Gold has been an integral part of the business world for as long as one can remember.
People have kept it as an asset, pledged it as security, or used it in intricate jewelry. But regardless of why someone acquires or uses gold, having gold has always translated into a diverse and secure investment portfolio.
That said, owning gold, while beneficial, possesses a few risks that go beyond stealing and theft. There are also some other potential hazards to gold acquisitions, particularly one that is rehypothecation.
Before we get into the whats and hows of the overlong term, we need to discuss the concept of hypothecation that comes before rehypothecation.
Hypothecation is a common financial phenomenon that everyone’s familiar with, though not as the technical term.
Hypothecation is the practice of pledging an asset to secure a loan, whereby the asset’s ownership rights remain with the borrower, but the control is transferred to the lender.
The most common example of hypothecation is mortgaging. When a person takes out a property loan on mortgage from a bank, they put up the house itself as collateral, giving the creditor (aka the bank) the right to liquidate or seize the estate in case of default.
Mortgaging is essentially hypothecation, but for immovable acquisitions such as a house.
In simple words, when you hypothecate a property or asset, you put it up as security against a loan, relinquishing your control over it until the debt is paid off in full and all terms of the contract are met.
The term hypothecate has its origin in the English word hypothetical, in that a debtor gives hypothetical rights of an asset or property to the lender of a loan.
Similar to mortgaging, gold hypothecation occurs when a borrower takes out a loan and pledges physical gold against it.
Resultantly, the controlling rights of the metal are transferred to the creditor, which is typically a bank or brokerage, which can liquidate it in case of default.
Hypothecation is a pretty common practice (and by the looks of it, quite safe too), which it is, for the most part, until its evil twin, rehypothecation, gets into the picture.
Rehypothecation complicates things quite a bit, blurring the lines of rightful ownership and hypothetical possession.
Rehypothecation occurs when a creditor hypothecates an asset (over which they have theoretical rights) to another lender to secure a loan for any reason. Simply put, a rehypothecated asset is one that has more than one on-paper owners.
Let’s say you put up gold bullion as collateral to acquire a loan from a brokerage, which in turn pledges (originally) your gold to another bidder to get a loan for themselves.
Now, the physical metal essentially has no categorical owner because you don’t have the right to use it until you pay your debt. And your creditor has transferred the right of control of your gold to a new creditor, of course, after getting a go-ahead from you.
Typically, debtors are recompensed for the re-pledging of their collateral by a lower cost of borrowing or a rebate. Nonetheless, this chain of lenders and borrowers is risky business due to the uncertainty it breeds, which can lead to loss of property and even bankruptcy in some cases.
How can that be?
Let’s understand the risks of rehypothecation with an old case study.
Dangers of Rehypothecation
Rehypothecation was a widely practiced financial trend up until 2007, but then the financial crisis shook up the banking sector, leaving several institutions at their wits’ and forcing them to turn towards rehypothecation, which led to rather horrible repercussions.
When the financial doom befell the economy in 2007, many businesses and banks ended up on the brink of bankruptcy. Out of the many struggling enterprises, the one that became a deterrent to the practice of rehypothecation was the Lehman Brothers.
Desperate to forestall its impending collapse, the Lehman brothers used their clients’ assets as collateral to secure funds from more prominent names in the business.
But, the tactic failed, and the unfortunate corporation’s creditors claimed the pledged assets. As a result, the unsecured creditors were left in the lurch. They never got their money back, and the Lehman Brothers went bankrupt.
The tragic but didactic incident shed light on the horrors of rehypothecation. We know what you are thinking, no where in the story was gold mentioned, so does that mean gold rehypothecation can be done? But is rehypothecation a risk in the case of gold?
The answer to this question is a sad yes, and the famous broker MF global case’s untimely demise is a testament to that.
Four years after the Lehman Brothers debacle, MF global brokerage met with the same fate in 2011.
Before the imminent bankruptcy, MF global brokerage has been playing with its clients’ assets unrestrained; that is, the entire institution went into disarray.
The chain of creditors became so loose that the company’s CEO, Jon Corzine, had to admit that they had lost track of all the records in front of the congress. He said:
“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.”
Anyone can interpret Jon Corzine’s words and figure out that things got out of hands one after the other, like the domino effect. MF Global’s downfall didn’t affect large corporations as they had stringent protective measures in place.
The unfortunate parties that suffered the brunt of the financial calamity due to the ultimate deficit of $1.6 billion were the unsecured smaller investors who were using gold and other commodities to expand their investment portfolio and set up a hedge fund for financially turbulent times.
Even though the federally governed agency that works to retrieve investment assets, the security investor protection corporation intervened and commanded MF Global’s parent company to distribute $8.1 billion among the robbed investors in 2016, but that only made up for 5% of the victimized investors.
And that’s not all!
The unfortunate creditors who once owned physical gold never got their honey-hued metal back, despite having receipts and documents backing their claims because the government had frozen MF Global’s assets, including the gold and silver bullions stored in COMEX safes.
MF Global’s tragic end demonstrates a number of things. Firstly, it illustrates the dangers of gold rehypothecation, which couldn’t be more evident now.
Since the dicey practice converts one entity’s liability into another’s asset, making a tenuous chain of borrowers and lenders. The collapse of just one link in the string can send the entire arrangement in tatters, which is what the world saw happen when MF Global went bankrupt.
Another reality that the incident pointed out was the loopholes in the law supposed to protect people involved in brokerage works. And lastly, and perhaps most importantly, the catastrophe highlighted the risks involved with paper assets.
When people treat paper wealth as the real deal, they can end up destitute if not completely broke. And this is particularly true in the case of gold. Digital gold or paper gold is a common form of acquisition, but it is practically not an asset and just an illusion of sorts at best.
When you own stocks of a gold company in shares or funds, you do not have the rightful ownership of the shiny yellow metal itself. What you have is a piece of paper giving you rights, which is technically only a claim and nothing more.
In the financial world, having paper gold is called entitlements.
And if someone tries to convert their virtual gold into the physical metal, the procedure they’ll have to follow is so cumbersome that they’d never see the end of it. In a practical sense, there is no sure-fire method to materialize gold bars or coins from paper money.
And on that note, we’ll move towards the last part of our guide.
Is Paper Gold Worth Anything In A Financial Crisis?
As mentioned earlier, the procedure to turn paper gold into physical metal is rather impractical.
If you hold shares to a gold company, you have a fractional share of possibly a massive reserve, which means you are at the mercy of the involved corporation to let you have the honey-hued metal. Whether you’ll get the gold or not is entirely up to the company.
Who knows if they have hypothecated the gold or if they have enough inventory in their vaults to give you your physical share?
So, even though paper gold is not completely invalid, it is also not of any use per se.
If you want to invest in gold, the better choice would be procuring physical bars, though that comes with additional costs, such as storage and insurance. But, giving up money for keeping an asset is safe than losing it altogether.
Gold hypothecated to take out a loan is safe as long as it remains that way. If rehypothecation wheedles its way into the arrangement, you can very easily lose your possession
No matter how enticing the terms of rehypothecation seem, never indulge in it. Lastly, avoid investing in paper gold to keep your hard-earned money protected and redeemable.