Hypothecation definition explanation securities and other valuables as collateral

Using securities as collateral to obtain your business loan or the art of Hypothecation

Normally business loans are very simple and don't deviate from an established pattern. You either get a line of credit to help you finance short-term working capital specifically your accounts receivable and inventory or you get a term loan for capital expenditures such as equipment or property purchases. From time to time, something out of the ordinary crosses your desk and it makes you think and remember past cases.

For example, a long time ago a lending officer and myself had a bit of a disagreement on what rating makes a security investment grade.. My department does not grade securities for the bank to invest, however, we do perform credit analysis on Fortune 500 companies when we are part of syndicated deals. These deals, which are usually for over $5 million each are governed by certain guidelines in our credit policy requiring a minimum rating of Ba3 from Moody's and BB- by from S&P on its senior unsecured debt.

In this particular case this company, which is a household name, had its senior unsecured debt rated Ba3 by Moody's and BB- by S&P and I happened to write in my analysis that although it met our criteria the securities were classified below investment grade that little sentence created a storm that ended up with me having to erase that statement even though I still think I was right.

Anyway today I was reminiscing about that, when the idea of securities and loans meshed in my head and I remembered a loan I worked on seven years ago that involved a couple of municipal bonds and a line of credit for a jewelry store. This loan was my first exposure to hypothecation.. As mentioned above Hypothecation is the act of pledging securities as collateral to obtain a loan.

Seven years ago the bank where I worked as a commercial lending assistant had a deposit customer that was continuously overdrawing its account. This customer, a neighborhood jewelry store, was going through some financial difficulty and the numbers were not coming up right for the loan request. The money was needed to clear the overdraft and provide some short-term working capital. The jewelry store just couldn't pay the term loan.

We had a meeting with the owner, her husband and a friend of the owner to discuss the situation and see how our concerns could be addressed. The friend mentioned during this meeting that she owned several municipal bonds and was willing to pledge them as collateral for the new loan. This made it possible for the bank to give the customer a line of credit secured by the third party hypothecation of the municipal bonds. Although, we had to rework the structure of the facility from a term loan to a line of credit, the securities made the difference between an approval and a denial.

Lending based on collateral is not a sound banking practice. However, it would be misleading for me to say that collateral does not play a part in the decision making process. I have been fortunate that the banks where I have worked on have strong credit practices, but I have still seen many people make an argument for a loan based on the collateral offered. The underlying lesson of the story is that providing stock, bonds and other marketable securities that you, a family member or a friend owns might make it easier to obtain that bank financing. I would be suspicious of financing companies, which might be more interested in the securities than on the repayment of the loan and might just be waiting for you to be late so they can take them. However, You should be ok with most commercial banks.

Regarding our friend with the jewelry store, she eventually used up the line and was unable to pay it back. We had to demand payment. Nevertheless, the fact that we had such quality collateral assured that we got paid.


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