Hypothec


Hypothec, sometimes tacit hypothec, is a term used in civil law systems to refer to a registered real security of a creditor over real estate, but under some jurisdictions it may additionally cover ships only, as opposed to other collaterals, including corporeal movables other than ships, securities or intangible assets such as intellectual property rights, covered by a different type of right. Common law has two main equivalents to the term: mortgages and non-possessory lien.

Overview

This real right in security operates by way of hypothecation. It may arise only through being entered into the land and hypothec register or the ship registry, as a result of:
Hypothec gives a creditor a preferential right to have claims paid out of the hypothecated property as last recourse when the debtor is in default. In the hypothec, the property does not pass to the creditor, but they acquire a preferential right to have their debt paid out of the hypothecated property; that is, they can sell it and pay themself out of the proceeds, or in default of a purchaser they can become the owner themself.

History

Originating in Roman law, a hypotheca was essentially a non-possessory pledge over a person's entire estate, but during the Renaissance the device was revived by civil law legal systems as a hypothecatory security interest taken strictly over immovable property and, like the late medieval obligatio bonorum, running with the land (Latin jus persequendi.

Hypothecation and rehypothecation

Hypothecation is the practice where a debtor pledges collateral to secure a debt or as a condition precedent to the debt, or a third party pledges collateral for the debtor. A common example occurs when a debtor enters into a hypothecary loan agreement, in which the debtor's house becomes collateral until the hypothecary loan is paid off. The debtor retains ownership of the collateral, but the creditor has the right to seize ownership if the debtor defaults. The main purpose of hypothecation is to mitigate the creditor's credit risk. If the debtor cannot pay, the creditor possesses the collateral and therefore can claim its ownership, sell it and thus compensate the lacking cash inflows. In a default of the obligor without previous hypothecation, the creditor cannot be sure that it can seize sufficient assets of the debtor. Because hypothecation makes it easier to get the debt and potentially decreases its price; the debtor wants to hypothecate as much debt as possible but the isolation of 'good assets' for the collateral reduces the quality of the rest of the debtor's balance sheet and thus its credit worthiness. The detailed practice and rules regulatory hypothecation vary depending on context and on the jurisdiction where it takes place. Hypothecation is a common feature of consumer contracts involving mortgages the debtor legally owns the house, but until the mortgage is paid off, the creditor has the right to take ownership but only if the debtor fails to keep up with repayments.
If a consumer takes out an additional loan secured against the value of his hypothec the consumer is then hypothecating the hypothec itself the creditor can still seize the house but in this case the creditor then becomes responsible for the outstanding hypothecary debt. Sometimes consumer goods and business equipment can be bought on credit agreements involving hypothecation the goods are legally owned by the borrower, but once again the creditor can seize them if required.
Rehypothecation occurs when entities re-use the collateral to secure their own borrowing. For the creditor the collateral not only mitigates the credit risk but also allows refinancing more easily or at lower rates; in an initial hypothecation contract, however, the debtor can restrict such re-use of the collateral.

Hypothec in mixed legal systems

Under a handful of mixed legal systems, the hypothec was imported as a non-possessory real security over movable property. In the mixed legal systems of some other countries it may cover any corporeal movables, securities or intangible assets. Whereas a pledge operates by bailment and transfers possession on delivery and a chattel mortgage operates by conveyance and transfers title, a hypothec operates by hypothecation and transfers neither possession nor title. The name and the principle have passed into Scotland's civil law system, which distinguishes between conventional hypothecs, as bottomry and respondentia, and tacit hypothecs established by law. Of the latter the most important is the landlord's hypothec for rent, which extends over the produce of the land and the cattle and sheep fed on it, and over stock and horses used in husbandry. In the US, the legal right for the creditor to take ownership of the collateral if the debtor defaults is classified as a lien.
The most common form of hypothecation is a repo transaction: the creditor gives a loan to the debtor and receives in return the possession of a financial asset until the maturity of the loan.
A reverse repo is a hypothecation 'in the reverse direction': creditor and debtor swap roles. When an investor asks a broker to purchase securities on margin, hypothecation can occur in two senses. First, the purchased assets can be hypothecated so that, if the investor fails to keep up credit repayments, the broker can sell some of the securities; the broker can also sell the securities if they drop in value and the investor fails to respond to a margin call. The second sense is that the original deposit the investor puts down for the margin account can itself be in the form of securities rather than a cash deposit, and again the securities belong to the investor but can be sold by the creditor in the case of a default. In both cases, unlike with consumer or business finance, the borrower does not typically have possession of the securities as they will be in accounts controlled by the broker, however, the borrower does still retain legal ownership.
Rehypothecation can also be involved in repurchase agreements, commonly called repos. In a two-party repurchase agreement, one party sells to the other a security at a price with a commitment to buy the security back at a later date for another price. Overnight repurchase agreements, the most commonly used form of this arrangement, comprise a sale which takes place the first day and a repurchase that reverses the transaction the next day. Term repurchase agreements, less commonly used, extend for a fixed period of time that may be as long as three months. Open-ended term repurchase agreements are also possible. A so-called reverse repo is not actually any different from a repo; it merely describes the opposite side of the transaction. The seller of the security who later repurchases it is entering into a repurchase agreement; the purchaser who later re-sells the security enters into a reverse repurchase agreement. Notwithstanding its nominal form as a sale and subsequent repurchase of a security, the economic effect of a repurchase agreement is that of a secured loan.
Re-hypothecation occurs mainly in the financial markets when the creditor re-uses the collateral posted by the debtor to back the broker's own trades and borrowing. This mechanism also enables leverage in the securities market. In the UK, there is no limit on the amount of a client's assets that can be rehypothecated, except if the client has negotiated an agreement with their broker that includes a limit or prohibition. In the US, re-hypothecation is capped at 140% of a client's debit balance. In 2007, rehypothecation accounted for half the activity in the shadow banking system. Because the collateral is not cash it does not show up on conventional balance sheet accounting. Before the Lehman collapse, the International Monetary Fund calculated that US banks were receiving over $4 trillion worth of funding by rehypothecation, much of it sourced from the UK where there are no statutory limits governing the reuse of a client's collateral. It is estimated that only $1 trillion of original collateral was being used, meaning that collateral was being rehypothecated several times over, with an estimated churn factor of 4. Following the Lehman collapse, large hedge funds in particular became more wary of allowing their collateral to be rehypothecated, and even in the UK they would insist on contracts that limit the amount of their assets that can be reposted, or even prohibit rehypothecation completely. In 2009 the IMF estimated that the funds available to US banks due to rehypothecation had declined by more than half to $2.1 trillion due to both less original collateral being available for rehypothecation in the first place and a lower churn factor. The possible role of rehypothecation in the 2008 financial crisis and in the shadow banking system was largely overlooked by the mainstream financial press, until Dr. Gillian Tett of the Financial Times drew attention in August 2010 to a paper from Manmohan Singh and James Aitken of the International Monetary Fund which examined the issue.

By jurisdiction

Scotland

The law of agricultural hypothec long caused much discontent in Scotland; its operation was restricted by the Hypothec Amendment Act 1867, and by the Hypothec Abolition Act 1880 it was enacted that the landlord's right of hypothec for the rent of land, including the rent of any buildings thereon, exceeding two acres in extent, let for agriculture or pasture, shall cease and determine. By the same act and by the Agricultural Holdings Act 1883 other rights and remedies for rent, where the right of hypothec had ceased, were given to the landlord.
Under Scots law, landlord's hypothec is a common law right of security enjoyed by landlords over any goods sited on the leased premises, regardless of who owns those goods. The hypothec does not secure all sums which happen to be due to the landlord, only a portion of the rent. Landlord's hypothec is enforced by court proceedings known as sequestration for rent. The Bankruptcy and Diligence etc. Act 2007 abolishes the common law diligence of sequestration for rent.
The Scottish Executive felt that such a mechanism had no part to play in a modern enforcement system, not least because a landlord is able to use other diligences to recover unpaid rent, such as attachment sequestration for rent can now be used to sell only goods that are secured by a right known as the landlord's hypothec, which arises automatically whenever there is a qualifying lease.
The act makes some changes to the hypothec, even though it is not a diligence. For example, it completes the process of abolishing the hypothec over goods in dwelling-houses that was initiated by the Debt Arrangement and Attachment Act 2002. It also abolishes the hypothec over goods owned by a third party.
The act also states that, notwithstanding the abolition of sequestration for rent, landlord's hypothec does continue as a right in security ).