Student Debt Could Be A Landmine For Lenders

Includes: NNI, SLM
by: Braden Holstege

If the last 5 years have taught investors anything, it’s that “safe” debt holdings are often far riskier than ratings may suggest. One particularly prevalent type of debt that has been largely ignored by analysts is student loan debt, which recently passed credit card debt as the single largest type of unsecured debt in the United States, with total value exceeding a trillion dollars. Companies holding substantial debt of this type, such as Sallie Mae (NYSE:SLM) and Nelnet (NYSE:NNI), may face much greater downside risk than has been accounted for in their share prices.

On the face, student loan debt should be extremely safe. Bankruptcy proceedings can only remove student loan debt in the case of “undue hardship”, and courts will allow for garnishment of wages to recoup on missed payments. Federal loans are also guaranteed by the Department of Education, further reducing apparent risk. Essentially, default is impossible in most cases, which has led to the perception of student debt as a risk-free holding.

This perception is false. Just because debt cannot be removed via bankruptcy does not mean that a return to the loan is assured -- courts cannot garnish wages that students are not earning. The New York Times reports a substantial increase in borrowers who have defaulted on loans over the last year. Growth in defaults has been fastest in for-profit colleges, which also happens to be the fastest growing sector of higher education in terms of enrollment. Default rate is also well correlated with youth unemployment, which has lagged behind other age groups in terms of economic recovery.

Additionally, there is some likelihood that federal policy regarding student loans will change in ways that will not benefit loan issuers. In 2010, new regulations took effect to ease circumstances under which students could escape debt, and there has been activism and editorials supporting further debt relief policies. Recent Congressional hearings over the role of loans in for-profit educational institutions has centered around the high level of debt held by students attending those schools could well result in tightening of debt, and therefore a reduced customer base for lender. Recent concerns over a bubble in higher education could have a similar effect, dragging down new revenue sources while a poor macroeconomic situation raises default rates on old debt.

Sallie Mae holds more than $150 billion in total student debt versus a market capitalization of $7.4 billion at a current share price of $14.49. Nelnet has a market capitalization of $1.1 billion at share price of $24.36 versus $25 billion in student loan obligations. This situation should be viewed with concern. I would advise caution when considering a long position in these companies, or others that hold a large quantity of student debt.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.