What is hypothecation?
Hypothecation occurs when an asset is pledged as collateral to secure a loan, without giving up title, possession, or property rights, such as the income generated by the asset. However, the lender can seize the asset if the terms of the agreement are not met.
A rental property, for example, may be subject to a mortgage to secure a mortgage issued by a bank. Although the property remains a guarantee, the bank has no claims on the rental income that comes in; however, if the owner is in default, the bank can seize the property.
How Hypothecation Works
Mortgage most often occurs in mortgage loans. The borrower is technically the owner of the house, but since the house is pledged as collateral, the mortgage lender has the right to foreclose on the house if the borrower cannot meet the terms of the loan agreement repayment – occurring during the foreclosure crisis. Auto loans are also guaranteed by the underlying vehicle. Unsecured loans, on the other hand, do not work with the mortgage as there is no collateral to be claimed in the event of default.
Since the mortgage provides security to the lender because of the guarantees given by the borrower, it is easier to guarantee a loan and the lender can offer a lower interest rate than an unsecured loan.
Key points to remember
- Hypothecation occurs when an asset is pledged as collateral to secure a loan, without giving up title, possession, or property rights, such as the income generated by the asset.
- Mortgage most often occurs in mortgages, where the home is used as collateral, but the bank has no claim on the cash flow or income generated, unless the borrower defaults.
- Another common form of mortgage in trading and investing in securities is margin lending in brokerage accounts.
Special considerations: investment hypothesis
Another common form of mortgage is margin lending in brokerage accounts. When an investor chooses to buy on margin or sell short, he accepts that these securities can be sold if necessary in the event of a margin call. The investor owns the securities in his account, but the broker can sell them if they make a margin call that the investor cannot meet, in order to cover his losses.
When banks and brokers use mortgaged collateral as collateral to support their own transactions and transactions with the agreement of their client, to secure a lower cost of borrowing or a fee rebate. This is called remortgage.
If certain types of remortgage can contribute to the functioning of the market, if the guarantees collected to protect against the risk of default by the counterparty have been remortgage, they may not be available in the event of default. This, in turn, can increase systemic risk and amplify market tensions by causing a chain reaction in asset sales. So when the guarantee is renewed, investors need to understand the length of the guarantee chain.