What it means
Securities become encumbered in several ordinary ways. Pledging bonds under a repurchase agreement, buying shares on margin, lending stock to a short seller, posting collateral with a clearing house and ring-fencing assets to back an insurance liability all create an encumbrance.
None of these are unusual or improper, and most large financial institutions carry a substantial encumbered balance at all times. The reason to track encumbrance is liquidity.
In a stress event you can only sell what is genuinely free, so a firm with a large portfolio and a small unencumbered slice can look wealthy on paper and still fail to meet a redemption or a margin call. Bank regulators pay close attention to asset encumbrance for exactly this reason.
Measurement is straightforward: subtract encumbered securities from total securities to get the unencumbered balance, and divide encumbered by total to get an encumbrance ratio. Lenders also apply a haircut, which is a discount to the market value of the collateral, so pledging $100 of bonds might only raise $95 of cash.
The gap is overcollateralisation, and it is dead weight until the pledge is released. Two nuances catch people out.
First, rehypothecation lets a broker re-pledge a client's collateral to its own lenders, which extends the chain of claims and complicates recovery if anyone in the chain fails. Second, encumbrance is disclosed in the notes to the financial statements rather than on the face of the balance sheet, so readers who only skim the headline asset figure will miss it entirely.
In practice
Real-world examples.
Example
A regional bank pledges $400,000,000 of mortgage bonds to a central bank facility to secure funding. Those bonds can no longer be counted in its liquidity buffer, so reported unencumbered liquid assets fall from $1,200,000,000 to $800,000,000. The headline balance sheet is unchanged, but the usable cushion has shrunk by a third.
Example
A company founder borrows $5,000,000 against 2,000,000 shares valued at $12 each, worth $24,000,000 in total, a loan-to-value ratio of just under 21%. Those shares are now encumbered and cannot be sold while the loan is outstanding. Analysts note the pledge because a sharp price fall could force a margin call and a disorderly sale.
Example
An insurer posts $75,000,000 of government securities as collateral against its interest rate swap positions. A move in rates triggers a collateral call for a further $12,000,000, taking encumbered securities to $87,000,000. The treasury team has to sell other holdings to meet the call.
Formula
Calculation
Unencumbered securities = total securities - encumbered securities. Asset encumbrance ratio = (encumbered securities / total securities) x 100.
An asset manager holds a securities portfolio with a market value of $500,000,000 and has pledged $180,000,000 of government bonds under repurchase agreements. Unencumbered securities are $500,000,000 - $180,000,000 = $320,000,000, and the encumbrance ratio is $180,000,000 / $500,000,000 = 36%.
The repo counterparty applies a 5% haircut, so the cash raised is $180,000,000 x 0.95 = $171,000,000. The remaining $9,000,000 of value is locked up as overcollateralisation, earning nothing for the manager until the trade unwinds.Case study
Seen in the real world.
Marlin Ridge Capital is an invented investment fund used here for illustrative purposes. It ran a $900,000,000 portfolio and had gradually pledged 78% of it, or $702,000,000, across repurchase agreements and prime broker margin, leaving only $198,000,000 unencumbered. The strategy worked well while markets were calm, because the borrowed cash amplified returns.
A difficult quarter brought redemption requests of $240,000,000. That exceeded the unencumbered pool by $42,000,000, so the fund had to unwind repo positions early, selling collateral into a falling market and crystallising losses it had not planned for. Investors who read only the headline asset figure had assumed the fund was far more liquid than it was.
Marlin Ridge survived, but the board imposed a hard cap of 50% encumbrance and began reporting unencumbered assets alongside net asset value in every monthly investor letter. The illustrative lesson is that total assets and available assets are not the same number, and only one of them pays redemptions.
Watch out
Common mistakes.
- Reading total portfolio value as though it were available cash, when a large share of it may be pledged and legally out of reach.
- Ignoring the haircut, and assuming that pledging $100,000,000 of bonds raises $100,000,000 of cash rather than something less.
- Believing that encumbered securities disappear from the balance sheet, when they usually remain recognised as assets with the pledge disclosed in the notes.
Questions
People also ask.
Are encumbered securities still owned by the pledger?
Usually yes in economic terms, so the owner keeps the price exposure and often the income, but the counterparty holds a claim that limits any sale or transfer.
Where can I find a company's encumbrance level?
It is normally set out in the notes to the financial statements under collateral, pledged assets or repurchase agreements, and banks often publish an explicit asset encumbrance ratio.
Is a high encumbrance ratio always bad?
Not necessarily, since secured funding is a normal and cheap source of finance, but a high ratio leaves little room to raise cash quickly if conditions turn.
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