The Custodial Process
March 3, 2011

The Custodial Process

The custodial program is a secure process used to help Investors and Banks efficiently manage borrowing relationships and is used for many types of loans.  For example, you may currently have an existing portfolio of notes that you would like to borrow against to take advantage of other investment opportunities, or you may have a piece of property that you intend to subdivide and then sell the individual lots through seller-financed transactions.

A custodial agreement is a three party agreement between Investor Loan Services, Inc. (ILS), a borrower and a third party lender.  The third party lender has made a loan to the borrower which is secured by notes receivable owned by the borrower.   We will refer to the borrower as the “Investor” and to the third party lender as the “Bank”, so as not confuse with the borrowers and lenders under the individual notes that are part of the notes receivable portfolio.

ILS serves two roles under the custodial agreement.   The first is as loan servicer, to collect the note payments for the Investor for each individual note in the note receivable portfolio pledged as collateral for the Bank loan.  The note payments, less the servicing fees, are disbursed to the Investor’s bank account on a semi-monthly basis.

The second role for ILS in the custodial arrangement is to serve as custodian of the original notes and deeds of trust for the note receivable portfolio.  ILS keeps the original notes and deeds of trust, in a secure area, segregated from its other files.  The custodial files are available for inspection by the Investor and the Bank or its representatives.

ILS will provide the Bank with an initial certification of the notes and deeds of trust held under the custodial agreement.  Thereafter, ILS will provide reports to the Bank on a quarterly basis, certifying the notes in its possession.  The reports will include additional information pertaining to each note, such as current principal balance, monthly payment amount and next due dates.

Our attorney will work with the Bank’s attorney to document the loan subject to the custodial agreement.  Possession of the notes by the custodian perfects the Bank’s interest in the collateral.  ILS has possession of the notes (collateral) on the Bank’s behalf.

The custodial arrangement is easier to manage than the traditional collateral transfers.  Since collateral transfers are hard to keep up with, they tend not to be done timely.  In some instances, after several years of failing to keep up with the collateral transfers and original notes, the Bank has discovered that its collateral position has deteriorated to the point that its loan is under-secured or perhaps unsecured.  With all of the changes and mergers within the banking industry, sometimes the collateral (underlying notes) is lost, which puts both the Bank and the Investor in a precarious situation.

With the custodial agreement, the Bank will no longer be required to hold and manage the portfolio of original notes.  This will be done by ILS and reports are provided to allow the Bank to keep abreast of the loan to value ratios and quantity and quality of its collateral, in accordance with their loan agreement. The process is seamless to the Bank; saves the Bank management and employee time, and allows the bank to know where it stands in reference to their collateral.

Mechanics of the Custodial Process

Through a custodial arrangement collateral is easier to manage than the traditional collateral transfers.  Since collateral transfers are hard to keep up with, they tend not to be done timely and often result in the deterioration of the Bank’s collateral position.

Traditionally, the Bank would initially have a master deed of trust on the entire subdivision.  Then as the lots are sold, the Bank would receive a Collateral Transfer of the seller-financed note and deed of trust as its collateral and the Bank would execute a partial release of its master deed of trust as to the lot being sold.  The Investor would deliver the original note and deed of trust, along with the Collateral Transfer to the Bank.  This is a cumbersome process and difficult for most Investors and Banks to manage.

Under the custodial arrangement, the Bank would continue to take a master deed of trust on the entire subdivision.  The Borrower would also execute an Assignment of Income with regard to the income generated from the sale of the lots.  As the lots are sold, the bank would execute a partial release of its master deed of trust, the original note and deed of trust are delivered to ILS as custodian, to hold the documents on behalf of the Bank.  On a quarterly basis, ILS will verify the notes in its possession and provide a certification to the Bank

An Assignment of Income is executed and recorded to give notice to others (i.e. title companies) of the Bank’s security interest.  It is a blanket assignment, and in many instances, there is no need to prepare additional assignments for individual sales.

While an Assignment of Income provides notice of the Bank’s security interest, it does not prevent the Investor from managing its portfolio of notes.  Thus, if one of the underlying notes receivable is past due, the Investor can proceed with collection of the note and even foreclosure of the underlying deed of trust.  When the foreclosed property is re-sold, the original note and deed of trust are delivered to ILS as custodian and the new note receivable becomes part of the collateral.

The Bank can establish parameters as part of its loan agreement with the Investor to establish a loan to value ratio and a borrowing base (based on lots in inventory and notes receivable balances).  The Bank can monitor its parameters quarterly using the information in the custodial certification that ILS provides.  If the Investor is over the established borrowing base, the Bank can require that the Investor make a principal payment to reduce the loan balance to meet the established borrowing base.

ILS and its attorney will strive to work with your Bank to provide a program to meet the needs of your particular situation.

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