What Is the Margin of Safety in Promissory observe Investing?

What Is the Margin of Safety in Promissory observe Investing?




It’s a fact that many observe investments do not have a happy ending. Let’s examine some of the reasons for observe investments to fail. Let’s look at some lemons and see what could have been done to make them into lemonade.

A basic rule of investing in notes is to realize that unexpected negative things can happen. There is probably no active observe investor, in spite of of education and experience, who has not been hit by a totally surprising negative event. Unintended consequences and unanticipated happenings take place at the national level, and at the small observe investing level; no investor is smart enough to predict the future.

The only way to protect against a big loss is to always continue a “margin of safety”.
That method that your investment should always have a “safety net” or have the equivalent of wearing both a “belt and suspenders” to keep your pants up.

As an example, assume that you are buying, or brokering, or originating a $ 25,000.00, 8.5% interest rate, three year balloon observe that is secured by one thing-the borrowers potential to pay monthly interest and to repay principal in three years. Further, assume the borrower’s credit score is very high (700), his employment history is very strong (18 years same company), and he is a respected pillar of honesty in the community (on the City Council).

Now, that seems to be about as good as it gets doesn’t it? Well it is, if nothing changes for three years. But, let’s pretend that some unexpected, unanticipated negative event happens. Let’s see what impact a negative event has on the safety and value of this observe. Here are some examples of what can and does often happen in the real world:

His employer, Chrysler Corporation, declares bankruptcy and he looses his job at age 55.

One of his children get busted for dealing drugs and he has $65,000.00 in unexpected legal fees to pay.

A routine physical examination detects cancer and he can no longer work.

He and his wife get into a nasty divorce/character settlement/custody argument.

As you can see, any one of the above can turn a safe observe into a defaulted, non-performing observe! Suddenly, the Fair Market Value of a $25,000.00 can become pennies on the dollar.

In this example, there was no margin of safety. The value of the observe was 100% dependent on the borrower’s health, employment, and family circumstances. If there would have been additional collateral security, such as a co-signor, a guarantor, or a mortgage lien on real estate, then this loan might have been 100%, or 80%, or 60 % salvageable.

Always remember, when dealing with promissory notes, that the risk comes from what you don’t know. Since you don’t know the future, assume something negative will happen (and hope that you are wrong) and allow some additional protection, or additional margin, or additional collateral that will cushion the impact of the negative event. There is no formula to figure out the inherent value of a promissory observe. You have to know the business.

Investing is like baseball – you do much better if you’re not always swinging for the fences!




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