Rehypothecation

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Frankly, I don’t expect many readers to be familiar with the term above, let alone to know what it means. So let’s begin by turning to the fount of all knowledge in our age — Wikipedia. Here we learn that “hypothecation is the practice where (usually through a letter of hypothecation) a borrower pledges collateral to secure a debt or a borrower, as a condition precedent to a loan, or has a third party (usually an affiliate) pledge collateral for the borrower. The borrower retains ownership of the collateral, but the creditor has the right to seize possession if the borrower defaults. A common example occurs when a consumer enters into a mortgage agreement, in which the consumer’s house becomes collateral until the mortgage loan is paid off”.

Hopefully, that is clear enough. The Talmud uses the term “apotekai” for a mortgage loan and, although the linguistic origins of that term are probably Roman, the prominence of the Jews in medieval finance may be the reason it entered mainstream financial parlance. Be that as it may, hypothecation is something most of us do, or have done, even if we didn’t know that’s what it’s called.

We now advance to “rehypothecation” and, reverting to Wiki, we learn that “rehypothecation is a professional financial market practice, where counterparty reuses a security pledged as a collateral for its own use. It is how the hypothecation mechanism fundamentally works in the security market, replacing the overhead of liens through actual title transfer against cash with the promise of an opposite transaction in the future (repo). Counterparties receiving the security can use it freely”.

For most readers, that is impenetrable jargon. But the distinction is now clear — hypothecation is something everyone does, rehypothecation is something that only financial market professionals practice. Let us, therefore, stick with hypothecation and see what we can do with it. You want to buy an apartment, house, building or property. You don’t have money, so you go to the banks — “cos that’s where the money is”, as bank-robber Willy Sutton explained, when asked why he kept robbing banks — and they lend you money. But they want collateral, so they take a lien on the asset you are buying with their money, effectively making it their asset, until you have repaid the loan.

Now, suppose you tried to be clever and, having borrowed the money from Bank A and pledged the asset to them, you then went to Bank B and tried to borrow money from it, offering your asset as collateral. In Israel, as in all counties where the financial system, real-estate sector and government bureaucracies function properly (that’s not the same as efficiently…), Bank B would check and discover that the said asset was already pledged to Bank A. It would then refuse to lend you money, unless you put up another asset — and maybe it would throw you out in any event. If somehow the second loan was made (maybe you bribed the relevant manager) and the fraud was only discovered ex post, Bank B would probably initiate legal proceedings against you.

Now we’ll play a different thought experiment. Supposing you had an asset, a real, hard asset — such as a consignment of thousands of tonnes of iron, or copper, or even thousands of kilos of gold. You had documentation proving that your asset was being stored in a secure warehouse facility — and on this basis, Bank A gave you a loan, against which the asset was duly pledged. But in the imaginary country we are talking about, you could go to Bank B and do the same thing, i.e. rehypothecate your asset, getting two loans both underwritten by the same lien. You could, in fact, go to Banks C, D and E and do the same thing. In theory, if the lenders played along with you, for whatever reason (most likely, the one cited above), you could rehypothecate the same asset infinitely.

In reality, the rehypothecation process would be much more sophisticated, as befits a “professional financial market practice”. It would involve hedging the physical asset (base or precious metals) against futures contracts, so that the financing would be made against these derivative instruments and would be “rolled over” every three months or so. But these details are unimportant, once the principle is understood. Oh yes, one more thing, which is very important indeed: The money you receive in loans is invested in speculative ventures, whether real-estate (can’t possibly lose), or in financial markets.

Now imagine that this imaginary country where multiple rehypothecation was possible really existed and it was called China. It imported huge quantities of raw materials and built endless housing projects, whilst its currency offered a one-way rise to slow, unspectacular returns which, if you used massive leveraging, became enormous. Imagine that eventually, this monstrous distortion of physical markets was uncovered — 100, 000 tonnes of iron, 20, 000 tonnes of copper, etc. were found to be “missing”, just in China’s third-largest port and the investigation is spreading. In fact, they never existed, the import documentation was fictitious — but the loans given against them were real. However, the money from the loans is gone, because the housing market has crashed, the currency has changed direction, the whole “sure thing” has fallen apart.

Now wake up. This nightmare is really happening in China and the scale of the fraud being unearthed — and hence of the banks’ losses — keeps growing. Obviously, the Chinese are trying to prevent a systemic collapse and, so far, they are holding the line. We had better hope they succeed, unlikely though that is, because otherwise everyone will soon know all about rehypothecation — and curse the day they heard of it.