If youre looking for a new economic doomsday scenario, U.S. student loan debt default is probably a solid choice. The countrys student loan debt now sits north of $1.3 trillion, according to the Federal Reserve Bank of New York. As of 2012, U.S. Department of Education data show that 48 percent of students were taking out loans for their education, up from 33 percent in 2002; more and more members of that group are going into default.
Students who are behind on or have defaulted on their loan debt take a major hit to their credit scores, which can limit their ability to find jobs and buy cars and homes. Also, parents who have cosigned on loans may become the target of debt collectors and see their credit suffer too if theyre unable to pay. Economists and regulators have drawn parallels to the mortgage crisis, and some investment managers predict that taxpayers may be on the hook for a bailout when the rising default rate becomes too much for the economy to bear.
Players in the credit markets have long traded in securitized baskets of student loans, with some shorting their imminent demise, but the student loanbacked securities market is somewhat illiquid. Now equities traders are getting in on the act with a group of stocks that represent the business end of the American collegiate system, and theyre betting that the college industry will feel the heat. Companies on their list range from debt collectors and loan servicers to textbook publishers and student housing builders.
So how did we get here? Rapidly rising college tuition has been a problem for U.S. students since before the financial crisis, and it has only been exacerbated by a tepid economy. If you went to school in 1976, the average yearly cost of tuition, room and board was $2,275, according to the Washington-based National Center For Education Statistics, a branch of the Department of Education. Today out-of-state tuition, room and board at a public four-year institution cost $32,762 per year on average, the New Yorkbased College Board reports.
Just as going to school was getting more expensive, employers shifted their expectations. A bachelors degree is required for even the most basic employment, and when the financial crisis hit, many students opted to stay in school longer to pursue advanced degrees, in the hope that having an extra level of education would make them stand out in the fight for the few available jobs that pay a living wage.
On average, new graduates make $48,707 not much more than one year of school according to the Bethlehem, Pennsylvaniabased National Association of Colleges and Employers. Upward mobility remains elusive: Data from the Bureau of Labor Statistics show that on a seasonally adjusted basis and before taxes, hourly wages rose just 2 percent in the 12 months ended this August. Starting salaries do go up for those with advanced degrees, given that such programs typically require specialization.
Meanwhile, new types of schools have emerged that operate on a for-profit model, often appealing to low-income students and offering online access for a high price with little in the way of postgraduate job placement. All of this means that Americas students have more debt, fewer prospects and a higher debt default rate than any previous cohort.
The table below from a recent report by Washington-based think tank the Brookings Institution shows the growth in debt per school from 2000 to 2014. The highest default rate comes from attendees of for-profit and two-year colleges. But the debt load at many other institutions is equally significant, as is the potential for default.Institutions Ranked by Accumulated Federal Loans
of Their Students, 2000 and 2014
|Rank||Institution||TOTAL DEBT ($1,000s)||Total Borrowers||Institution||TOTAL DEBT ($1,000s)||Total Borrowers||5-Year|
|2000||2014||2009 Cohort in 2014|
|1||New York University||$2,184,601||72,650||University of PhoenixPhoenix Campus||$35,529,283||1,191,550||45%||1%|
|2||University of PhoenixPhoenix||$2,099,828||103,475||Walden University||$9,833,470||120,275||7%||0%|
|3||Nova Southeastern University||$1,736,919||34,900||Nova Southeastern University||$8,748,887||94,350||6%||-3%|
|4||Pennsylvania State University||$1,710,951||123,800||DeVry UniversityIllinois||$8,249,788||274,150||43%||-4%|
|5||University of Southern California||$1,609,511||51,525||Capella University||$8,043,635||104,450||19%||-5%|
|6||Ohio State UniversityMain Campus||$1,533,954||82,250||Strayer UniversityGlobal Region||$6,693,570||144,400||31%||-6%|
|7||Temple University||$1,531,762||59,900||Kaplan UniversityDavenport Campus||$6,664,067||220,125||53%||0%|
|8||Arizona State UniversityMain||$1,385,858||70,675||New York University||$6,307,264||110,775||6%||34%|
|9||Michigan State University||$1,321,997||65,650||Argosy UniversityChicago||$6,179,207||104,325||15%||-7%|
|10||University of MinnesotaTwin Cities||$1,289,873||66,675||Ashford University||$5,891,799||205,000||47%||2%|
|11||Boston University||$1,289,257||50,850||Grand Canyon University||$5,881,420||145,850||36%||0%|
|12||University of Texas at Austin||$1,264,226||64,650||Liberty University||$5,678,555||142,875||14%||14%|
|13||University of Florida||$1,186,645||52,050||University of Southern California||$5,340,123||83,400||5%||20%|
|14||University of CaliforniaLos Angeles||$1,159,430||54,975||Pennsylvania State University||$5,310,636||210,125||14%||21%|
|15||University of MichiganAnn Arbor||$1,126,159||44,725||Arizona State UniversityMain Campus||$4,928,019||158,800||17%||12%|
|16||Columbia University||$1,120,001||31,225||ITT Educational Services Inc System Office||$4,618,538||191,225||51%||-1%|
|17||University of PittsburghPittsburgh||$1,106,448||48,925||Ohio State UniversityMain Campus||$4,362,143||132,725||12%||19%|
|18||Indiana UniversityBloomington||$1,101,234||53,225||Temple University||$4,251,334||100,500||12%||13%|
|19||Rutgers UniversityNew Brunswick||$1,077,418||60,150||DeVry University's Keller Graduate School||$3,900,283||49,375||13%||1%|
|20||University of Pennsylvania||$1,033,615||33,300||American InterContinental UniversityOnline||$3,735,319||129,850||41%||-3%|
|21||University of Arizona||$983,809||45,975||University of MinnesotaTwin Cities||$3,679,264||101,650||7%||18%|
|22||University of WisconsinMadison||$981,553||45,050||Michigan State University||$3,596,661||99,925||11%||14%|
|23||Florida State University||$976,114||49,125||Rutgers UniversityNew Brunswick||$3,436,474||116,925||9%||19%|
|24||Virginia Commonwealth University||$965,668||39,425||Colorado Technical UniversityColorado Springs||$3,300,070||114,000||47%||1%|
|25||University of WashingtonSeattle||$954,589||51,625||Indiana UniversityPurgue U.Indianapolis||$3,141,584||74,500||15%||10%|
|Notes: This figure ranks institutions by student loans outstanding in 2000 and 2014. For each year, the first column shows the institutions name, the second column shows the total volume of student loans outstanding and the third column shows the number of outstanding borrowers. Dollar values are in thousands of 2014 dollars. 5-Year CDR is the fraction of the 2009 repayment cohort that had defaulted by the 5th year (2014). % Balance repaid is the fraction of the total balance of borrowers who entered in 2009 that had been repaid by 2014 (1-[total balance 2014]/[total balance 2009]). Negative numbers indicate balance has increased.|
Source: U.S. Treasury tabulations of 4 percent NSLDS sample.
Source: Brookings Institution.
Changes in the way that debt is managed first attracted investors in the bond markets. Newark, Delawarebased Sallie Mae, the federal governments biggest student loan organization, has been offering securitized baskets of student loans since the 1980s. Then in 1998, Congress opted to make it impossible for students to discharge their student debts in personal bankruptcy. Since 2010, when the government ceased the origination of federal student loans by private lenders, the DoE has provided all such loans, with a Department of the Treasury guarantee. Even if borrowers quit paying, creditors have a golden parachute or so they think.
The current default rate hovers around 17.9 percent, up from 13.9 percent at the end of 2007, according to Juan Sánchez, senior economist at the St. Louis Federal Reserve Bank. There is also a group of students known as shadow defaulters who havent yet defaulted but are 90 or more days delinquent on their loans, making the probability of default much more likely.
Taylor Mann, CIO and founder of Pine Capital, a boutique research and hedge fund firm in Larue, Texas, has emerged as the go-to resource for many investors including other hedge funds on how to short the student loan market. He says the bond market for student loans and the equities of the publicly traded companies that handle the debt are inextricably linked.
If you read the covenants of the bonds on these federal loans, they say that if the debt isnt properly managed, the government doesnt have to pay, Mann explains. Instead, the liability falls to the entity managing the debt. A lot of people are making assumptions about getting paid on this debt, and that might not be the case.
The largest manager of student debt is Navient Corp., which was spun out of Sallie Mae last year after the government changed how it issued federal loans. The company manages $133 billion in student loans. Mann, who is short Navient, says in a research note that there is clear evidence of predatory lending practices and improper handling of debt collection at the Wilmington, Delawarebased company, which has encouraged borrowers to go further into debt by not making voluntary prepayments. If the government determines that Navient violated the covenants of its federal student loan business, it could be on the hook for hundreds of millions of dollars or more.
Navient has already had to settle with the Federal Deposit Insurance Corp. for deceptive practices in its student loan business and for violations of the Servicemembers Civil Relief Act, which provides relief to servicemembers who go to college after they leave the military. In August the company announced in a Securities and Exchange Commission filing that it has been under investigation by the Consumer Financial Protection Bureau and may face legal action.
Until late September, it was unclear how the CFPB might go after loan servicers like Navient. Then the agency released a 152-page report on the student loanservicing industry and its problems. The document includes some 8,000 comments from borrowers and industry representatives, and one thing is clear: The CFPB does not like what it sees.
Comments from borrowers note that even if they submit paperwork on time to certify income in order to obtain a lower repayment amount, servicers like Navient routinely lose those forms, file them incorrectly or take up to two months to file them, causing the borrower to miss deadlines, which often results in higher repayment amounts. The report notes parallels with the problems surrounding mortgage servicers uncovered in the wake of the 200809 financial crisis and recommends setting universal standards for student loan servicers. The CFPB may also move to sue servicers in federal court if it finds violations.
Navient says it has taken steps to improve how it does business. Spokeswoman Patricia Christel said in an e-mailed statement that the company has improved its web site and created a free set of videos to help borrowers understand their options. Were rewriting letters, redesigning monthly billing statements and launching a new online experience to enhance clarity and promote customer engagement.
Still, a shiny new web site doesnt give borrowers more money to pay. And programs like the Income-Based Repayment Plan, which the federal government instituted in 2013, may make it less likely that existing senior tranches of these bonds will ever be paid, because the plan contains a debt forgiveness provision, Pine Capitals Mann says. Bond issuers could extend the maturity dates of their offerings, but that possibility has already caused Moodys Investors Service and Fitch Ratings to bring some tranches under review for potential downgrade.
In comments at the Deutsche Bank Leveraged Finance Conference in Scottsdale, Arizona, on September 29, Navient chief executive John (Jack) Remondi said the company doesnt think the potential liability is as great as the bond review suggests. The market impact, we believe, is disproportionate due to a misunderstanding of the size and the impact of this issue overall, Remondi asserted. We would project that less than $50 million of bonds that are on watch in the next five years would be outstanding. So of that $3 billion that Moodys has identified as an area of concern, only $50 million would be at exposure.
Remondi added that Navient has been exercising call options $1.9 billion since last year and is amending deals so it can call an additional 10 percent of the original balance of the bonds. The company is also working with investors to extend the maturity date on more of its bond holdings. We believe the size here is manageable, Remondi said.
Data from the Congressional Budget Office show that taxpayers could be on the hook for some $88 billion if the government ends up paying out on student loans. Its unclear what would happen if Navient is found to have violated the covenants, but when news of the CFPB investigation came out in the companys SEC filing, its stock price plummeted to $12.16 on September 2, the lowest since it spun out from Sallie Mae. In the filing, Navient said it is committed to resolving any potential concerns.
But its not just loans. Another hedge fund firm, $15 million, Boston-based FlowPoint Capital Partners, made news in August when it released an investor letter that noted it was short Navient. FlowPoint founder and managing partner Charles Trafton tells Institutional Investor hes identified 17 other companies, including textbook publisher Scholastic Corp. and student housing provider American Campus Communities, that hes shorting too. We think this is a long-term opportunity, Trafton says.
In their campaign platforms, would-be Democratic presidential candidates Hillary Clinton and Bernie Sanders are pushing for reforms to student lending as well as caps on the cost of tuition. When it comes to a real fix, though, theres nothing concrete before Congress. On October 1 Republican Senator Lamar Alexander of Tennessee effectively ended the Federal Perkins Loan Program for low-income students by blocking a vote on its extension, which was required by September 30. This means that at least for the short term, colleges will have fewer affordable options to offer low-income students who must borrow to pay for school.
Trafton and Mann say its only a matter of time before the situation comes to a head. Nobody has done more to destroy the middle-class dream than the [cost of] American college, Trafton contends. But once this bond market breaks, colleges arent going to be able to raise tuition, and thats going to hit a variety of businesses.