothecation occurs when the lender is exercising its rights on the pledge to participate in their operations, often with hopes of financial gain. For example, if the client leaves the number of securities the broker as collateral, often in the margin account and then the broker uses the securities as collateral for the margin on your margin account or as a backup for the loan, rehypothecation has occurred.
The Risks Of Rehypothecation
With rehypothecation, the asset was promised to the institution beyond the original intentions of the borrower. For example, if the property functions as collateral for the mortgage loan, and the lender agrees assets to another financial institution in exchange for the loan, if the mortgage lender fails, the second financial institution can claim the property.