Hypothecation

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Hypothecation

Generally, in English and American law, a contract of mortgage or pledge as collateral for a debt in which the subject matter is not delivered into the possession of the pledgee or pawnee.[1] The arrangement is common with modern mortgages - the borrower retains legal ownership of the property but provides the lender with a lien over the property until the debt is paid off.


Hypothecation of securities in capital markets

Hypothecation and re-hypothecation, respectively, are commonly used to describe the means by which securities brokers and dealers first extend credit on margin to their customers using pledged securities as collateral, and then pledge the client-owned securities held in the client's margin account as collateral for the brokerage's bank loan. In this example, hypothecation describes the posting of collateral to secure the customer's obligation to the broker; rehypothecation is the pledging by the broker of hypothecated client-owned securities in a margin account to secure a loan to the broker from a bank. This common use of the terms hypothecation and re-hypothecation is technically inaccurate, since the pledgee of the securities collateral, in the case of the broker, may be deemed to have possession of it.

While rehypothecation is not permitted in some jurisdictions, it is common practice in the United States, generally under the terms of a written collateral agreement that explicitly permits it. In addition to the re-hypothecation of a securities broker-dealer's collateral by re-lending it or posting it as collateral for one of its own obligations, another means of re-hypothecation is the repurchase agreement (or repo). In a two-party repo agreement, one party sells the other a security at a specified price with a commitment to buy the security back at a later date for another specified price. Overnight repos, the most commonly used form of this arrangement, comprise a sale which takes place the first day and a repurchase that reverses the transaction the next day. Term repos, less commonly used, extend for a fixed period of time that may be as long as several months. Open-ended term repos are also possible. A so-called reverse repo is not actually different than a repo; it merely describes the opposite side of the transaction. The seller of the security who later repurchases it is entering into a repo; the purchaser who later resells the security enters into a reverse repo. Notwithstanding its nominal form as a sale and subsequent repurchase of a security, the economic effect of a repo is that of a secured loan.[2]

 No creditor's duty of care

Since under a strict hypothecation, goods remain in the custody of the borrower or third party, who also enjoys the right to deal with them in the ordinary course of business, the hypothecation itself does not normally impose upon the creditor a duty of care over the hypothecated property. Accordingly, a judgment of the Kerala High Court of India[3] held that where hypothecated property was lost and the banker was not aware of the loss otherwise than in the ordinary course of business, the surety was not discharged.

 Alternative uses of 'hypothecation'

A more recent use of the term hypothecation is as a contraction of "hypothetical dedication," as in a "dedicated tax" to be collected for a specific purpose. (This may be a spurious origin of the word, since the original definition of hypothecation as a pledging of assets could also be applied: the expected revenue from the tax in question being pledged to a particular cause). Dedicated taxes are often subject to unexpected shortfalls and surpluses. This may create political pressure to adjust the tax, to budget non-dedicated revenues for the purpose in question, or to reallocate surplus funds to other purposes. Examples of hypothecation in this sense include the gasoline tax in the United States, which is dedicated to the funding of transportation infrastructure. A common example in many European countries is a television licence. Here, all owners of televisions are obliged to pay the government an annual fee to use their televisions. The proceeds of the fee are then used to fund public broadcasting. Another example is a dedicated tax on the private trading of securities (for example, 0.3 cents per dollar traded) used to fund public infrastructure programs directly (such as the building of a water treatment plant) or to pay the finance costs of such programs.