What Is Gold Hypothecation and Rehypothecation?

 

Perhaps you’re familiar with the term hypothecation. Perhaps not. Or perhaps you’ve heard it but aren’t quite sure what it is.

As a precious metals investor, you need to understand it.

The Bottom Line

Hypothecation, generally, is when an asset is used as collateral for a loan. If you take out a margin loan against your stock investments, for example, or an equity loan using your gold, you’ve “hypothecated” that asset. Which means you now own a legal claim in an asset but that you do not own that asset outright. For example, if you have a mortgage, you have the title to the property, but if you do not pay your mortgage, the bank, as actual owner of the property through hypothecation, can take it away.

Rehypothecation is when the institution with whom you’re storing your gold (the gold that you supposedly own outright) lends out that gold, sometimes to more than one borrower at a time, often in exchange for a smaller or no storage fee. This is an important distinction and a serious risk most gold investors should avoid.

This threat played out during the 2008 financial crisis, when banks who were engaged in gold rehypothecation failed, resulting in a nightmare for those with hypothecation claims on that gold.

We at GoldSilver.com believe there is zero upside to exposing your gold holdings to this risk. That’s why we, and our partner vault providers like Brinks, never (re)hypothecate the gold or silver your hold in our storage program. Your metals remain in the vault, where they belong, in your name, until you and you alone decide to sell, personally borrow against, or take delivery of your precious metals.

Read on for details on how hypothecation works for gold and silver investors, what happened in 2008, and why that breed of bank/vault hypothecation can add unappreciated risks to what are typically your safety net assets.

Hypothecation

The definition is simple: Hypothecation occurs when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral, but it is "hypothetically" controlled by the creditor, in that he has the right to take possession of the pledged asset if the borrower defaults. 

Hypothecation has something of a sinister connotation these days -- thanks in large part to the scary sounding “inside baseball” terminology first being uttered in the mainstream when it made the evening news and numerous books in the aftermath of the 2008 financial crisis. But it’s actually a very common type of transaction.

A mortgage, for instance, is the hypothecation that most people will be familiar with, even if not by that technical name. You get a loan from a bank in order to buy your home, using the house itself as your collateral. You have legal title to the property, but your ownership is subject to the lien you’ve incurred. Should you fail to make your loan payments, the bank has the right to take the house back and sell it to someone else.

Same for a home equity loan. Or a margin account at your brokerage.  Or when you borrow against gold holdings.

Straightforward. Merely business as usual. And nothing to be afraid of. In fact, self-hypothecating as asset like gold or real estate can be a smart way to unlock capital while maintaining your exposure to an asset class.

(RE)hypothecation— The Illusion of Ownership

But we enter the twilight zone with hypothecation’s nasty stepchild, rehypothecation.

That’s the one that causes so much trouble, wherein a bank or broker-dealer reuses the collateral put up by its clients as collateral for its own borrowing.

Now, you might think that that would be illegal. And you’d be right, if the bank or broker hadn’t told you what they were doing. But the hard fact is that you may have agreed to let them do this when you signed your original agreement with them. Your permission would have been voluntarily granted, although buried somewhere down below, in the fine print.

If you didn’t do that, then the bank or broker is supposed to abide by what are known as “segregation rules.” That is, the law says that they are supposed to fully segregate your assets, keeping them away from any financial dealings that the company itself engages in. Yet your assets could still be at risk, depending upon the ethics of the organization you’ve charged with the safekeeping effort.

It appears that cheating is hardly uncommon.

The Financial Crisis

Many naïve investors became unpleasantly aware of hypothecation and rehypothecation during the financial meltdown of 2008 and its aftermath. It wasn’t as if the dangers weren’t already known. The European Union’s Legal Certainty Group had studied the subject, and issued a report on it, in 2006.

In that report, the E. U. states:

“Rehypothecation puts the client at risk: during the time the account provider exercises its rehypothecation right, the client's ownership right is replaced with a contractual right to return of equivalent securities…This works well until a bankruptcy occurs. If the account provider defaults, a client with a mere contractual claim becomes an unsecured creditor, meaning the client's assets are, as a rule, tied in the insolvency estate and it is obliged to line up with all the other unsecured creditors to receive its assets back.”

As everyone knows, there were bankruptcies aplenty during the Financial Crisis, including the most massive in history, that of investment bank Lehman Brothers. During its death throes, Lehman had desperately tried to forestall its collapse by using client assets as collateral to obtain the funding needed to keep it afloat. The tactic failed, of course. Whereupon Lehman’s secured creditors (the big banks) claimed those assets, leaving unsecured creditors — namely, individual investors — high and dry.

Untying that legal tangle took many, many years. And in the end, some investors who thought they “owned” stocks had to settle for a pro rata share of what was left over after the secured creditors were satisfied.

But the assets in question with Lehman were securities.

Could the Same Thing Happen with Commodities Like Gold?

Unfortunately, the answer could be yes. Which is why it’s worth considering just how/where you keep your precious metals investments. For example, it could and it did happen with commodities broker MF Global, which went belly-up in 2011.

MF Global had been playing so fast and loose with client assets that Jon Corzine, its former CEO, was forced to admit in testimony to Congress: “I simply do not know where the money is, or why the accounts have not been reconciled to date. I do not know which accounts are unreconciled or whether the unreconciled accounts were or were not subject to the segregation rules.”

You may fairly translate that as, “I have no idea what went on, but I admit it wasn’t entirely on the up and up.”

It’s notable that MF Global's collapse had no effect on other large financial institutions, which build in a maze of self-protections. Those victimized, in a shortfall of about $1.6 billion, were smaller clients such as individual investors and small business owners who were using commodities to diversify portfolios and hedge risk.

Did they get their money back? The Securities Investor Protection Corporation, a federally-mandated company that works to retrieve investor assets in bankruptcy situations, proclaimed in 2016 that it had supervised $8.1 billion in distributions from MF Global’s parent company. This made whole all but 5% of unsecured creditors, the SIPC said.

"The end of the MF Global liquidation demonstrates that the law designed to protect customers of failed brokerages works, and works well," said SIPC President Stephen Harbeck.

Well, maybe not quite that cut and dry.

What he fails to point out is that, at best, the resolution saddled maligned investors with over 4 long years of legal hassles in order to reclaim what was rightfully theirs. Moreover, what about those who thought they had claim to actual physical metal, like those with warehouse receipts or futures contracts? They were wrong. In the course of the bankruptcy proceedings, federal trustees froze all of MF Global’s assets, including gold and silver bullion bars stored in COMEX depositories, like HSBC’s.

“Owners” of those bars who had warehouse receipts proving they held title were out of luck. They had to endure a market downturn unable to sell. They had to accept the liquidation value of their assets. And to add insult to injury, they had to continue to pay accrued storage fees on metal they’d been unable to reclaim.

Other kinds of problems surfaced, as well. According to Barron’s: “Investor Gerald Celente says he was hit with a big margin call when the gold contracts in his MF Global account were transferred to another brokerage. ‘I refused to put up more money,’ he explains, ‘so they closed out a number of my open positions at the current market price’."

When all was said and done, precious metals investors had to wait in line with the rest of the unsecured claimants. And when they were finally compensated, they got cash, not gold. An amount based on whatever price “their” metal had sold for, not its value at the time of settlement. Too bad if they lost money.

Does a Paper Sun Glow?

As with Lehman, the MF Global debacle illuminated the dangers inherent in treating paper assets like they are the real thing. This risk especially applies to so-called “paper gold.” Some investors believe they own gold because they have shares in an ETF like SPDR Gold Shares (ticker: GLD). Others’ gold holdings might consist of mint certificates or unallocated metal held in pool form.

These are claims on the asset, not gold itself. They are known as entitlements in the lingo of finance.

In the case of GLD, the procedure for turning shares into physical metal is so onerous that it is, for all practical purposes, non-existent. If you hold a mint certificate or a fractional share of a large gold pool, you are at the mercy of the company involved. Your entitlement is only as good as they are. They may or may not be rehypothecating. They may or may not hold enough inventory in their vault to make good on their promises in the event of insolvency.

This is the way the New York Fed put it, in a moment of unusual honesty. They were writing about the stock market, but the principle applies equally to precious metals: an investor, the Fed cautioned, “is always vulnerable to a securities intermediary that does not itself have interests in a financial asset sufficient to cover all of the securities entitlements that it has created in that financial asset.”

Which is a roundabout way of saying, your broker might borrow too much; so be careful whom you trust.

Thus, if you use a large bank or brokerage for your gold depository, or if the company you deal with does, then you are choosing to place your faith them and not the asset itself. That faith could easily be misplaced, if you consider these banks’ histories of unsavory activities. Bullion dealer HSBC, for example, avoided prosecution for laundering Mexican drug cartel money in 2012 only by paying nearly $2 billion in fines. JP Morgan Chase, another bullion-holding bank, was fined $135 million in 2018 for improper handling of American depository receipts. Overall, for a wide range of crimes and misdemeanors, banks were fined a staggering $243 billion in the decade following the 2008 financial crisis.

Now, you may think that holding a promise for gold is a minimal risk, since in the normal course of events you’re not likely to lose your claim. However, if that describes you, you may want to do some rethinking.

If trading “paper gold” via ETF or a similar vehicle makes up a part of your portfolio because you’re playing the market — buying to try to profit on a rising price, or short selling to capture a decline — then you’re in a high-risk game with some powerful players. Granted that paper gold is a relatively efficient way to take those chances. But you’re presumably hip to the fact that you may win or you may lose your shirt.

Conversely, if you’re a buy and hold person, your motive should dictate how you proceed. Yes, you’re apt to be safe in normal times. But why did you want to hold gold in the first place? Wasn’t a good part of the reason that gold will give you security in abnormal times? Do you see it as a hedge against economic disasters such as a currency crisis, or another breakdown of the overleveraged financial derivative system?

Even if worse doesn’t come to worst, what about the next recession? It cannot be forestalled forever; it is an inevitable product of the business cycle. It will happen. When it does, there will be bank failures, in large numbers, just as there were between 2008 and 2012.

It’s quite possible that included in the next wave of insolvencies will be some large financial institutions that store and/or trade bullion. When they go, the likelihood is that your entitlement will be paid off in US fiat currency, rather than in the gold you thought you owned, and at a price determined far away from your control.

Take that into consideration.

What This All Means for You as an Individual Investor

If you want the security of ownership of physical bullion, the obvious conclusion is to not hold paper gold in the form of certificates/shares in a gold pool or in ETF securities. The former are entitlements, subject to rehypothecation, and the latter doesn’t even pretend that you own any actual gold.

Always remember that there are only two scenarios where you actually own gold bullion in the legal sense:

You bought coins or bullion bars and you have them somewhere in your physical possession.

You hold your gold in a truly allocated bullion account, and the account is allocated to you and only you. (Preferably stored in a third-party, non-bank vault.)

If you are buying your gold through a bank or broker/dealer, do your due diligence. Check their reputation. And be aware that there are those who misrepresent their services. One common dishonest ploy is when a broker tells investors their metal is held in “allocated accounts”, while in reality it’s held in some third-party bank vault and actually allocated to the account of the broker, not the investor. In this case it’s just unallocated metal, not divided so as to show indisputable ownership. There is no legal meaning to the word allocated, so if you want to own gold this way, be sure to read all your investment documents very very carefully.

Or, just avoid the situation.

Your goal should be to place your metal with a company that has a spotless reputation for honesty, reliability and security.  Ideally, it should not be a bank that engages in bullion transactions, which are subject to hypothecation. It should not be a dealer who maintains his own “vault” and trades in and out of it, potentially hypothecating along the way. It should be someone whose only job is security. That’s why GoldSilver.com uses vaulting provided by Brinks, the name globally synonymous with high-level asset protection for over 150 years.

For most investors, fully allocated storage — which we offer through Brinks — is sufficient and the most cost-effective option. If this is your choice, an allotment of bullion, with your name on it, is placed in the vault. We guarantee that at all times the gold is there for you to withdraw, at your discretion. It is commingled with other people’s gold, so that when you claim it, you will receive the full amount you put in, however you may not get the exact same coins and bars. We NEVER rehypothecate your assets; nor do our vault providers.

If you wish, you can also opt for fully segregated gold storage. With this, you receive all the benefits of allocated, plus your assets will be separately shelved, wrapped, and marked apart from all other assets held at the vault. Obviously that kind of handling costs more, but it is truly the ultimate standard for ensuring peace of mind.

Bottom line: make absolutely sure that any dealer or vault you deal with doesn’t practice rehypothecation.