The BMW Method
Buying Debt and Preserving Capital

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By qazulight
March 4, 2009

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Why is it desirable to buy the bonds of a company entering bankruptcy?

It is not desirable to buy the bonds of a company that will enter bankruptcy. It is however desirable to buy the bonds of company that has entered bankruptcy, it is also desirable to buy bonds in companies in troubled industries where some companies, but not the one you are considering, has entered bankruptcy.

Can't you end up losing a good portion of your investment?

If you buy debt, (I use the term debt because there are so many creative ways of buying debt, preferred stock, bonds, convertible bonds, subordinated bonds, senior debt, asset backed bonds and so on.) and you do the due diligence, and lot is required, then no you have a very good chance of preserving your capital.

Think of a company like a house. You go out and buy a house, you get a first mortgage, then maybe you want to add on, so you get a second mortgage, then maybe you want to spruce up the kitchen....

You already have a first and second mortgage, so the cabinet maker carries a note. Its a you and him hand shake thing.

Now, you the homeowner have equity in this house. One day news comes out the plant you are working at will close. Everyone loses their job. You lose your job. You can no longer pay the notes on the house, it is worth more than you owe on it, but you just cannot pay the note.

You file bankruptcy. The court decides, your a good guy, you paid your bills when you could, too bad. Your house gets sold on the court house steps.

The first lean holder is the senior debt, the second is the subordinated debt and the carpenter is the unsecured debt.

If the house sells for more than the total debt, you, get the remains of the money.

The same thing works in a bankruptcy of a business. The business seeks protection from its creditors. The court decides what to do. When everyone lines up with their hands out, the senior debt gets paid first, the subordinated debt gets paid second, the unsecured debt gets paid last, and if there is anything left, the stock holders get a penny or two.

The secret is finding companies where you believe the stock holders will get anything at all, because for them to get anything, the bond holders have to be made whole including all of the suspended dividend payments. ( dividends on debt are not optional.)

When Enron went belly up, El Paso energy was in the same trading business. The credit agencies cut El Paso's credit rating. El Paso was and is a profitable company with more assets than liabilities. But the stock was depressed and the convertible bonds that I had bought converted at a price above the stock price. So the debt was selling way below face value. The dividends on these convertible bonds was 13 percent or better. By the time the bonds were converted, the stock price had recovered and it was a break even. I will say that if I had done good due diligence I probably would not have bought those bonds.

Another time my broker mentioned preferred in Mirant. Mirant had been forced into bankruptcy with the Enron debacle. Mirant was making money, but the banks had a chance to steal the company and the tried to do it by refusing to roll over the debt.

I picked up the debt for the interest owed on it. If I had been smart I would have backed up a Brinks Truck and loaded up.

Sometimes the companies have debt structures that are too complicated to figure out. I had bought stock in Calpine. I watched it fall for a while and sold it. I wanted to short it but I don't have the mechanisms in place to do so. I watched it fail. I studied its balance sheets, I read the filings, I read the prospectuses on the debt. I decided that the most senior asset backed debt holders were the only ones that could be paid off. That debt was not for sale. I passed on Calpine. In the end Calpine stock holders got some equity, this tells me that all the debt holders were made whole. I missed that one.

I was looking at GOM, it was way down and yielding 26 percent, I knew that they would probably get a place at the FED discount window, but I wasn't sure, and I needed to unload some other stock to buy. I waited and missed, when the news hit that GMAC got the place at the discount window the price of GOM doubled within a week.

So be it. There will be many, many more chances this year, maybe for 3 or 4 years.

Anybody looked into Toll Brothers bonds?