What Is Hypothecation

Today We are Introducing To what is hypothecation 

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 creditor's 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.