Rehypothecation Explained In Simple Terms

The dictionary definition of rehypothecation is as follows:

• "Pledging to banks by securities brokers of the amount in customers' margin account as collateral for broker loans, which are used to cover margin loans to customers for margin purchases and selling short."

What this means for you as a depositor:

When you deposit money into a bank, the bank is LEGALLY able to take your deposit and use it however it pleases.  You agree to this when you sign the agreement when opening an account at a bank or with a broker.  To give an example of how absurd rehypothecation is, imagine a homeowner was able to take out 17 home equity lines of credit against 1 home.  Then imagine that the homeowner is unable to make payment, and thus defaults on his obligations to his creditors.  In this situation, there will be 16 creditors who are unable to claim any collateral while 1 creditor (the strongest and most well connected) ends up with the home.  To restate this argument, we can say that by depositing funds into a bank or brokerage account, the depositor may unwittingly have his or deposit become collateral for someone else's leveraged bet.  At this point as a depositor, you do not really have control of your money until you execute a withdrawal and resecure your assets in the form of cash-in-hand. 

What are the implications of this?  Very simple but also potentially catastrophic.  There are at this time an unknown number of investors, pensioners, 401K, and IRA holders who's bank statements have positive balances in them.  If the bank or brokerage house that these people are invested in take customer funds as collateral for leveraged bets, and the bets go the wrong way (see MF Global), the customer's accounts can be taken to zero with no warning.  In bankruptcy court, the customers will be the last in line to reclaim assets and will most likely end up with an account balance equal to zero.  The customer has no recourse.

Another factor to consider from the example above is that 16 out of 17 creditors will be in immediate danger of bankruptcy if they issued credit to another institution who has repledged, or rehypothecated their creditors deposits.  There is a potential for a chain reaction type of bankruptcy event that could potentially dwarf the events in 2008.  In the event of a 2008 type crash, Central Banks will have the god power to choose life or death for any given creditor.  Central Banks can back-stop any firm that they deem worth of saving, while letting others fail.

Rehypothecation creates the illusion of widespread wealth.  The truth is that whoever holds the actual collateral is, in the end, the true owner of asset.  If the asset is not in your hands, it is not yours.  Secure your wealth now or risk taking losses that are out of your control.