#3 – Student debt and the next bubble in the US

Wild and crazy times. A failed coup in Turkey. Weakening of the EU project – through systemic and targeted terrorism across France, Germany… Trump and Hillary (need I say more). What is going on!! Simply put these are scary times.

We will take a moment and unpack one of the headlines that sometimes goes under the radar. A deeper focus on student debt, and the scary economics that are heading for a crash…

The next bubble will be student loans (or perhaps the impacts we will be subtly felt and we wont even realize it!). The student debt market has many of the same characteristics as the mortgage meltdown and in some cases is even worse (i.e., no collateral, credit scores present a misleading picture, and credit underwriting standards are not calibrated to the type of schools students are applying to/what their trajectory is).

The problem is we don’t really know it’s a bubble, because the government guarantees most of the outstanding student debt. Bank’s who own the securitized assets of these student loans don’t mark to mark the values of this (due to the guarantees)… and in the end the crazy amounts of interest that are accrued on these un-sustainable loans are enough to keep the government whole on their outstanding loans.

Why is it only getting worse?

The government guarantees many of these loans through a program (Federal Family Education Loan Program) in which, the US Treasury backed private loans to college students. This meant that even if facing massive amounts defaults, the government would bail them out. In 2010 President Obama ended the Federal Family Education Loan Program, after it had grown to a $ 60 billion per year program.

This has all the underpinnings of a bubble, the belief that all Americans should get a college degree coupled with a market in which no collateral is posted, limited credit analysis is performed, no bankruptcy protection for borrowers – means no losses? And no one really feels skin in the game (e.g., schools continue to raise prices) with the expectation that regardless of default rates it’s not their problem.

Despite the growing costs, Americans believe deeply in the importance of higher education. A survey of parents released this month by Discover Student Loans found that 95 percent believe college is somewhat or very important to their child’s future. They have reason: In 2012, full-time workers with bachelor’s degrees earned 60 percent more than workers with just a high school diploma.

Policymakers also encourage college attendance. In a speech earlier this year, President Obama called higher education “one of the crown jewels of this country” and said it was “the single most important way to get ahead.”[1]

There is also the matter of “credentialism,” the trend in many professions to screen for ever higher qualifications for jobs that may not require them. A 2014 study by Burning Glass, a labor analytics firm, found that 42 percent of management job holders had bachelor’s degrees, but 68 percent of job postings required them. In computer and mathematical jobs, 39 percent of employees had bachelor’s degrees, but 60 percent of job listings called for them.

“Many middle- career pathways are becoming closed off to those without a bachelor’s degree,” the report concluded. The confluence of those trends has led to a nearly unbroken increase in college attendance for almost 30 years. At the same time, though, the cost of college has risen for decades, far outstripping inflation.

As a 2012 economic analysis by The Hamilton Project, a policy research group, concluded: “The cost of college is growing, but the benefits of college—and, by extension, the cost of not going to college—are growing even faster.”

Whatever the reason,  the cost of both a private and a public college degree has skyrocketed. Average tuition, fees, and room and board at a private, non-profit, four-year college were $42,419 for 2014-2015, up from $30,664 in real dollars in 2000-01. At public, four-year schools, costs for the 2014-15 school year, at $18,943, were up sharply from the $11,635 price tag in 2000-01, according to the College Board.

Due to the economic crisis in 2008, more students went back to school and tried to get another degree to blunt the effects of not having a job. What they are finding is the value of the degree does not line up to the economic reality of how much they are paying in debt (average 7% interest rate and higher) with the variable rate in many cases tied to the prime rate (which interest rates are going up!). The default rate of the 2009 cohort has surpassed that of the earlier cohorts much more quickly., and that early delinquencies are worse among lower-balance borrowers, and that’s true for default rates, too.

The results for the 2008 Cohort (or those that went to school during the economic crisis are striking)

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Impact on Home Ownership?

The Federal Reserve has been researching the impacts of student debt on other parts of the economy – including does this impact the timing / or when a home is purchased by a individual? Further, can the record low home ownership %’s be explained

“Taken together, our results suggest that for those with college education student loan debt more likely affects the timing of home ownership than people’s eventual attainment of it”

Their analysis showed that home ownership by those with debt plunged from over 30% in 2008 to just over 20% by 2012, two percentage points below the rate among non-student debtors. (Typically student debt holders have higher ownership rates because more education tends to equal higher incomes.)

 

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What’s Next?

The large and sustained increase in student loan balances over the past decade or so has raised concerns that student loan borrowers are incurring debt burdens that will be difficult to repay and will hinder their ability to achieve life goals such as purchasing homes, starting families, investing in small businesses, or retiring from the workforce. “Student loan debt is the only form of consumer debt that has grown since the peak of consumer debt in 2008. Balances of student loans have eclipsed both auto loans and credit cards, making student loan debt the largest form of consumer debt outside of mortgages” (FRBNY 2012). Since 2004, student loan balances have more than tripled, at an average annualized growth rate of about 13 percent per year, to nearly $1.2 trillion, in 2014. As interest rates go up (increasing the payments required), the price of a College Degree continues to goes up, and the intrinsic value of education goes down – the default rates and delinquency rates will continue to go up. Putting further pressure on private companies that have student loans on their balance sheet, and or companies that securitize and issue private student loan debt; private companies want no part of issuing student debt – which will further challenge student loan pricing (e.g,. JP Morgan leaving the business of issuing student loans). Banks who are facing increased capital requirements and pressure on returns, will continue to look to rid the often illiquid student loan debt (e.g., US Bancorp unsuccessfully tried to sell 4bn of student loans at a 30% discount).

You are starting to see the deterioration from the market/students in colleges that the degree is not panning out to be worth the debt burden (e.g., University of Phoenix). Enrollment at America’s largest for-profit university was about 460,000 students five years ago. Now it’s 213,000.The University of Phoenix’s parent company, Apollo Education Group (APOL), announced more losses Wednesday. Its revenues and enrollment both sank roughly 14% in its latest quarter compared to a year ago.[2] The US government also has a fair amount of exposure, as many of these losses are directly guaranteed by the government (up until 2010). A further worsening of the US credit rating may further deteriorate prices and economics of student debt – leading to a ripple on many other aspects of economic stability. There is no viable solution on the table and the problem continues to worsen – so what do we do?

Is the end going to be tied to the US credit rating, i.e. this crisis will only hit a breaking point when creditors demand the exposure of student loans to the US balance sheet be reduced?? How does this play out for the real estate market??

 

 

Appendix 

Figure 1 and 2: Rise of Student Debt[3]

Data indicate that both increased numbers of borrowers and larger balances per borrower are contributing to the rapid expansion in student loans. Between 2004 and 2014, a 74 percent increase in average balances and a 92 percent increase in the number of borrowers. Now there are 43 million borrowers, up from 42 million borrowers at the end of 2013, with an average balance per borrower of about $27,000

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Figure 3: Default Rates by Cohort by Q4 2014

The denominator is the number of borrowers who entered repayment during a specific cohort year and the numerator is the number of borrowers from that cohort who have ever defaulted on their loan since they entered repayment. The chart below shows our calculations for the 2005, 2007, and 2009 cohorts. Roughly one quarter of each of the cohorts has defaulted as of the fourth quarter of 2014. Note that the default rate of the 2009 cohort has surpassed that of the earlier cohorts much more quickly. In fact, the chart shows a pronounced worsening of the cohort default rate schedules over time. CDRs at all durations are higher for more recent cohorts, with only one exception being the two-year default rate of the 2009 cohort.  CCP data show that early delinquencies are worse among lower-balance borrowers, and that’s true for default rates, too. The results for the 2009 cohort, presented in the chart below, are striking: the highest default rates, at nearly 34 percent, are among the borrowers who owe less than $5,000. These borrowers made up 21 percent of the 2009 cohort. The default rate among the borrowers who leave school with more than $100,000 in debt is almost 50 percent lower, at 18 percent.

 

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In Summary… 

The economics and drivers of the student debt crisis are further outlined below[4]

Cultural/Behavioral

  • It’s something along the lines of “I have to get a college degree, regardless of the cost, because a college degree is the only path to prosperity, and I won’t be able to succeed without it.”

The Value of a Degree is decreasing:

  • The gap between wages that someone with a degree earns and someone without a degree is narrowing, therefore lowering the intrinsic value of the degree. In 1940, only one in 20 Americans held a college degree. By 1977, that number had soared to one in four. The increase in supply of labor with college degrees, lowers the value of the degree.
  • If the price of higher education increase further, or potentially if it simply doesn’t decrease, people might see higher education as a less attractive investment opportunity.
  • Schools have minimal “skin in the game.” They face little or no negative consequences when defaults are extremely high, and don’t have much incentive to make sure that people can get jobs after graduating. Raising Prices Because most student loans are guaranteed by the government, schools face minimal consequences if the student defaults. Schools get their payment regardless. Schools know people virtually “need” them, and they know that students may be insensitive to price increases because they’re paying with the government’s money.

The Economics of Student Loans are frightening:

  • Students do not have to pay any down payment, and do not have much history of employment. The lack of down payment leaves lenders with even more risk on the table.
  • Student loans are often based on credit score. However, evaluating the credit score of someone who hasn’t entered the workforce, won’t for at least four more years, and with unemployment as high as it, may not make for the best assessment. Many student loans have parent co-signers who have higher credit scores than their children. Therefore the credit score may not properly reflect the ability of the actual borrower to repay the debt.
  • Students don’t have either of these options for student loans. It’s illegal to absolve student loan debt through bankruptcy, and you can’t re-sell an education. Students in default on a federal student loan might have their tax refund taken and/ or their wages garnished [thus much of this debt is not properly mark to market on lenders books / and is not reflected in the value of SLABS (Securitized Student Loan Trusts)
  • At some point, the rising price of education offsets the increased earnings potential, especially if earnings potential declines because of an increased supply in the number of graduates.
  • Many student loans seem to have been made without proper consideration for a student’s ability to pay them back. For example, it is harder for someone majoring in philosophy at mid-tier school that costs forty thousand dollars per year to be able to earn enough to pay off those loans, than it is for someone majoring in software engineers at MIT.
  • By issuing student loans at below market rates, demand for student loans is stimulated. By stimulating demand, the government is essentially funding the production of labor that there’s not enough demand for.
  • Decrease in Supply If more lenders, like JP Morgan, decreased or stopped supplying student loans, it could make it more difficult for prospective students to obtain loans. JP Morgan cited competition as reasons for discontinuing their student loan business and it seems plausible that others could do the same.

Sources

[1] http://www.cnbc.com/2015/06/15/the-high-economic-and-social-costs-of-student-loan-debt.html

[2] http://finance.yahoo.com/q;_ylt=AwrSbm5bFHhWS8IAYrNXNyoA;_ylu=X3oDMTExM2Jia211BGNvbG8DZ3ExBHBvcwMxBHZ0aWQDREZENl8xBHNlYwNzYw–?s=APOL

[3] http://www.federalreserve.gov/econresdata/notes/feds-notes/2015/how-much-student-debt-is-out-there-20150807.html

 [4] http://higheredbubble.com/

#2 – An uncertain way forward, Brexit and what’s next

As I wrote in my first post in May of 2016, I predicted a major transformative economic/political event was on the horizon for Europe; whether it was Grexit, Brexit or some other crisis – the foundation of the European Union would be tested in the near future. While Brexit surprised many – it was only a matter of time for one of these make or break moments to actually occur. For those that are in shock or still mired in a state of disbelief, are still likely underestimating the rising swell of discontent amongst the “have nots” and those that are not participating in the new economy. Political parties and citizens are becoming increasingly polarized and extreme.  This is the start and not the end,  the fear of immigration and outsiders is on the rise. The Trump vote is a real global phenomenon that should not be underestimated.

While analysts and scholars debate what’s the most likely outcome for the UK (e.g., whether the UK will pursue a Norway/Swiss solution to working with the EU – or be treated as a third party country), and as such the damage and next steps will becoming clearer; I think we should be a lot more focused on what’s happening in Italy. As I think the EU actually is worse off as a result of this than the UK, and the underlying question of the EU will survive – is going to come into focus a lot sooner than people think. The UK will eventually sort through the mess they made, and although London will be diminished in it’s standing as a business friendly financial hub, it will survive.

The Financial Times reported on Sunday July 3rd, that Italy was prepared to unilaterally pump billions of euros into its troubled banking system if it comes under severe systematic distress. As we discussed in the first blog post, many of the factors for the previous Euro zone crisis have not been addressed; namely the feedback loop between sovereign risk and bank risk. Further exacerbating the situation in Italy is:

  • Low growth Eurozone wide (many countries still not back to GDP levels seen pre-crisis), impacting bank’s growth prospects
  • Negative interest rates, compressing bank return’s on core banking products
  • Total of 400 billion euros of Non-Performing Loans across large Italian banks
  • Rising political instability – due to referendum on constitutional reform (if Renzi – the current PM loses the vote and resigns- significant instability will introduce )
  • Confidence in the Italian banking system is wavering, and the capitalization levels lag large US and EU peers
  • Brexit only hurts these banks further

Let’s look at what’s developed – this is as of July 1st (source: Yahoo Finance / Bloomberg)

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Large Italian banks are getting hammered, when we take a closer look at what’s changed from April to July. Stock prices are on average across the top 5 Italian banks are down 32%, and CDS has risen 13%. Take a closer look at Unicredit, which is the only Italian large globally systemically important banks (G-SIBs). Down more than 42% (at a price of 1.92 a share).

While the news cycle will be focused on next steps of Brexit. Look deeper at some of the other dark clouds on the horizon..