Rehypothecation: What is it?
Rehypothecation Defined.
To understand what is happening with rehypothecation, we must first start with the concept of hypothecation. Hypothecation occurs when you pledge your financial assets to a broker, bank, or a financial institution to obtain a loan. The pledged asset is called collateral. A few examples of this arrangement – pledging your house to obtain a mortgage loan and/or pledging your car to obtain a car loan. The collateral, in case you default on your loan, remains free to be disposed of by the lender. So, in effect, the ownership of that asset passes to your creditor.
Rehypothecation happens when a lender re-uses the collateral from one loan to take out a new loan. Now the collateral is being doubly pledged or bears the burden of multiple debts.
Advantages of Rehypothecation.
When a borrower allows his asset(s) to be used as collateral for rehypothecation, the borrower can be awarded with a lower cost of borrowing or a certain amount of rebate – lower interest and borrowing costs. Promoting leverage can also be seen as a good. Trading without an entity using their own money – by pledging and rehypothecating securities, leverage is being generated in accessing capital markets. Thus, necessary trading encourages price discovery and helps to increase efficiency in capital markets.
Disadvantages of Rehypothecation.
Consumers may be unaware that their asset(s) are being used by the lender for speculative purposes. Securities would be misused under this scenario. Risk of default is probably the biggest negative. If the underlying entity defaults (or one of the underlying entities defaults) due to leverage and borrowing, it can cause enormous stress on the whole financial system. It can cause repercussions on the entire economy. One default, due to significant leverage, would magnify the impact and rehypothecation could cause massive losses.
Examples of Actual cases of the Disadvantages of Rehypothecation.
The Lehman Brothers bankruptcy and subsequent credit crunch in 2008-2009 put the word rehypothecation on the world map – showing us the dangers.
This bankruptcy resulted in Lehman clients ending up being last in line to retrieve their assets – becoming mere creditors. Rehypothecation had combined their assets with Lehman’s other assets. The bank/brokerage/financial institution that the collateral has been rehypothecated to has priority over clients by law. After court proceedings one would be lucky to end up with anything – you were basically paying for someone else’s failures.
Also, through no fault of your own, your assets could be seized – not just assets you have borrowed against. The bankruptcy of MF Global (run by Jon Corzine, 54th governor of New Jersey, US Senator, CEO of Goldman Sachs) in 2011 shows how your other assets can be taken away from you. The firm was a major publicly traded financial and commodities broker with billions in assets. MF Global took highly speculative bets using clients’ collateral and later on took the same clients’ money to cover the magnified losses.
How to Protect Against Rehypothecation.
The simplest way to protect yourself is to refuse to hypothecate your holdings – do not open a margin account. If you want to trade derivatives such as stock options, this will be an inconvenience; however, you will never face a margin call or risk more funds than you have at any given time in your account.
The important point here is to understand what you are signing when you open an account with a financial institution – read the fine print too!
Market Commentary.
By now, everyone knows that 2022 was a tough year in all the markets. We are not surprised and have been talking about our concerns for quite some time. We have talked in prior newsletters about these issues. So, on to 2023. Our concerns for this year are as follows: anti-growth policies of our government elites; liquidity issues that are changing – from quantitative easing (QE) to quantitative tightening (QT) – QE responsible for asset bubbles; our strategic petroleum reserves are sitting at below 1984 levels; persistent inflation (peaked, but how high will it remain?); and ultimately the severity of a recession. We, like some, are watching and maintaining a cautious stance for now. So, what to do? Money market rates have gone up dramatically. Having some cash reserves now affords us to earn a decent rate of return while waiting for better market conditions to put more money to work. Having reserves provides opportunity. Opportunity to invest when we have a clearer picture of the future and good value presents itself. We are ever optimistic that these opportunities will do just that.
We appreciate and thank you for the trust and confidence you have placed in Occam Capital® Management, LLC.