Commodity notes use commodities as collateral for loans, without the lender taking physical possession. The borrower and lender work together to structure terms for repayment and sale of the product.
Commodity notes are a special type of loan or advance made using commodities in the borrower’s possession as collateral for the transaction. In general, the lender does not take possession of the physical products as part of the loan agreement. Documents such as bills of lading, verified inventory lists, and warehouse receipts are often used to establish the status of products and allow the lender to prepare a product document.
The nature of commodities is different from many other investments in that the commodity is a physical substance that must be produced before it can be sold on an exchange. For example, food products and grains are raised by farmers and then stored, all in the hope that the products will sell for a good price when the time comes. Commodity paper is one of the ways that the owner of the produced products can benefit from the products stored before the point of sale.
Loans and advances that are processed using basic paper are very similar to any other type of loan. Typically, the lender charges a fixed or variable interest rate. Repayment of the loan balance plus interest can be structured in monthly installments of a series of balloon payments. In case the borrower defaults on the loan, the lender has the right to take over the commodity as a means to pay off the remaining debt on the commodity paper.
In general, the lender and the borrower will work together to structure the terms so that the borrower can obtain permission to sell the promised products when the sale price is attractive. The terms will often involve a commitment by the borrower to use a portion of the sale to pay off a portion of the outstanding balance on the commodity paper. This type of agreement makes selling the commodity at the highest possible market price an objective for both the lender and the borrower.
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