Short-Sellers: Watch The Student Loan Market

Less than a decade after the biggest mortgage lending crisis in U.S. history nearly decimated the economy, another debt market is showing some troubling similarities to the mortgage bubble: the student loan market.

The total amount of national student loan debt eclipsed $1.2 trillion dollars earlier this year, and a growing number of people believe that the debt will never get repaid.

Student Loans: Just Like The Mortgage Crisis?

The current state of the student loan debt situation shares an eerie number of unsettling similarities to the mortgage market prior to the Financial Crisis.

First, both the housing bubble and the student loan bubble started with government programs designed to stimulate and facilitate lending. The government created the Community Reinvestment Act and government-sponsored entities Fannie Mae (OTC: FNMA) and Freddie Mac (OTC: FMCC) to encourage citizens to buy homes.

To encourage citizens to attend college, the government created the Federal Direct Student Loan Program and SLM Corp (NASDAQ: SLM), nicknamed “Sallie Mae.” SLM Corp was formed in 1972, 34 years after Fannie Mae was established. Freddie Mac was formed in 1970.

Fannie and Freddie did expand the housing market. Between 1996 and 2006, U.S. home prices rose by 85 percent. And in the five years before the housing market’s collapse, mortgage debt rose by 12 percent per annum.

It appears Sallie is stimulating the student loan market as well. Between 2003 and 2013, the average cost of college tuition rose by 79.5 percent. Student loan debt rose by an average of 11 percent per year from 2009 to 2014.

Stagnant Earnings Power

The single biggest problem of skyrocketing tuition costs is correspondingly high levels of student loan debt. Both phenomena cut into students’ earnings power, which has been declining over a period in which costs have been rising, according to multiple studies.

Much like the loose standards for subprime mortgage lending during the housing bubble, some student loan lenders give little consideration to factors such as the school being attended, the probability of graduation and how earnings prospects vary by degree.

Why does this matter? A major factor that led to the bursting of the housing bubble was loan rising loan defaults – there are already indications a similar event is happening in the education space. Delinquency rates on student loans doubled from about 6 percent in 2003 to about 12 percent by 2013.

Taking Notice

These statistics are getting attention from high places. Venture capital mastermind Mark Cuban recently told Inc. he believes a bubble in student loans will one day lead to the closure of several U.S. colleges. “You’re going to see a repeat of what we saw in the housing market: when easy credit for buying or flipping a house disappeared”, he said. “We saw a collapse in the price [of] housing, and we’re going to see that same collapse in the price of student tuition, and that’s going to lead to colleges going out of business.”

Earlier this year at 13D Monitor’s Active-Passive Investor Summit, hedge fund billionaire Bill Ackman called student loan debt the biggest risk in the credit market today. “If you think about the trillion dollars of student loans we have outstanding, there’s no way students are going to pay it back”, Ackman explained.

Even credit rating agency Moody’s, which took a lot of heat about its ratings of mortgage-backed securities prior to the collapse of the housing market, has recently begun taking a closer look at a group of student loan asset backed securities (SLABS).

In late June, Moody’s announced it was placing about $34 billion of SLABS under review for possible ratings downgrades. “The reviews for downgrade are a result of the increased risk that the tranches will not fully pay down their respective final maturity dates”, Moody’s said in a statement.

Silver Lining

Despite the many similarities to the housing bubble, there are two key differences that could serve as a silver lining if the student loan bubble bursts any time soon. First, while $1.2 trillion is certainly a massive amount of debt, the burden pales in comparison to the more than $10 trillion in collective U.S. mortgage debt that coincided with the peak of the housing bubble.

In addition, the systemic economic risk that occurred during the Financial Crisis came about mostly because of an enormous mortgage-based derivatives market. This industry effectively linked mortgage debt to most major U.S. financial institutions at the time.

While many large lenders, such as Wells Fargo & Co (NYSE: WFC) and Bank of America Corp (NYSE: BAC) are actively engaged in student lending, student debt represents only a small portion of the banks’ total balance sheets.

Short Idea?

However, companies that specialize in student lending could soon find themselves at the center of another bursting bubble. In addition to Sallie Mae, The First Marblehead Corp (NYSE: FMD), Navient Corp (NASDAQ: NAVI) and Nelnet Inc (NYSE: NNI) are all currently shouldering exposure to student loans.

In a report published May 12, Sandler O’Neill analyst Christopher Donat mentioned that changes in federal policy could put a dent in these companies’ books. He was especially wary of the laws that would allow student loan debt to be more easily discharged.

Two months later, Donat’s fears are becoming a reality. Newly introduced legislation in Congress seeks to afford farmers protection under the Public Service Loan Forgiveness Program, which already helps certain teachers, law enforcement officials, and other public service professionals. The bill would forgive agricultural workers’ outstanding debt after 10 years of income-based payments.

And since President Barack Obama has identified himself as a champion of affordable education and student loan relief, there is little reason to believe he won’t pursue such policies into the final year of his presidency.

Thus, with a bubble potentially ready to burst and increased federal regulation possibly on the way, firms exposed to large amounts of student loan debt have plenty of reason to be on edge. Short-sellers, keep an eye on this space.

Lightspeed Financial Services Group LLC is not affiliated with these third-party market commentators/educators or service providers. Data, information, and material (“content”) are provided for informational and educational purposes only. This content neither is, nor should be construed as an offer, solicitation, or recommendation to buy or sell any securities or contracts. Any investment decisions made by the user through the use of such content is solely based on the users independent analysis taking into consideration your financial circumstances, investment objectives, and risk tolerance. Lightspeed Financial Services Group LLC does not endorse, offer nor recommend any of the services or commentary provided by any of the market commentators/educators or service providers and any information used to execute any trading strategies are solely based on the independent analysis of the user.

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