Posted by: Financial Sith Lord | November 29, 2009

Structured Leveraged Finance and Investment Mechanism

As mentioned before in my previous posting, on how an Equity Trade could possible achieve high-returns on his portfolio via simplified leveraging, this methodology has been practised by the privileged community for ages. The greater segment of that community enjoys greater returns through a more sophisticated mechanism. It’s a cocktail of structured financing, leveraged financing, asset backed credit financing, leveraged credit financing, leveraged margin financing. Yes, over leveraging yourself is like a sensitive time-bomb, if not managed properly. The greater segment of the privileged community, such as banks, financial institutions and major investment houses do practise and apply these cocktail mechanism after they have defined a solid reason to do so. For example, through their detailed and elaborate research, they identified an arbitrage opportunity in co-related markets etc, and they know for a fact the risk factor for such opportunity is negligible. So, this is how they do it..

Assumptions: Investment House ABC has a capital of $10 million, and after conducting their research, they found an opportunity to gain 10% profit from trading a single underlying instrument and they could trade it for 3 rounds. ABC’s investors are expecting a minimum ROI of 15%p.a  from their investments with ABC.

ABC places their capital of $10 million into a time deposit with Bank B (that generates 3% p.a. interest), and places the time deposit as lien for a leveraged facility of 1:5. The bank grants them a facility of $50 million. ABC then makes a private placement deals with their network of property owners, promising them a return of 20% p.a. with the yield being paid in advance (This would definitely be accepted by the property owners, as under normal circumstances, their properties only generates between 7 – 9% p.a.). In return, the property owners assigns their properties to ABC in a legal binding contract, with the properties valued at $ 250 million. ABC then pays the property owners $ 50 million as advance yield. With the $ 250 million properties assigned to them, ABC then approaches Bank C and applies for asset backed leveraged credit facility. As this is a non-cash facility, the banks are rather lenient with their credit control procedures. Using the $ 250 million properties as collateral, they get $ 330  million worth of  banking instruments (which reflects 7:10 leveraged facility – normal for asset backed facilities).

ABC then instructs Bank C to issue a $ 330 million banker’s guarantee with a maturity period of 1 year. The guarantee is issued directly to Bank D for a Secured Cash Facility against the guarantee, where the bank would give out a cash loan amounting to 80% of the guarantee’s face value. With the $ 260 million (80% of BG value), ABC then places it in their investment broking firm’s custodian account, and obtain a 1:5 leverage margin facility. Now, ABC has a tradable margin facility of $ 1.3 billion.

With the $ 1.3 billion in capital, ABC then trades the arbitrage and obtains the 8% profit as projected earlier. At the off-set of the trade, ABC’s custodian account would have a new balance of $ 1.690 billion.

ABC then off-sets the Custodian Account (less $ 1 million for charges), returns the BG to Bank C (less $ 1 million for charges), surrender the properties back to their respective owners, and pays Bank B $ 40 million and waives the interest in contra for the bank charges. So the accounting would look something like this:-

CustAcc. Closing Bal:       $ 1,690 m
Less:
CustAcc. Opening Bal:     $ 1,300 m
Custodian charges:           $          1 m
Bank C’s BG Charges:        $          1 m
Pay Bank B & facility:       $       40 m

Balance to ABC            $    348 m

ABC’s ROI for that particular trade, based on their initial capital of $ 10 million  is a staggering 3,480%!!! And after deducting their commitment with their investors of 15% p.a., they pocket the remaining 3,465%!!

Like I mentioned earlier in my prior postings, this exercise is achievable provided that you have a solid financial and banking track record..

So now you know how they do it…

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