Shorting Student Loans: The Next Major Credit Bubble

America's debt crisis did not end with the subprime mortgage crisis. Mortgages, may set off the trigger, but the student loan debt is an overlooked bond bubble waiting to crash.

Student loans have surpassed credit card debt for the leading type of private debt among Americans. The cost of higher education has been outpacing inflation since 1982, as the real cost of education has increased 339%. Societal pressure to go to college and some students' decisions to go to non-Ivy League private schools has students from middle income backgrounds racking up anywhere between $50,000 to $200,000 in student loan debt. That figure does not include graduate school, where many students will add more loans that easily surpass six figures to obtain a masters, law degree, MBA, or medical degree.

With the current state of the job market, many if not most of these unfortunate borrowers will not be able to pay off their debt with a lower than expected income. This trend is showing itself through increasing default rates of student loans. Three-year default rates have risen from 11.8% for loans issued in 2007 to 13.8% issued in 2008 (most recent data available). Meanwhile, the fundamental factors driving these defaults have not changed since.

Historically, investors have not worried about the default of these securities because of their explicit government guarantees through FFELP. In addition to this, student loans are the only debt that cannot be forgiven through bankruptcy. Student loan collectors have gone to the extent of garnishing wages and racking up penalties that can double the borrower's debt in the name of "forgiveness" to maintain a return for bondholders.

This story sounds similar to housing: If the borrowers fail to pay, lenders seize the asset (house for a mortgage, garnished wages for student loans). The story will end the same way, as students lack the income to maintain their living expenses plus the debt or even just the interest payments if they are unemployed. The other option that students will begin to take more is moving abroad to avoid collectors. Financial distress will make it practical to exile oneself to avoid a lifetime of debt slavery. The combination of lower incomes for college grads and expatriation will increase the default rate to even high levels than current record rates.

So how do investors go about shorting the bubble in higher education? Ideally, the best way would be to buy credit default swaps on student loan asset-backed securities, which have a similar construction to the mortgage-backed securities that caused the last financial crisis. However, this strategy is not available to most readers. Average investors are better off short-selling the leading providers of student loans or for-profit universities, which have some of the highest default rates of student loans for any academic institution.

The leading student loan provider in the United States in the Sallie Mae corporation (SLM). It was launched as a government-sponsored enterprise (since privatized) similar to Freddie Mac and Fannie Mae; it currently services and manages $180.4 billion of government-backed student loan debt. It's also begun to issue private student loans as well. With a debt to equity ratio of 36, Sallie Mae is already on the edge of insolvency. A small drop in collections can amount to significantly levered losses to the company. If the student loan default rate increases to 20%, Sallie Mae will most likely not be able to survive. The continuing upward trend of student loan defaults will lead to either insolvency of Sallie Mae or a government takeover -- which will both wipe out shareholders.

Shorting for-profit universities is the other way to profit off a student loan collapse. Companies such as DeVry (DV), Apollo Group (APOL), and ITT Educational Services (ESI) have 90% of their revenues coming from federal student loan aid. They also have a significantly higher rate of student loan default rates versus non-profit competitors (14.7% vs. 10.8%). These factors -- along with the low regard and credibility these institutions have among the general public and accrediting organizations -- make these schools prime for shorting. Also, increased government scrutiny towards their predatory lending tactics may end the game for many for-profit educators.

Overall, the student loan bubble is the next domino along with sovereign debt that will fall as the Western world deleverages. Student loan borrowing is rising at unsustainable amounts, and the combination of a weak employment market and the overpricing of higher education will ultimately bring large-scale waves of uncollectible defaults.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in DVAPOL over the next 72 hours.

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