What is "hypothecation"

Hypothecation \Hy*poth`e*ca"tion\, n. [LL. hypothecatio.]

1. (Civ. Law) The act or contract by which property is hypothecated; a right which a creditor has in or to the property of his debtor, in virtue of which he may cause it to be sold and the price appropriated in payment of his debt. This is a right in the thing, or jus in re.
   --Pothier. B. R. Curtis.

   There are but few cases, if any, in our law, where an hypothecation, in the strict sense of the Roman law, exists; that is a pledge without possession by the pledgee.
   --Story.

   Note: In the modern civil law, this contract has no application to movable property, not even to ships, to which and their cargoes it is most frequently applied in England and America. See Hypothecate.
   --B. R. Curtis. Domat.

2. (Law of Shipping) A contract whereby, in consideration of money advanced for the necessities of the ship, the vessel, freight, or cargo is made liable for its repayment, provided the ship arrives in safety. It is usually effected by a bottomry bond. See Bottomry.

   Note: This term is often applied to mortgages of ships.

Etymology 1 n. the use of property, or an existing mortgage, as security for a loan, etc. Etymology 2

n. (context British English) A tax levied for a specific expenditure

Hypothecation is the practice where (usually through a letter of hypothecation) 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 mortgage agreement, in which the debtor's house becomes collateral until the mortgage 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 creditors 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 worsens the quality of the rest of the debtor's balance sheet and thus its credit quality.

The detailed practice and rules regulating hypothecation vary depending on context and on the jurisdiction where it takes place. In the US, the legal right for the creditor to take ownership of the collateral if the debtor defaults is classified as a lien.

''' Rehypothecation ''' occurs mainly in the financial markets, where financial firms re-use the collateral to secure their own borrowing. For the creditor the collateral does not only mitigate the credit risk but also allows to refinance more easily or at lower rates; in initial hypothecation contract however, the debtor can restrict such re-use of the collateral.