Rehypothecation – A Fun Word You Might Need To Know

January 20, 2013 / Michael E Picray

Rehypothecation is one of those words that, the more you look into its use, the funnier it gets. Although the word itself is a technical term that describes a simple relationship between brokerage accounts and customers, the word can also lead you to a statue of Abraham Lincoln and a pig.
The simple definition of the word is;

Rehypothecation. Rehypothecation occurs when your broker, to whom you have hypothecated — or pledged — securities as collateral for a margin loan, pledges those same securities to a bank or other lender to secure a loan to cover the firm’s exposure to potential margin account losses.
When you open a margin account, you typically sign a general account agreement with your broker, in which you authorize your broker to rehypothecate.”

To simplify, a margin account is where you make a down payment on stocks, bonds or securities. Just before the Great Depression, margin accounts were commonly required to deposit 10% of the purchase price of the stocks you wanted to buy with the broker. Then when the price of the stock went up, you’d use the profits of selling the stock to pay for the other 90% and pocket the difference. But if the price of the stock went down, you were supposed to pay in more money to “cover” the stock’s loss in value. (If a $100 stock on 10% margin lost $10, you’d have to put up $9 more because the stock lost $10 of value, effectively eating your margin deposit.) which was why the market crashed in 1929 – because as stocks went down, more and more people couldn’t “cover” their “margin position” and so had to sell the stock at any price to try to come up with the new margin cash.
If you want to get into the different kinds of margin accounts and contracts, such as commodities futures, I’ll do that, but since the word of the day is rehypothecation, we’ll try to limit the scope of the discussion to that by giving you a concrete example that is beginning to cause a LOT of trouble in the world.
Way back at the end of WW II, when Germany/the Axis Powers was defeated by the Allies the main victors in the West took possession of Germany’s National Stores of gold. One explanation was that Germany was concerned about the Soviets possibly grabbing the stuff. The gold was stored in places like England and the USA. The British and US gold vaults are pretty secure – ie safe places to put valuables.
Time has passed, and the global economy is getting worse. Countries around the world are starting to feel insecure, so they want their gold back. Holding a piece of paper that says you own gold isn’t quite like holding the gold in your hand and every now and then just piling it up and looking at it makes you feel more secure.
So nations like Germany and Venezuela that have been storing their gold in the US vaults, like the one in the bedrock under Manhattan Island, are starting to ask for the return of their gold, which is perfectly fine… except there is a good chance that their gold has been rehypothecated by the US Federal Reserve to cover loans to other nations, or to maybe prop up the TBTF banks, or for whatever.
Imagine that you are holding ten tons of gold that belongs to nation A, and via the magic of rehypothecation you use that gold as security for trade contracts with different countries and that the total possible obligated gold on the deal is up to 40 tons of gold. As long as everything goes well, then there is no problem. But what happens if everything does not go well? You are on the hook for 50 tons of gold (the original deposit plus the pledged amounts), gold you don’t have. And unlike fiat currency, you can’t just print up gold.
Oops!
And that is what seems to be happening today. Last August Venezuela demanded repatriation of 211 tons of the 365 tons of their gold from the various places around the world where they have the yellow stuff stored.
Last November Germany wanted to just come to the US Federal Reserve (FRB) and LOOK at their gold (“view” it), and the FRB said “NO!” So now Germany is demanding the return of 1536 metric tons of their gold that is supposed to be in the NY Fed’s vault. (See the story.) Included in the story was this little gem – “The Federal Reserve’s fervent secrecy has engendered suspicion and concern, with some claiming that Germany’s gold has long ago disappeared or been lent out, and that only promissory notes of nominal value are sitting in the vault.” (Another reason that Germany may not trust the FED anymore is that in a shipment of German gold from the FED to England, the German gold seems to have shrunk by a significant amount – ie the FED was apparently attempting to short change the Germans.)
So…. it now begins to appear that Germany’s gold may have been rehypothecated. If you buy EFT gold, or from GLD (not taking physical possession, accepting instead “certificates” or account statements), then “your” gold may never have existed at all. And if Germany’s gold has been rehypothecated, who else’s gold has been also?
And if that’s the case, then think of the possible repercussions of that on the global currency markets! And now you see why the word “rehypothecate” has suddenly become so important, and a word you might need to know.
To me, the word “rehypothecate” is funny. You see, I’m just a poor schmuck. I don’t own any gold. We recently weighed up our “junk gold” (old jewelry) and with the price of gold around $1700 an ounce, it turned out that we have the amazing value of about $24 USD. Yep. That’s funny!