What is Rehypothecation and How Does it Affect Investors?

What is Rehypothecation and How Does it Affect Investors?

What is Rehypothecation and How Does it Affect Investors?

The increasing popularity of holding investments in “street name” (Not the individual investors’ names) presented a golden opportunity for brokerage firms. All those stocks and shares were worth a lot of money – and they were just sitting there. What was to stop them from going to a bank and borrowing money against them? After all, their name was on them, so what could anyone say? With the borrowed money, they could multiply the size of their own investment portfolio many times over – they could quite literally make a fortune with such a huge amount to invest.
This practice is called rehypothecation. Rehypothecation occurs when a broker borrows money for themselves using their customers’ investments as security against their loan.

It is called re-hypothecation because your broker is hypothecating a second time the hypothecated account you hold with them. Only this time, he’s the one that’s borrowing money, and he’s giving the lender a legal claim on your assets in order to secure the loan. Brokerage firms then use the borrowed money to trade solely for their own gain. Their customers receive absolutely none of the profits made, yet their customers are carrying the risk.
It is also a common practice for brokerage firms to lend out customers’ shares to a third party in exchange for payment. In this way, your broker has the power to place your wealth in the hands of people you may never have heard of.

Rehypothecation has been recognized as a dangerous and unethical practice, and it is illegal under US law. But it is legal when permission has been granted to the brokerage firm by the customer. 
It is very likely that you gave your brokerage firm this permission when you signed your account agreement. Even some cash accounts can be subject to rehypothecation. 

According to the Federal Reserve, 90% of traditional assets held at investment banks are re-hypothecated, creating unnecessary risk for the investor. 

The vast majority of investors are unaware of this camouflaged content in account forms. The brokerage firms, it seems, like to tiptoe around the matter in such a way that most investors sign their account forms without knowing they are granting any such permission.

What are the Consequences of Rehypothecation?

A hundred years ago, Wall Street considered rehypothecation to be the practice of unethical individuals. But today, after extensive research, we are not aware of any major brokerage firm that shuns this practice. Generally speaking, individual brokers working for brokerage firms know little or nothing of the practice in their own company.
Like all borrowing, rehypothecation is a double edged sword. Broker-dealers can use it to make lots of profit in a rising market, but in a falling market, the risk of serious financial loss is greatly multiplied. This multiplication of effect is called ‘leverage’.

Here’s how leverage works. If I invest $100 of my own money, and the market falls by half, I’ll lose $50. But I’ll still have $50 left. But if I had borrowed $100 and put that together with my own money and invested $200, I’d have lost $100 instead of $50. And I’d only have $100 left – with which to pay back the loan. Because of the leverage from my borrowing, I’d be wiped out completely.

Risks that arise through Rehypothecation & Leverage

Because brokerage firms borrow money to invest, they can suffer badly from the effects of leverage when the markets fall sharply. Because leverage in brokerage firms was probably at its highest level ever just before the crash in 2008, we saw the largest stock market crash in eighty years.

This is precisely the reason why Lehman Brothers failed.

It is possible that many brokerage firms are in a worse state now than Lehman was in when it was shut down by the federal authorities in September of 2008. The stock and bond markets fell dramatically after that, showing the increasing adverse effects of leverage.

In short, if your broker has leveraged your assets – and then goes bust – your assets could be liable to claims from unpaid creditors.

If you would like to protect your wealth from risks like rehypothecation, schedule a FREE consultation today

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