It’s May 2017 on an ivy-draped college campus. You just graduated with a degree in English. In 2013, you borrowed $50,000 from the U.S. Department of Education’s Direct Loan Program. Job searches for teaching and journalism positions have been fruitless. Within a matter of weeks, you must start making loan payments on a waiter’s wages and tips. On sleepless nights, you fear what defaulting on this loan will mean down the road.
Signing up for a huge student loan was a mistake. Both you and the lender had assumed a certain type of job market would exist four years into the future. Your lender — the U.S. government — has long subsidized unsustainable activity. In 2009, economists encouraged politicians to promote even more nonsensical spending than usual. “Spending on something — anything — is valuable and necessary stimulus!” they said.
We got government spending in 2009 — spending that worsened imbalances. Since then, the economy has mutated into a state of addiction to credit and low interest rates. Most of the new jobs created have been in low-value-added service industries like hospitality and healthcare administration.
Today, the gap between a self-sustaining economy and today’s stimulus-addicted economy extremely wide. It’s so wide that policy fixers must commit ever more resources to prop up past spending mistakes.
People are smart and adaptive; governments are dumb and reactive. Markets often fail. Mismatches between supply and demand drive changes in prices. Assuming we have flexible capital and labor markets, market failures get corrected quickly.
However, in today’s bailout-heavy, politics-driven economic system, market failures are not corrected quickly, and are usually made worse. This has huge implications for the government budget — and the investing environment staring us all in the face…
Let’s return to the student loan mistake facing the English graduate and why it’s bad news for the future of many investments. According to Labor Department statistics, 1.2 million Americans between the ages of 20 and 24 not in school are officially unemployed. The size of this age group working part time is near an historic peak.
Unless recent college grads hold degrees in high-demand fields like computer science or engineering, they aren’t finding jobs; they aren’t buying new cars; they aren’t starting families; and they aren’t buying houses. As a result, the housing market for first-time buyers has never really recovered its pre-2007 peak.
Those born in the 1980s and early 1990s make up a large demographic bulge; these are the “echo boomers” or “millennials” — the baby boomers’ kids. This generation had a coddled upbringing. It remains to be seen if economic circumstances have forced some degree of maturity. Many millennials have adopted the worst of their parents’ habits during an era of credit excess. And many feel entitled to pursue career dreams regardless of practicality.
It may not seem like it now, but we may be witnessing the maturing of a new generation with Great Depression-era values, including thrift, selflessness, stoicism and, most importantly for investors, an attitude that debt is dangerous and saving is “cool.” Harsh job market reality and a tsunami of student loan defaults will — over time — alter a generation’s behavior.
Brace for the Student Loan Bomb Impact: $100 Billion-Plus Losses
The fallout from the student loan crisis started hitting in mid-2013, four years after the volume of government-funded student loans surged. Like the infamous option ARMs (adjustable-rate mortgages) during the housing bubble, these loans have precisely timed fuses: Four years after the loans are made, borrowers must start making payments.
The U.S. Department of Education is the Santa Claus of student lending. It doesn’t have any real loan underwriting discipline, because there is no real capital on the line! These bureaucrats figure that if defaults rise in the future, taxpayers will foot the bill.
After a lending binge started in 2009, the Department of Education’s loan portfolio now exceeds the size of all but the biggest banks. According to the National Student Loan Data System, the Department of Education now holds a $1.26 trillion portfolio of student loan receivables. If this portfolio were a bank, it would rank as the fifth-largest bank by assets — behind only JPMorgan Chase, Bank of America, Wells Fargo and Citigroup.
As time passes, and defaults rise, this $1.26 trillion “asset” will become a liability. Thanks to the punk job market, a huge percentage of these loans will go bad, and have to be restructured in “income-based repayment plans.” The latest data show that the size of the Direct Loan portfolio in some form of deferment or income-based repayment plan has tripled over the past three years, to $293 billion. That’s 23% of the Department of Education’s loan portfolio that is not performing as expected when the loans were extended to borrowers.
As these restructured loans will surely wind up paying less than originally expected (and many will be forgiven), Congress will have to appropriate money to make up for the loan payment shortfall. What was quietly off budget will soon make a big splash on the federal budget. The accounting is opaque, but we can expect defaults on government student loans made since 2009 to ultimately reach over $100 billion.
Like Countrywide did during the housing bubble, the government is not honestly accounting for its portfolio risks. The chief accountant of the Government Accountability Office (GAO) wrote a report dated December 2011 on the federal government’s accounting deficiencies: “The deficiencies, for the most part, involved credit subsidy estimation and related financial reporting processes.” In other words, accounting for below-market loan interest rate subsidies is complex, and the government is not adequately disclosing the risks it is taking.
What conclusions can we draw for your portfolio? Right now, even professional investors aren’t talking about the ticking time bomb of off-balance sheet student loan defaults. This, along with other unreformed entitlement programs, will swell the federal budget deficit far beyond even the biggest projections.
Again, the cumulative losses on the Department of Education lending binge will probably be north of $100 billion. But the Department of Education is doing everything it can to avoid transparency about the defaults hitting its portfolio — including the reclassification of loans that are really in default as “restructured” with some sort of income-based repayment plan. If GAAP accounting were being used, the Department of Education would have to write down the value of its loan portfolio to reflect the lower present value of the future payments that will flow in from restructured loans.
This is bad news for savers waiting for a return to reasonable interest rates on savings. The exploding deficit will force the Federal Reserve to not only keep rates at zero for the rest of the decade, but also to print trillions more dollars in order to buy the Treasury bonds floated to fund these deficits.
In the meantime, you want to avoid owning any company associated with underwriting or servicing student loans. Here are the three pure-play student loan stocks:
- SLM Holding Corp. (SLM: NASDAQ)
- Navient Corp. (NAVI: NASDAQ)
- Nelnet Inc. (NNI: NYSE)
The magnitude of this problem is so large that legal risk alone could one day make these stocks radioactive. Whatever analysis is based on historical fundamentals won’t be relevant in era of mass student loan default, restructuring, and forgiveness.
Make sure you don’t own those three stocks! We’ll be watching this ticking time bomb closely… and if these three become compelling short candidates, we’ll update you.