"I took out $100,000 in student loans from Sallie Mae to finance my degree (graduated in 2009), and my father co-signed the loan. Now, I'm working for a technology solutions firm, earning $40,000/year and facing $1,200 monthly payments I can't afford," one recent graduate told Business Insider in 2013.
This is a simple example of the situation of the bubble occurring. While most investors talk about the bubble in the high-yield bonds, Mark Cuban couldn't resist mentioning on every channel the $1.3 trillion student debt dangers. He even bought year ago a website which live counts the student debt.
My curiosity pushed me to know if whether Cuban is right or exaggerating the situation, like others who kept saying since early 2000s that credit card bubble will burst in a couple of years, just to grab media attention. To examine the reality of the situation, I looked into Wells Fargo's (NYSE:WFC) annual fillings to know how it behaved in recent years regarding student debt. I chose Wells Fargo and not other bank since I think that Wells is the most risk averse among its peers, and it will always be ahead in expecting troubles, due to its long history of avoiding them.
Wells Fargo's actions toward the situation
What I found raised my alarm, according to Wells' 2015 report, in Q4 2014, it sold most of its student guaranteed loan portfolio ($8.3 billion), making a gain of $200 million, to an entity formed by a third-party called VIE; then, Wells made a loan to that entity by an amount slightly less than the amount VIE paid for the loans ($6.5 billion). I analyzed this move and made two possible conclusions. Either Wells needed to realize a quick gain on the student loan portfolio, or it needed to get rid of them being on its books. I doubt my first conclusion since the realized gain from the sale is barely half the annual amount Wells was going to get for keeping the portfolio. Assuming a 5% net interest margin, Wells would have made $415 million annually for about 10 years, much higher than the realized gain of $217 million it made.
Here is its statement explaining what it did to the portfolio, according to its 2014 10-K:
My second conclusion, as said, is that Wells needed to get rid of naming the student loan section on its loan books, which will make it much harder in the future to know WFC's exposure to this sector. The $6.5 billion loan to VIE will be named under the loans to the financial entities section. And thus, Wells will be able to show no direct exposure to the student loan sector in case the bubble burst.
Another thing that alarmed me is the high allowance for credit losses that Wells put aside for the student loans in 2013. The Other Revolving Credit and Installment is the section that includes the total student debt and other margin loans (which are not guaranteed of course). Wells put aside $10.696 billion of the revolving credit and installment, guaranteed loans. The whole student loan portfolio was about $22 billion in 2013. Putting aside half the amount of loans is not something usually a bank like Wells will do. It is definitely expecting something. Just to mention, I'm using 2013 because it was the last data of Wells' student portfolio before it sold a big chunk of it in 2014.
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In addition, $900 million of student loans were non-performing loans in 2013; this is quite a big amount compared to the $10.7 billion guaranteed student loans (8.41%).
In Wells' reports, I didn't worry about the situation of the net charge-off numbers for 2013 as it was 1.43%, which is much lower than the credit card charge-off and slightly higher than the automobile charge-off. But I had some red flags about the selling of loans to VIE and the non-performing rates, but they weren't enough evidence to tell about the level of danger in the student loan industry.
How Sallie Mae reacted
So I looked into Sallie Mae (NYSE:SLM), one of the biggest student loan lenders. According to its 2015 annual report, the net charge-off rates for 2015 and 2014 were about 0.82% and 0.3%, respectively. These are low numbers, extremely low compared to a private risk-averse bank like Wells which has net charge-off rates of 1.36% and 1.35% for 2015 and 2014, respectively.
I've always seen the public sector as the most reckless, as it manages hundreds of billions of taxpayer money and gives it to anyone who asked for it regardless of his/her credibility. Business Loan Express, BLX, an investment vehicle that takes loans from the government to fund small businesses, which David Einhorn fought, was an example. So when I see a loss percentage of a public lending entity lower than that of a private one, then I sense that things are not adding up.
Thus, I rigged more into the report of Sallie Mae and found out that it did the same thing Wells did, but for a more dangerous portfolio. Sallie Mae's previous net charge-off policy was to classify charge-offs after 212 days of making any payment, but then the company changes its strategy and began classifying charge-offs after only 120 days. What Sallie Mae then did? It sold all of the loans that have more than 90 days of delinquency to an entity that is a subsidiary of Navient (NASDAQ:NAVI), a company that was spun off from Sallie Mae in 2014.
So now, we all know where the bad loans are. At Navient. I looked into Navient's reports and found out what struck me. The FFLP loans delinquent more than 90 days were 7% and 8.4% for Q1 2016 and Q1 2015, respectively. For an economy that has averaged 5% to 6% of unemployment, 7% delinquency rate is way too high.
Even though the net charge-off rate for the Private Education Loan Segment was much lower, 3.2% and 3.6% for Q1 2016 and 2015, I used the FFLP loan charge-off rate because I believe it serves as a better indicator of charge-offs since the program was eliminated in 2010; all loans are made before 2010, which gives a better picture of how students are reacting towards paying their loans after they graduate.
The student debt is without any doubt in a bubble; it has so much in common with the previous housing bubble. Both were funded and guaranteed by GSEs and fueled by a low interest rate environment. What extended the lifetime of the housing bubble is the increase of house prices. What is currently extending the lifetime of the student loan bubble is the high employment track. In order to continue the party, employment rates should continue their current trend, and we all know this isn't going to happen. Any economy will pass through different cycles; recession is a must, but the duration of that recession is all that matters. The longer the duration, the higher the probability that the student loan bubble will burst. But not any burst will result in destructing effects. It's true that the student loans sector is in a bubble. It has all the characteristics of it, but if it bursts, it will have limited effects. The housing bubble reached 100% of GDP in 2007; the current student loans bubble is barely 9% of the GDP. In addition, investors in the housing bubble took advantage of it through the huge process of securitization, taking houses as collateral, thus multiplying the effect of such collapse. Investors in the current student bubble can't make a multiplier effect like they did in the housing bubble, that's because the former market is much more illiquid, and there is no euphoria about it, there is no collateral.
I think that the current student bubble is a problem that must be faced, especially if the universities continue to took advantage of the market and continue raising tuition at current rates (as seen below). But the problem is somehow exaggerated. A current burst of the bubble in my opinion won't happen. Debt balances are low compared to the GDP and also low compared to the disposable income of the student. However, if the current trend continues with high delinquency rates like seen in Navient, and increasing tuition rates thus increasing debt balances, a future bubble will definitely be bigger and its burst will have huge implications on the economy. But, for the time being, do not worry about that; the high-yield market is in much worse condition, which I'm going to write about next week.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.