Rehypothecation occurs mainly in the financial markets, and is where financial institutions such as commercial banks, investment banks and brokerages etc, re-utilise collateral such as stocks, bonds, currencies and commodities that have been placed with them by re-issuing the collateral as a new debt instrument in the form of a financial derivative.
The result of issuing this new debt instrument, often referred to as Collateralised Debt Obligation, (CDO’s), which carry an interest rate is increased liquidity.
In order to understand rehypothecation, what first must be understood is hypothecation. Hypothecation is where certain assets can be pledged in return for what is known as debt collateral which can easily be seized in the event of a default. A classic example is a mortgage where a hypothecation agreement is entered into, and whilst the title to the house is retained by the owner(s), failure to keep up the mortgage repayments can result the house being seized by the lender.
How Rehypothecation Works
Obviously, some rehypothecated assets work differently from others. Shares for example can be placed with bankers or brokers and the owner can then hypothecate the shares and use the funds, (rehypothecation), to buy more shares in another company. This is a simple form of rehypothecation.
However, there is a down side to rehypothecation as witnessed in financial meltdown of 2008, often referred to as the subprime mortgage crisis. This where banks and investment banks took all the mortgages they owned and rehypothecated them into debt instruments, attached an interest rate and sold them in the secondary market. Sadly, when the housing market crashed the value of these instruments plummeted, leaving the holders with a value of only cents in the dollar.
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