Student Debt: A Trillion Dollar Bubble

Includes: QQQ, SLM, SPY
by: Colin Lokey

On November 27, the New York Fed reported that during the third quarter, non real-estate household debt rose 2.3%. The primary driver of that expansion -- accounting for $42 billion of the total $62 billion increase -- was student loan debt. Out of that $42 billion, only $23 billion was attributable to new student loans. The other $19 billion reflects previously defaulted student loans that were just finding their way onto credit reports. The Fed's data indicated that the percentage of student loans over 90 days delinquent had risen to 11% during the quarter, a new all time record and up 2.1% from the previous quarter.

Default Rates

As it turns out, 11% is quite a telling figure. The delinquency rate for student loans is now higher than all other types of debt, surpassing the 90+ day delinquency rate for credit cards, which stands at around 10%. For comparative purposes, consider the following chart, which shows the 90+ day delinquency rates for student loans compared with the same rate for other types of debt in America (note the dramatic uptick beginning in 2012):

Source: NY Fed, Equifax via Forbes

While it is extraordinary that student loans are now apparently more risky than credit cards, the data presented above is only the tip of the iceberg. On September 28, the U.S. Department of Education published, for the first time, three-year federal student loan default rates.

Previously, the Department of Education relied on two-year cohort default rates, which track defaults before September 30, 2011 by borrowers who began (or, perhaps more accurately, didn't begin) repaying their loans between October 1, 2009, and September 30, 2010. That rate, as of September 28, 2012, was 9.1%.

However, as part of the Higher Education Opportunity Act of 2008, the Department of Education has begun the transition to a three-year calculation, which tracks defaults before September 30, 2011, by borrowers who started making payments between October 1, 2008 (as opposed to 2009 on the two-year cohort) and September 30, 2009. As Bloomberg recently noted,

Congress demanded a more comprehensive measure because of concern that colleges counsel students to defer payments to make default rates appear low.

It appears our elected representatives were onto something. The default rate on the three-year cohort was a disconcerting 13.4%. Shockingly, one in five students at for-profit institutions defaulted by the third year, nearly double the rate those institutions reported under the two-year standard. According to the Department of Education's report,

...there were 218 schools that had three-year default rates over 30 percent, and 37 schools had three-year default rates in excess of 40 percent.

Unfortunately, these default rates may in fact paint far too rosy a picture. For student loans, delinquency rates are calculated in a way that clearly favors understatement. When payments are deferred during school and during the six-month grace period that follows graduation, the deferred payments are not technically overdue and as such, they are not included in any calculation of aggregate past-due amounts. This makes sense until one considers that the total amount due on these deferred loans is included in the delinquency rate calculation. So for the purposes of calculating delinquency rates, deferred loans are treated just as current loans are treated, even though no payments are being made. As noted by the NY Fed,

...this may help explain the low proportion (12.6 percent) of borrowers with past due student loans among those under thirty years old, compared with 16.9 percent among those between the ages of thirty and thirty-nine, since many of the younger borrowers are still in school and don't yet have to make any payments.

When this dubious calculation method is dropped (i.e. when loans in deferral or forbearance are excluded), the NY Fed found that as of the third quarter of 2011, fully 27% of borrowers had past due balances and 21% of borrowers were delinquent. According to the Fed, this means that the 11% delinquency rate reported for student loans during the third quarter of 2012 is in all likelihood "roughly twice as high." If true, this would mean student loan delinquency rates are twice as high as credit-card delinquency rates and around four times as high as delinquency rates on mortgages and auto-loans.

To better understand how this might end, compare the projected delinquency rates accounting for deferrals and forbearance (around 22%) and the total amount of student-loan debt outstanding (over $1 trillion) with the same statistics for the subprime mortgage market in 2007:

Source: ZeroHedge

As you can see, the similarities here are alarming. ZeroHedge made this comparison last September, but it used the delinquency rate for student loans at for-profit institutions rather than the NY Fed's adjusted calculation for the total delinquency rate, which I have used here. I think using the adjusted delinquency rate (i.e. the rate that takes into account deferrals and forbearance) makes the subprime comparison far more intriguing given that one might plausibly assert that the delinquency rate at for-profit institutions isn't likely to be representative of the industry as a whole. Since the adjusted delinquency rate for the entire market is just as high as the unadjusted rate at for-profit schools, it makes just as dramatic a case but utilizes a data point that is far more reliable as an broad indicator.

Private Student Loans

As Business Insider noted in the summer of 2012, federal student loan debt is only part of the equation. According to a report by the Consumer Financial Protection Bureau dated August 29, 2012, U.S. consumers have in excess of $150 billion in private student loans on their books. The report notes that the market for private student loans grew alongside investors' demand for asset-backed securities and between 2005 and 2007,

...the percentage of [private] loans to undergraduates made without school involvement or certification of need grew from 18% to over 31%...[as lenders] originated loans to borrowers with low credit scores...[making] private student loans riskier for consumers."

The private loans were securitized and those doing the securitizing could realize a 5% profit upon the sale of student loan asset-backed securities (hilariously called 'SLABS') to investors. Of course, the SLABS effectively transferred the risk of default to the investors and as such, it made little difference to the originators of the loans or to those doing the securitizing whether the borrowers ever intended to repay the debt or not. All of this changed when the credit bubble burst of course and as the demand for asset-backed securities declined, so too did the amount of private student loan originations.

No matter: the damage as they say, was already done. Beginning in 2008, defaults on private student loans made when the demand for SLABS was high and lending standards were low, skyrocketed:

Source: Consumer Financial Protection Bureau

Perhaps more instructive is the following graphic, which shows the percentage of private student loans in default, broken down by origination year:

Source: Consumer Financial Protection Bureau

As you can see, the trajectory for the 2009 vintage loans looks slightly better, but the trend is clear. The Consumer Financial Protection Bureau notes that

...the default curves for the 2005-2008 vintages... show increasing loss rates for each successive vintage, reflecting increasingly aggressive underwriting [but] the 2009-2010 vintages do not show the steep trajectories of earlier years.

I would argue that the chart above does not reflect that assessment. It would certainly appear that the default trajectory for the 2009 vintage loans is above that for 2005 and 2006. In any case, defaults on these loans are likely to rise going forward. This is made especially true by the rather unfortunate fact that, in contrast to federal programs which offer

deferment or forbearance of repayment, income-based and income-contingent repayment plans, public service debt forgiveness and methods to cure default... income-based or income-contingent repayment has never been a feature of private loans and is not now contemplated. For the relatively high number of private student loan borrowers currently having difficulty with repayment, it is hard to avoid default and equally hard to escape it, as compared to options available to federal loan borrowers. (emphasis mine)

Regarding the market for private student loans, perhaps U.S. Secretary of Education Arne Duncan said it best:

Subprime-style lending went to college and now students are paying the price.

Economic Impact

According to the NY Fed and Equifax (cited above), as of the third quarter of 2011, 40% of people under 30 and 25% of people 30-39 had student loan debt. More broadly, 25% of households have student loans and the average amount due as of 2011 was over $23,000. Furthermore, around 67% of the nearly $900 billion in student loan debt outstanding during 2011 was owned by people under 40. Due to the intractable nature of student debt, this burden may well be a major drag on consumer spending going forward. As CNN's William Bennett recently noted,

Unlike credit card debt or automobile loans, student loans are virtually impossible to liquidate, even after declaring bankruptcy. So 20- and 30-year-olds buried under student loan debt are forced to put off other purchases crucial to the health of the economy, like buying a car or home or investing in the markets.

For more perspective, the following chart shows outstanding student debt as a percentage of income:

Source: Bank of America, NY Fed

Put simply, Americans have simply replaced one form of debt (mortgage debt) with another (student debt). This point is illustrated by St. Louis Fed data, which shows that contrary to the deleveraging myth, total consumer-credit outstanding is now at an all-time high:

Source: St. Louis Fed via Economic Populist

To further illustrate how all of the above will likely erode economic growth by inhibiting households' ability to make discretionary purchases, consider the following chart, which shows disposable income per capita, average federal aid, average federal loans, and tuition over a nearly 30-year period:

Source: Bank of America, College Board via ZeroHedge

One can see from the graph that the growth in disposable income per capita stopped keeping up with tuition and federal assistance some two decades ago and the disparity is getting more pronounced by the year.

The student-debt bubble is yet another defining characteristic of the "New Normal" and is perhaps far more important in terms of its potential deleterious effect on economic progress than negative real wage growth, depressed capex, or a hamstrung housing market. Student loan debt is a trillion dollar problem that affects one in five U.S. households to the tune of $23,300 on average.

Furthermore, there are $150 billion in outstanding private student loans, many of which likely carry variable interest rates. Rising delinquency rates should serve as the proverbial canary in the coal mine and indeed suggest that this is no more of a far-off problem than the subprime crisis was in 2007. This is perhaps the best reason of all to bet against the U.S. economy in 2013 and steer clear of U.S. equities in general (NYSEARCA:SPY) (NASDAQ:QQQ). A crippled consumer equals crippled consumption, hobbled corporate profits, and a sluggish economic environment. Investors should also be particularly wary of private student-loan originators like Sallie Mae (NYSE:SLM).

Disclosure: I 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.