A few days ago one of the couples we work with was talking about all the things we’ve been through together since they became clients of TAAG. Talk turned to investments: the internet bubble, the real estate bubble, then they asked, ‘Are student loans the next bubble? If they are, what should we be doing now to protect ourselves – or benefit from it?’
Good question; and a perfectly reasonable concern given what we’ve experienced over the past 10+ years.
There’s over $1.2 trillion in outstanding student loans, according to an estimate by the Consumer Financial Protection Bureau, making them the second largest type of household debt after mortgages. About $150 billion of the total is made up of private student loans made by banks and other financial institutions, with the majority of the loans held by Sallie Mae. Loans guaranteed or held by the federal government make up the difference. The 90 day delinquency rate on all these loans was 11.8% and increasing, according to a Federal Reserve report published in November.
So what are the similarities to the mortgage debt crisis of 2007 – 2008? Beginning in the late 1990’s, people began using their homes as ATMs, refinancing their homes and drawing out equity to make improvements or spend on other, less long-lasting expenditures like vacations. People were also buying homes that seemed outside their price range based on traditional banking metrics; but newly constructed homes got bigger, and continued to be sold and financed at a fast pace. Even after questions began to be raised about whether lending practices had gone too far, banks continued to lend because they were convinced home values would continue to rise. They were also making money repackaging the same loans and selling them to investors as high-yield investment alternatives.
Student loans are only backed by the borrowers’ future earnings, which is why 95% of the loans are made or guaranteed by the federal government. Student loans are repackaged into loan pools, which have become more popular as investors (with short-term memories) look for investments with higher interest rates. But the size of these asset pools don’t come close to the volume of collateralized mortgage obligations and collateralized debt obligations that precipitated the Great Recession. In addition, although people walked away from their mortgages or had them discharged in bankruptcy, it is very difficult to discharge a student loan.
Several banks have also decided they no longer want to take the risk of lending for education. US Bancorp stopped making new student loans in late 2012, and last September, JPMorgan Chase sent a notice to colleges notifying them that the bank would no longer make new student loans beginning in October. It’s unlikely that more banks will jump in to pick up the slack given the continued scrutiny of their balance sheets by the federal government after the mortgage bender from which they are still recovering.
Given the increasing volume of discussion about the value of a college education vs. the debt many students acquire to acquire their degrees, people are paying more attention to what they plan to borrow and what degrees they plan to pursue. A recent blog we posted provided helpful guidelines for things to think about as college approaches for your kids or grandchildren. Going forward, it’s more likely that the financial risk lies with loans that have already been made vs. future loans.
A recent article by Ron Lieber, a financial writer for the NY Times provided an excellent guide for graduates trying to get a handle on their student loans, and provided steps to prevent them from becoming delinquent.
But what about our risk as investors?
The mortgage crisis and the Great Recession were preceded by years of excellent investment returns. If you jumped out of the market in the late 1990’s when the mortgage run-up began, you would have missed returns of 8.5% per year in the S&P 500 alone. During the Recession, those who held a broadly diversified portfolio of stocks and bonds; spread across countries, company sizes and industries, were able to purchase more stocks at deeply discounted values. If they held high quality bonds (not collateralized mortgage or debt obligations) and used those assets to live on and buy beaten down stocks, they emerged from the Recession with significant unrealized gains in their portfolios today. That’s not to say that the ride wasn’t scary. When everyone around you is running for the exits yelling ‘FIRE’ it’s nearly impossible not to have a crisis of confidence.
But a well-thought out financial plan, with an investment discipline that allows you to take advantage of market drops when other people are panicking – that’s how you both protect yourself and benefit from the next bubble!
PS. Many thanks to Sam and Nancy for asking the question!