In investment banking, rehypothecation occurs when a bank acquires loans by using the collateral of its clients as the bank’s own collateral. It is a common practice within the so-called unregulated “shadow banking” sector and has been cited as one of the causes of the 2007-2008 credit crisis.
Rehypothecation is conducted as a way of getting around collateral requirements for obtaining credit. Lenders often give money to people or firms which they fear may not be able to pay back the loan. In such cases, they often demand that the borrower set aside certain assets which will be forfeited to the lender if the borrower defaults on the loan. This is known as collateral. For instance, when a couple obtains a mortgage on a new house, the house itself may be set as the collateral. However, collateral can also be any other valuable assets upon which the lender and the borrower can agree, like a car or some jewellery.
In recent years, critics of the global banking system have grown increasingly concerned about a process called rehypothecation. This term refers to a re-collateralization of assets that a company does not necessarily own, but has control of via other financial instruments. Moreover, in rehypothecation, a borrower pledges the assets that have already been pledged to it as collateral by its own borrowers. A bank does this instead of pledging its own assets as collateral. Economics writer Tyler Cowen refers to this simply as “an asset used as collateral more than once and at the same time.” The most common form of rehypothecation in the markets today occurs when investment banks re-use the collateral already guaranteed to them by hedge funds. A hedge fund is a specialized company that invests private capital in certain types of complex investment strategies designed to neutralize risks while maximizing returns.
As long as the market was working smoothly and growing steadily, this practice seemed very appealing. It allowed the investment banks to effectively increase their collateral and secure larger loans. Those loans were funneled into new investments, which led to increased revenue. As long as most of the loans were being paid back on time, it made very little difference what was being advanced as collateral; this is because it almost never had to be drawn upon anyway. In the United States, there were limits placed on the amount of collateral that could be re-used in this fashion. When investors in Europe started to pick up the practice however, they usually did so in the absence of any regulations at all.
The result, according to financial analysts, was an explosion of rehypothecation. According to a study published by the International Monetary Fund (IMF), rehypothecation was involved in the majority of activity within the unregulated shadow banking sector. That sector includes hedge funds, money market funds and other investors dealing in new and largely unregulated investment vehicles like derivatives.
Unfortunately, the key weakness of rehypothecation is that when things go wrong in the banking sector, they can spiral out of control very quickly. For example, when American banking giant Lehman Brothers collapsed in 2008, it was revealed that many of the assets pledged to Lehman as collateral had in turn been re-pledged to Lehman’s own creditors. This meant that when Lehman was unable to make its payments, its clients collateral became the assets that could be seized by Lehman’s creditors.
Since 2008, fear of the consequences of rehypothecation when a major bank fails have allegedly resulted in a dramatic reduction in the use of rehypothecation. However, the practice has not disappeared entirely. To illustrate, when MF Global collapsed in 2011, it was revealed that the bank had tried to make payments in the short term by using customer funds to pay its own loans. Rehypothecation was immediately identified as one of the culprits behind the MF Global collapse. Exactly what occurred at MF Global is still unclear, but it does illustrate the dangers of similar modern banking practices: Customers can suddenly be left without funds or assets because of the business losses incurred by the lender.