Why The Student Loan Bubble Is The Next Subprime (FAS, SKF, FAZ, XLF, WFC, BAC, JPM)

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April 5, 2012 12:50pm NYSE:FAS NYSE:FAZ

Martin Hutchinson: Don’t look now but there’s another giant bubble out there. It’s so big it rivals subprime. I’m talking about the student loan bubble.  Recently, the outstanding volume of student loans passed $1 trillion. What’s more bothersome is that the average individual amount owed by new college


graduates has passed $25,000.

With college costs zooming upwards faster than inflation, this is rapidly becoming another subprime mortgage-like sinkhole.

Just like subprime, the problem is that people of modest means are being suckered by high-pressure salesmen into taking on too much debt.

The difference is that since student loans are government guaranteed and can’t be released in bankruptcy, the burdens will be paid by the unfortunate ex-students and the U.S. taxpayer.

The standard justification for soaring higher education costs is a simple one.

The United States needs to maintain an educational lead in order for its wage levels to remain above those of its competitors.

I’m talking largely about emerging markets, which have been helped enormously by modern communications, making global sourcing much easier than it was.

There are two problems with this view.

First, the more esteemed colleges take great pride in not providing vocational training, and graduate large numbers of students with degrees that don’t obviously qualify them for anything.

In what way is the U.S. being made more competitive by graduating students in (insert your favorite useless college major here)?

Second, even as the demand for a college education is increasing, the efficiency of providing it is declining. Both the Ivy League and state university systems increase tuition rates far more rapidly than overall inflation.

The Student Loan Bubble Drives Up Costs

In fact, there is considerable evidence that finance availability is itself pushing up college costs.

As college funding has become more readily available to the general population, it has reduced the financial pressure on colleges, since few of their students are today paying their way from part-time jobs and parent cash flow.

Huge endowments in the Ivy League, which allow those elite colleges to provide full scholarships for students, focus the competition between colleges ever more closely on league table “prestige” rather than costs.

The ranks of college administrators have also exploded since they are effectively insulated from market forces – not unlike those in medical professions.

So have their earnings – according to The New York Times, in the decade between the 1999-2000 and 2009-10 college years, the average college president’s pay at the 50 wealthiest universities increased by 75%, to $876,792, while their average professorial pay increased by only 14%, to $179,970.

Meanwhile, the cost of tuition has increased by 65% while prices generally rose by 31% during the same decade.

That’s precisely the opposite of what you’d want to happen, if you were concerned about college productivity and cost.

Buried in Debt by Student Loans

There are two factors pushing the escalation in student loan volume.

One is the nationalization of most student loan programs in 2009, providing government guarantees on most student loans.

That has altogether removed the risks of student loan provision from banks, as well as encouraging low-quality degree scams by for-profit colleges. For-profit colleges are a good idea, but not when combined with government-guaranteed student loans.

The other factor pushing up student loans is the Bankruptcy Act of 2005, which allowed consumers to relieve themselves of all debts in bankruptcy except student loans.

This special privilege for the student loan market has caused great hardship.

The Washington Post reported this week that Americans 60 and older still owe $36 billion on student loans, and gave one sad example of a 58-year old woman who had borrowed $21,000 to fund a graduate degree in clinical psychology in the late 1980s (which one would think was at least moderately useful), had never been able to earn more than $25,000 per annum and was now left with student loan debt of $54,000.

If government guarantees and bankruptcy exemption remain in place, the volume of student loans will continue soaring, as unscrupulous lenders provide them to naive students.

That will cause the cost of college to continue rising in real terms as college administrators pad their sinecures.

As with the subprime mortgage industry, an eventual crash is inevitable. But unlike subprime mortgage borrowers, student loan borrowers will be unable to start afresh after bankruptcy.

The solution is to eliminate the two unwarranted subsidies to the student loan industry. Student loans must no longer be guaranteed by the government.

And in bankruptcy, they must be treated like any other debt. The banks will scream, and student loans will be much more difficult to get.

For most students, that will return them to choosing a cheaper institution and working their way through college, in the traditional way – some of them might choose more marketable degree courses, too.

For the poor but brilliant, the Ivy League can continue providing full scholarships and the government can continue providing Pell grants – with their cost fully accounted for on-budget.

College costs will drop back to 1970s levels in real terms, as overstuffed bureaucracies are eliminated.

And for college administrators and student lending banks, life will get considerably harder – which is no bad thing.

All bubbles eventually burst. This one will be no different.

Related: Direxion Daily Financial Bull 3X Shares (NYSEARCA:FAS), ProShares UltraShort Financials (NYSEARCA:SKF), Direxion Daily Financial Bear 3X Shares (NYSEARCA:FAZ), Financial Select Sector SPDR ETF (NYSEARCA:XLF), Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM).

Written By Martin Hutchinson From Money Morning

Martin is a Contributing Editor to both the Money Map Report and Money Morning. An investment banker with more than 25 years’ experience, Hutchinson has worked on both Wall Street and Fleet Street and is a leading expert on the international financial markets. At Creditanstalt-Bankverein, Hutchinson was a Senior Vice President in charge of the institution’s derivative operations, one of the most challenging units to run. He also served as a director of Gestion Integral de Negocios, a Spanish private-equity firm, and as an advisor  to the Korean conglomerate, Sunkyong Corp. In February 2000, as part of  the Financial Services Volunteer Corps, Hutchinson became an advisor to  the Republic of Macedonia, working directly with Minister of Finance Nikola Gruevski (now that country’s Prime Minister). The nation had been staggered by the breakup of Yugoslavia – in which 800,000 Macedonians lost their life savings – and then the Kosovo War. Under Hutchinson’s guidance, the country issued 12-year bonds, and created a market for the bonds to trade. The bottom line: Macedonians were able to sell their bonds for cash, and many recouped more than three-quarters of what  they’d lost – to the tune of about $1 billion. Hutchinson earned his undergraduate degree in mathematics from Cambridge University, and an MBA from Harvard University. He lives near Washington, D.C.

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