Hypothecation and Re-Hypothecation

The MF Global meltdown has brought the words 'hypothecation' and 're-hypothecation' to the forefront. Hypothecation is the relatively common situation where a buyer pledges collateral to secure a debt. The borrower retains ownership of the collateral, but in the 'hypothetical' case that the borrower defaults, then the creditor can take possession of the collateral.

In the US, the right of a creditor to take ownership of collateral if the debtor defaults is called a lien.

The lion's share of home mortgages reflect hypothecation. The home 'buyer' pledges the property to be purchased as collateral to secure a mortgage from a lender. Until the house is paid off, the creditor retains the right to take possession of the property if the borrower fails to keep up with mortgage payments.

Re-hypothecation occurs when financial entities pledge collateral that has already been posted by clients to support their own borrowing and trading. If a broker dealer such as MF Global puts up assets held by clients in 'margin accounts' as collateral to, say, speculate in Euro sovereign bonds, then this broker dealer would be engaging in re-hypothecation.

The immediate consequence of re-hypothecation is that it increases systemic leverage. More assets can be borrowed and controlled with less amounts of underlying equity.

As we noted many times on these pages, leverage becomes problematic when price moves against you. The higher the leverage, the smaller the change in price necessary to wipe you out.

Thus, when Euro bonds tanked over the past few months, MF Global was wiped out.

In the case where leverage is built on re-hypothecation, then the question becomes one of property rights. Whose property is lost when MF Global was wiped out? If re-hypothecation is in fact a legal aspect of a contract (e.g., a client of MF Global agrees that a condition of maintaining a 'margin account' at the firm is that holdings can be re-hypothecated for MF's own trading endeavors), then it is the client, not the firm, that is on the hook.

Thus, clients of MF Global may be out billions of dollars...