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Freddie Mac's new custodial requirements.

On March 16, 1994, Freddie Mac released its Seller/Servicer Bulletin #94-4 announcing new document custodian eligibility requirements. Except for the provisions relating to insurance, the new requirements will become effective on December 31, 1994, for all custodians currently holding mortgage notes and assignments ("documents") for Freddie Mac. For these custodians, the insurance requirements will become effective when each custodian renews its policies in 1995, but no later than December 31, 1995. For new applicants for approved custodian status, the requirements became effective on June 1, 1994. New applicants will have to meet the insurance requirements in 1995 as well. The new requirements have implications for seller/servicers as well as custodians.

The new requirements represent a joint effort over the past year between Freddie Mac's staff and special task forces of MBA's Document Custodian Subcommittee, which consists of both document custodians and seller/servicers. Special task forces worked on the project. MBA was very pleased at the willingness of Freddie Mac staff to discuss relevant issues with subcommittee representatives before publication of the final requirements. The dialogue resulted in the final requirements reflecting the industry's input on many significant matters. The following summarizes Freddie Mac's requirements, as amended.

A custodian must have net worth at least equal to the minimum net worth required for Freddie Mac seller/servicers. It must be a federally supervised financial institution or a subsidiary of such an institution having trust powers, or a Federal Home Loan Bank. (Seller/servicers that are financial institutions with trust powers may act as their own custodians subject to specific requirements on the separation of functions). The custodian and any federally regulated parent may not be in receivership, conservatorship or liquidation. In addition, it must have knowledgeable staff and be equipped with secure facilities subject to adequate controls for safety and security.

The new Freddie Mac custodian insurance requirements represent the most significant aspect of the bulletin. In its work with Freddie Mac, the subcommittee found that some custodians might have a gap in coverage relating to documents in transit. This gap and Freddie Mac's preferred means of resolution have necessitated Freddie Mac's delaying implementation of the new insurance requirements.

Document custodians will now be required to carry errors and omissions coverage and a financial institution bond or equivalent coverage against employee dishonesty and physical damage or destruction or loss of documents on the custodian's premises and while in transit, but the latter only if the custodian assumes responsibility for documents in transit. There is no specific requirement for separate all hazards, valuable papers and inland marine policies although GNMA currently requires a fidelity bond, errors and omission, property and inland marine coverage. Coverage must be maintained in amounts "deemed adequate for the number of [documents] held...and are deemed appropriate based on prudent business practice."

The most problematic aspect of the Freddie Mac insurance requirements is the new stipulation that policies provide coverage for notes as "negotiable instruments." Freddie Mac will now explicitly require that all notes be insured under both a financial institution bond and an errors and omissions policy as "negotiable instruments" to assure that notes are covered with respect to the value of the underlying obligation in the event of a total loss.

Freddie Mac believes that "negotiable instruments" coverage would not result in additional premiums because the risk of a full loss is so slight based on claims experience. Freddie Mac argues that payment of face value or the remaining principal balance would only be necessary if the normal mechanisms of claims adjustment are either unavailable or insufficient. These mechanisms include substitution or repair through obtaining a duplicate original, reconstructing notes, obtaining an affidavit, posting a lost instrument bond, etc. (Reconstruction costs can range from $10 to $2,000, depending on the problems involved.) Sources within Freddie Mac have explained informally that custodians will not be expected to obtain face-value coverage for their entire Freddie Mac portfolio. Sources explained that the amount of coverage was intentionally left to the reasonable discretion of the custodians to allow them to assess their portfolios as to the risks from fraud, loss and physical damage and the risk of being unable to reconstruct or otherwise substitute an original document when only an original document will be acceptable. A coverage amount can then be determined.

The potential gap in coverage relates to documents in transit. Under current bond forms, "negotiable instruments" in transit must be transported by a "transportation company" in an armored vehicle in order to be insured as negotiable instruments. It is our understanding that this is not how most sellers/servicers and custodians transport notes and assignments on a regular basis. Unless documents in transit are transported in an armored vehicle or are covered by the "J form," a very expensive parallel policy to the bond that is a form of inland marine insurance available through Lloyds of London, an issue exists as to whether these documents are fully insured.

In order to address the new Freddie Mac requirement, custodians would each have to negotiate their own endorsements, riders or modifications to their current policies. We understand that this could result in disparate coverages. In order to avoid this undesirable result, the subcommittee, given the requirement, recommended that Freddie Mac submit a request to the Surety Association of America for development of an endorsement to the standard bond that would cover notes as "negotiable instruments" when they are transported by unarmored vehicles. Freddie Mac has agreed to this request and has asked the MBA for assistance which it agreed to provide in order to help assure a mutually acceptable resolution of this issue.

Insurance companies providing coverage for custodians must have a B+ or better rating and a financial size category of VI or better according to the A.M. Best Company, or be affiliated with Lloyds of London. These rating and category levels will allow the majority of the industry's current insurers to qualify. Under earlier discussions of slightly higher requirements, such as a B++ rating and a FSC VI category, we were told that approximately two-thirds of the custodians' current insurers would have been disqualified.

The two required insurance policies must each have a deductible amount that is no more than the greater of 5 percent of the custodian's (or their parent's) GAAP net worth or $100,000, but in no case greater than $10 million. Freddie Mac had originally proposed a limit of $5 million but raised it upon learning that the majority of the industry would have needed a waiver. Many custodians are insured by their parent companies under policies that usually have very large deductibles to minimize their premiums. Based on the very low claims filed in this area, among other reasons, the permissible deductible was increased in the final bulletin.

Custodians will also be required to be a named insured on both of these policies and to notify Freddie Mac of any insurance cancellation or nonrenewal.

Sellers/servicers are now required to submit an initial assessment of their custodian's eligibility to Freddie Mac by June 15, 1994 and annually thereafter. They will also need Freddie Mac's approval of any new custodian they wish to retain, even if that custodian has already received Freddie Mac approval to hold documents for another lender.

Sellers/servicers will be limited to a single third-party custodian until such time as Freddie Mac develops the computer capacity to track multiple custodians.

After considerable discussion, Freddie Mac agreed to permit limited integration of warehouse collateral and document custody management. The document custodial function may share personnel with its warehouse lending function if there are separate record keeping and operating controls as well as separate tracking and reporting systems.

Freddie Mac, or its agent, will conduct on-site audits of document custodians with or without prior notice. Freddie Mac has conducted approximately 20 audits thus far and is making some industry-recommended adjustments to its audit reporting procedures.

The custodian will also be required to maintain a document tracking and reporting system that will monitor the receipt of notes, assignments and related documents; track the physical location of documents; account for transferred or released documents; and maintain a disaster recovery plan.

Freddie Mac has always required that the Freddie Mac loan number be entered onto a note and be used by lenders to track all notes held. Custodians will now also be required to track these notes by Freddie Mac's loan number, in addition to the seller/servicer's number, in order to comply with Freddie Mac's new tracking and reporting requirements. Because many sellers/servicers and custodians do not have the computer system capability to track both numbers simultaneously, custodians will have to operate dual tracking systems and track the Freddie Mac number manually.

The custodian will be required to subscribe to Freddie Mac's seller/servicer guides; develop procedures for maintaining, certifying, releasing, transferring and accessing documents; and develop written procedures to ensure compliance with Freddie Mac's requirements.

MBA will continue to address a number of insurance and other issues that remain outstanding and will monitor efforts of document custodians to comply with the new requirements. If a document custodian has a problem with a particular requirement, a representative should contact Freddie Mac's office of Institutional Credit Policy.
COPYRIGHT 1994 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1994 Gale, Cengage Learning. All rights reserved.

Article Details
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Author:Kinney, Helen Dean
Publication:Mortgage Banking
Date:Jul 1, 1994
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