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Rehypothecation Risk

15 Apr 2001

Granting rehypothecation or "use rights" with respect to pledged collateral is common in the over-the-counter derivative market. In fact, subject to the pledgor's consent, the credit support annex to the International Swaps and Derivatives Association master agreement provides the secured party with the right to rehypothecate, or use for its own purposes, collateral pledged to it---subject only to the obligation to return the collateral once the pledgor has satisfied its obligations. Customers, however, are often alarmed to learn that the dealer requires such an unrestricted right to use and sell the pledged collateral.

Dealers view this right as business as usual given the historical practice of brokerage firms' margin lending to their brokerage customers. In fact, dealers may be unwilling to enter into OTC derivatives transactions with a customer if the customer will not consent to rehypothecation. Dealers depend upon rehypothecating collateral to create additional liquidity for themselves. A dealer may "repo" the collateral to raise additional capital. A dealer may also even repledge the collateral to secure its own obligations, freeing up capital for other purposes.

Rehypothecation in the OTC derivatives area potentially represents new risks. By consenting to rehypothecation, the pledgor faces the possibility that a secured party may become insolvent and therefore unable to return the posted collateral after the pledgor has met its payment obligations---either because it was sold in a repo transaction or pledged as collateral to the secured party's other creditors. Although the pledgor may retain some property right in the rehypothecated collateral, reclaiming that collateral upon the bankruptcy of a secured party may, as a practical matter, be next to impossible.

Upon the bankruptcy of the secured party, the pledgor could theoretically end up paying twice: first, when pledging collateral that may not be returned to it, and, second, when it meets its contractual payment obligations under the transaction. To avoid the risk of double payment, the pledgor should be able to exercise its set off rights. The pledgor would set off what it owes the secured party against the pledged collateral.


The Set Off Remedy

The credit support annex to the ISDA master agreement expressly provides the pledgor a contractual right to set off any amounts that it owes to the secured party against any posted collateral that the secured party has failed to return after becoming insolvent or bankrupt. This contractual right of set off should be recognized under applicable state, banking and bankruptcy law. In addition to this contractual remedy, the pledgor probably has a set off right under the New York set off statute or under common law.

Although set off provides important protections, the pledgor may still be at risk if the pledgor has overcollateralized its payment obligation. The right of set off enables the pledgor to recover the value of the pledged collateral, but only to the extent of its obligation to the secured party. For example, assume that the pledgor had pledged USD20 million in collateral, but only had a payment obligation of USD18 million under the transaction. It would be unable to set off the remaining USD2 million. The pledgor would probably become an unsecured general creditor of an insolvent or bankrupt secured party for such excess.

The pledgor can end up overcollateralizing its obligations to the secured party for several reasons. First, the secured party may have required the pledgor to pledge not only collateral sufficient to secure its obligation, but also an additional "independent amount." This independent amount constitutes what one would think of as margin and is in addition to the obligation to be collateralized, providing the secured party with additional protection.

Second, the derivative transaction may move rapidly against the secured party, resulting in the secured party having the payment obligation. Until the secured party returns the posted collateral, the pledgor has overcollateralized its obligation. Third, the pledgor may become overcollateralized if the secured party fails to meet its contractual obligation to transfer the posted collateral as required. It is possible that a secured party may be unable to return rehypothecated (that is, sold or transferred) collateral if the secured party does not have the funds to repurchase or reacquire the rehypothecated collateral.

Many customers attempt to resist consenting to rehypothecation with a dealer. As a practical matter, however, a dealer may be unwilling to trade with a customer without such consent.


Avoiding Overcollateralization

A customer should focus on ways to minimize overcollateralizing its obligations. Because rehypothecation risk principally occurs upon the insolvency of the secured party, the pledgor may want to consider making the right contingent upon the secured party's maintaining a certain credit rating or not being in default with respect to the transaction. If the secured party fails to meet any of these conditions, it would be required to stop rehypothecating and reacquire any previously rehypothecated pledged collateral.

Overcollateralization can also be avoided by negotiating as large a threshold as possible with respect to when the pledgor will be required to pledge collateral. Under the credit support annex to the ISDA master agreement, a pledgor is required to pledge collateral to the extent that its obligation exceeds a negotiated threshold. A secured party will typically not become overcollateralized under the ISDA annex provided that the pledgor is only required to pledge collateral above the threshold amount, as opposed to an amount equal to its entire obligation to the secured party.

For example, assume that the pledgor is required to pledge collateral to the secured party when its obligation to the secured party exceeds a negotiated USD10 million threshold. If the pledgor's obligation exceeds USD11 million, the pledgor must pledge USD1 million. The pledgor's obligation to the secured party would need to drop below USD1 million from USD10 million for the pledgor to have overcollateralized its obligation to the secured party.

The pledgor may also insist that a third party custodian hold any posted collateral. Custodians would reduce certain rehypothecation risk for several reasons. First, a custodian is a disinterested third party in control of the transfer of the collateral. A custodian would not delay the transfer of collateral after the pledgor had requested its return as a secured party might be motivated to do. The custodian would not have the same incentives as a secured party to retain collateral in the event that the secured party became financially troubled.

A customer truly concerned about rehypothecation could minimize the risks by entering into other forms of credit support arrangements as opposed to posting collateral. A customer, for example, could make cash payments equal to mark-to-market exposure or provide a letter of credit, eliminating the need to post collateral. The dealer, however, may resist these alternatives, finding them inefficient and expensive as compared to using collateral.

Granting a right of rehypothecation has become a requirement to do business with certain dealers in the derivatives area. By granting that right of rehypothecation, however, the pledgor faces certain risks if the secured party becomes bankrupt or insolvent. These risks, however, are minimized by the pledgor's right to set off the amounts that it owes to the secured party and amounts that it has pledged. However, because this will not fully protect the pledgor in the event that it is overcollateralized, the pledgor should guard against pledging collateral in excess of its obligation to the secured party.


This week's Learning Curve was written byChristian Johnson, associate professor atLoyola University Chicago School Of Lawin Chicago.

15 Apr 2001