Everyone tries to predict the next big bubble, black swan event, or bear market. We may not directly think of these events but they are often factored into the "downside risk" question we ask when investing. Government bonds tend to be a hot topic, and rightfully so... But one subject that is often overlooked is educational loan debt. The purpose of this article is to identify the known and unknown facts about student loans, and my opinion as to how this will affect our overall macro economic conditions.
Educational loans more popularly known as "student loans" are a unique lending vehicles that are possibly known as the best and safest way to make money, should you be on the lending end.
Why would I say "best and safest" for lenders?
1. Borrowers can NEVER get rid of student loans, even in bankruptcy (well there are very specific circumstances, mainly death, total disability, or severe financial hardship)
2. Guaranteed payment (at some point) because borrowers can never get rid of their loans. The government is already profiting hugely from collecting from default borrowers.
No that wasn't a typo, student loans will haunt those who borrow for the rest of their life and sometimes even into the afterlife as those who cosigned for their child that dies are still on the hook. There are whispers of possible reform, allowing for private student loan debt to be discharged, but the reality of that happening is unlikely (at least until after elections).
To illustrate I will take you through a example of a typical student:
Bill decided to go to college. He has no money to pay for it but the college he wants to attend has a financial aid office to help find a variety of options. Bill gets a small scholarship, an offer from the gov't to lend him money (some accruing interest while in school, some deferred), and for the remainder of his need a private student loan (not backed by the gov't).
Bill is accepted and the financial aid office gets everything set for him so that he can start classes. A short time later loan docs arrive, along with the bill for school. It shows the charges, the loan covering the charges and usually a remaining balance of cash that typically is given to the student.
Bill is a college student and studies hard but likes to have some fun and uses that extra money to "live life." Over four years Bill received nearly 5000 in excess funds. It's his name on all the docs so his parents are unaware of what's happening.
Bill graduates and gets a reasonable job. He received his loan docs and a letter telling him it's time to start paying. He looks at the number and is stunned, looking diligently seeing why it's so much money. He sees the distributions made to him that he used for "fun", as well as the interest that was building on certain sets of loans. Bill realizes he was in over his head, but what can he do now. His current job isn't bringing in enough money to pay for his living expenses and the loans.
No problem, says the loan company, we can defer them, for a while. Your interest will still accrue and you will have to pay that...
Great, solution, Bill can defer them for a while until he makes more money to start paying.
Years go by and the interest compounds, suddenly Bill gets a call from the loan company and says we can't defer your loans anymore. You need to start paying. The amount has now grown significantly since he first started deferment and agreed he needed to pay something. They set up a payment plan the covers just the interest on the new larger principal balance.
The reality is that this is the typical student. Unaware until it's too late what their actions have caused.
As they say, where there is distress, there is profit to be made...
With this we look at the flip side of the coin. The patient lender is more than happy to allow interest to accrue and will work with the student to defer and reduce payments. While it seems they are doing this to help borrowers, they make more money by being patient and less when you pay off more. Since the lender knows you can never discharge these types of loans they have no reason to worry as long as you are paying your minimum interest payment. As soon as that stops, watch out; they wield a massive sword reaching into your pockets in this life and beyond. If there is more debt left over and you have cosigners they will turn and go after them as well. The only other organization that wields this type of power is the IRS.
The lenders can get judgments and garnish any income you make including but not limited to Social Security payments. Yes, if you are lucky enough to have student loans into old age, and you default, they will get a judgment and garnish your social security income.
Default rates in student loans have been raising slightly but the reporting requirements for these types of securities are skewed, as I said earlier deferment and forbearance, which are technically a default, but not counted because the lender allows it. In addition there is a big disconnect on how much debt there is and what state is it in? Felix Salmon wrote a great article in October of 2011 regarding the spotty reporting of student loan statistics.
Even without student loan defaults there is a much different phenomena happening; Since these students already have a "mortgage" (their student loans) they will reduce their ability to purchase a home, and other discretionary items.
I keep hearing the housing market is coming back but the investors are the only ones increasing their purchase of homes. With the number of students now paying student loans and not saving for a down payment on a home, I expect this trend will continue. Student loan borrowers are even putting off getting married due the immense burden of these loans.
Rep. Hansen Clarke introduces The Student Loan Forgiveness Act of 2012 (H.R. 4170): "This bill would forgive outstanding student loan debt for Americans who have made payments equal to 10 percent of their discretionary income for 10 years."
While some can toy with "forgiving" student loans, the reality is that government lenders possibly could, but private lenders would never. Even if the government forgave their students loans, how would that impact the economy, more importantly how would that affect our fiscal state of the union?
Forgiveness by the government would destroy money, reducing the amount of money in circulation thereby increasing inflation. (I am oversimplifying this) With loans paid off and disposable income available to the ex-borrower they are now able to purchase more goods, thereby further aggravating inflation.
In my opinion, from a macro view, student loans will cause a significant amount of stress on our system. It will most likely not affect the lenders but the borrowers and their economic movement indirectly. We will see less and less buying homes, and more renting. Even with rising rental rates those affected will have no choice but to continue to rent because they can't build up enough of a down payment.
For those seeking to short Sallie Mae or other financial institutions it is most likely a long shot that the lenders will suffer from student loans (I). Sallie Mae failing is always a possibility but I doubt our government would allow it to fail.
Seeking to short educational institutions, based on growing student loan debt, wouldn't be a sufficient method to determine if that particular institution was a good investment. The universities do not have exposure to these types of loans, but they do have other exposures (an article for another day). There are some institutions that will stand apart from the rest, those who are over leveraged will feel the squeeze at some point.
I think a more practical alternative to approach the situation would be to seek out multi family REITS, Essex Property's (ESS), which i feel is a bit expensive per share, but on a decent pullback 3-4% could be a good buying opportunity. Other comparable companies Equity Residential (EQR) - seems expensive, Camden Property Trust (CPT)- which actually looks attractive as I write this, Colonial Properties Trust (CLP) - just don't understand why this has not out performed like the rest.
Focusing on investments that will make money off the growing number of people relying on that particular company/product will be smart decisions. What will the students laden with debt that they can't get rid of do? They hunker down, rent, have used cars or public transport, discount shop every chance they get. A trend I don't see disappearing for some time.
In short, yes students loans are the "Elephant in the Attic" growing ever larger. No I don't think it's something that can "pop" like the housing bubble, unless... but I do think the longer term consequences facing a vast majority of every day individuals are much greater. If we don't stop feeding the elephant then it will continue to grow. The consequences will be on the borrowers.