Hypothecation

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The term “hypothecation” describes the transaction a person makes when he puts up an asset as collateral but still owns that asset. A common example of this is a mortgage. While a person still owns his house, he uses the house as collateral in order to secure the bank’s approval to take out a mortgage. To explore this concept, consider the following hypothecation definition.

Definition of Hypothecation

Noun

  1. The act of putting up an asset as collateral so as to secure a loan, but without giving up ownership to that asset.

Origin

1675-1685        Medieval Latin (hypothēcātus)

Hypothecation Agreement

A hypothecation agreement is an agreement a person makes in order to secure a loan by putting up one of his assets as collateral. He still owns the asset, but the lender can seize the asset if the borrower fails to uphold his end of the agreement.

The most common example of this is the act of securing a mortgage. While the borrower still technically owns his house, he agrees to use it as collateral to take out the mortgage. He does this with the understanding that, if he fails to pay, the bank can take his house as a form of payment, and so begins the foreclosure process. Another example of this is a car loan. The bank can repossess (“repo”) a borrower’s car if he fails to make good on his loan.

Stock

The stock market is another place where these agreements are common. Here, a broker will allow an investor to borrow money to buy stock, and the investor then puts up that stock as collateral. The investor is the true owner of the stock, but the broker can seize the stock if either the investor does not pay back the money, or the stock falls below a certain value.

Rehypothecation

Rehypothecation is a subsection of hypothecation, meaning that rehypothecation refers to what banks and brokers do with the assets their clients post as collateral in order to take out their loans. Clients must agree to this before banks and brokers can use their assets. If they agree, the banks and brokers may compensate them by either lowering their borrowing costs or providing them with a rebate.

Rehypothecation is more common when dealing with stock, as a brokerage will use collateral stocks to back their own trades. This used to be more common, but declined in popularity after the recession in 2008 and 2009.

Hypothecation Example Involving a Deceased Borrower

An example of hypothecation came before the Court in 1991 with the case of Bank IV Topeka v. Topeka Bank & Trust Co. Here, Florene E. Lauver took out a certificate of deposit (CD) in the amount of $100,000 in February of 1984 from Capitol Federal Savings & Loan Association. The CD had a maturity date of February 9, 1987. In July of 1984, Lauver executed a hypothecation agreement which she gave Richard Cummins authorization to use the CD as collateral with Topeka Bank & Trust Co. Topeka then sent a letter to Capitol Federal, advising Capitol of its new interest in the CD.

Lauver passed away in December of 1988, and Cummins passed away six months later. At the time of Cummins’ death, the promissory note Cummins obtained using the CD as collateral was in default. Topeka Bank & Trust Co. placed a lien on the CD, however Bank IV Topeka, as the executor of Lauver’s estate, filed suit to void the lien and recover the CD as an asset.

Lawsuit

Upon the conclusion of trial, the court granted Topeka Bank & Trust Co.’s motion for summary judgment, holding that the bank was, in fact, entitled to interest in the CD. Bank IV Topeka appealed, and the Court of Appeals of Kansas affirmed, though for different reasons. The Court explained that while it agreed with the trial court that there was a valid lien on the CD, the CD was not, as the trial court had described, an “instrument” under the Uniform Commercial Code. Said the Court:

“We hold that the hypothecation agreement signed by Mrs. Lauver was sufficient to prove that the Bank held a contractual lien on the account represented by the CD. The hypothecation agreement clearly indicates that it is to secure an indebtedness from Mr. Cummins to the Bank and the specific security is described. We are given no indication that Mrs. Lauver was incompetent, misled, or under an improper influence in signing the hypothecation agreement. We think that her intent is indicated by the hypothecation agreement, in which she has clearly granted a contractual lien to the Bank on the proceeds of her bank account at Capitol Federal. The lien that she created is certainly valid and prior to any interest her executor may have acquired in the proceeds of the bank account.

The executor argues that it is significant that the decedent did not endorse the document or otherwise transfer it to the Bank. We do not agree. The document in this case was ‘nontransferable,’ and it was never intended that it be negotiated or transferred by indorsement or otherwise. Mrs. Lauver was free, however, to create a valid lien on her bank account, and we conclude that she did.”

Related Legal Terms and Issues

  • Asset – Any valuable thing or property owned by a person or entity, regarded as being of value.
  • Brokerage Firm – A company that, through its employed agents and stockbrokers, facilitates the buying and selling of stocks, bonds, and other investments for consumer investors for a fee.
  • Certificate of Deposit (CD) – A certificate that a bank issues to a person allowing them to deposit money for a specified period of time.
  • Collateral – Something of value pledged as security for repayment of a loan.
  • Lien – An encumbrance placed on a person’s property to secure a debt the property owner owes to another person or entity.
  • Summary Judgment – A final decision on the case, handed down by the judge on the basis of the statements and evidence presented, without a full trial.