Hypothecation
Pretty much a margin agreement. That's what it is: a legally compliant margin agreement.
Someone (we're not naming names) wants to start investing, but doesn't have enough cash for all the investments they want to scoop up. So they use the stocks or securities they buy as collateral to borrow money to invest.
If the investments make money and the investor can pay back the cash, all is well and good. If the investor can't make good on the loan for some reason, the lender can grab up those stocks or securities.
Hypothecation is basically the process or rules behind pledging collateral for a loan.
Jimmy Walnuts has gotten out of the mafia game. He wants to take all the dough he made shaking down Quik-E-Marts. And invest it. And he wants his investment account at his stock brokerage to be a margin account.
He has 100 grand in the account, and with a 50 percent margin limit, Jimmy can borrow, or margin, up to 50 grand worth of his stock to, um...buy stuff. Like a new beamer without all the bullet holes in it. He will hypothecate his 100 grand in stocks as that collateral, borrowing 47 grand to buy the car, and all is good.
Eventually, he plans to pay down his margin account with both cash he deposits in there...and also through the dividends that the account generates on its own, which usually exceed the margin interest cost the brokerage is charging him.
So...where does hypothecation run into trouble?
Well, what if Jimmy wanted to buy 10 cars? Like, he just had a fetish for them. And he pledged $47k for this baby. But then also wanted that baby for $22k and that one for $35k. And that one for $70k. He can only pledge his collateral once for one setting, or one purchase.
That is, he can’t go to one car seller and promise him the $100k that’s in his brokerage account as collateral for a used Ferrari, and then go to a different car seller and pledge him the same $100k that’s in his brokerage account for that 1973 James Bond Aston Martin, and then go to a third car seller and do the same thing.
Quickly, he will have pledged a few hundred thousand worth of collateral in a brokerage account that only had value of 100 grand. So yeah, unless you’re, uh…connected…we don’t recommend going the Jimmy Walnuts route.