Bubble Trouble: Student Loan Debt

In a financial bubble things get out of hand quickly.

The previous recession was caused by speculation on subprime mortgages, eventually causing a collapse in the housing market and the global economy.

Now, years afterwards people are wondering: when is the next bubble going to happen and is it in the student loan market?

What is a bubble?

The term “bubble” in economics and finance refers to when there’s a mania around an asset, basically intense buying pressure that causes the price of that asset to rise way beyond its actual value.

Academics have identified five different stages in a typical bubble.

  1. Displacement: investors get caught up in a trend or new asset
  2. Boom: prices rise, slowly at first but then gain momentum as more and more people want to join the party
  3. Euphoria: in this phase, people go nuts and asset prices skyrocket. The asset is incredibly overvalued at this stage
  4. Profit Taking: savvier investors start to take money off the table, sensing that a bubble is in place and seek to lock in profits
  5. Panic: other investors catch wind that others are leaving the market and a decline in prices precipitates mass-selloff. Prices crater.

Famous bubbles include the Dutch tulip mania in the 1600s when speculation surrounding tulip bulbs pushed their price to incredible heights. By 1637 the price of a pound of tulip bulbs was 10 times the annual salary of a skilled craftsman.

That sort of decoupling from reality is more common than you think. During the Japanese real estate bubble, 27 years ago, land in Tokyo sold for 350 times the price of similar sized plots in Manhattan. In real numbers that works out to $139,000 per square foot. That’s the price of a Mercedes S-Class for something the size of a bathroom scale.

Is Student Debt a bubble?

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 There’s a lot of talk about a bubble being inflated in the student debt market.

Over the past decade student loan debt in the US has nearly tripled – reaching $1.3 trillion. This brings the value of student debt to over that of car loans or credit card debt. Some experts argue that post-2008 recession we’ve simply switched one bubble for another.

There’s a compelling case to be made. Right now in the states, 44 million people are carrying some kind of student debt, about 18% of them are in some kind of default. That number has been climbing and is worrying because it’s higher than the default rate for home mortgages, credit card debt or auto loans. The average amount owed by an individual with student debt is about $34,000 – an amount that’s increased by 70% in the last 10 years.

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Source: Visual Capitalist

The chart above shows delinquency rates for different types of debt. Credit card debt have historically had the highest rates of delinquency; that is no longer the case.

It’s clear that people are finding it harder than ever to pay back their student loans and the amounts they have to pay back are greater than ever as well.

The reason for that is rising education costs. While inflation, a measure of how prices are increasing over time, is about 2%, tuition at four-year colleges have increased by 9%. That number is even higher at fancy-schmancy private colleges.

What it means is that the cost of education is rising way faster than the cost of other goods.

Meanwhile, on the other side of this equation, wages have been relatively stagnant while jobs have gone missing. The labor participation rate, the amount of people working or looking for work, is at its lowest point since the 80s. In 1970, nearly 50% of GDP was paid out as wages to employees. Today that number is about 40%.

It comes together like some kind of terrible soup. People are demanding higher education, and putting themselves in great debt over it, but job prospects are bleak and even if you do find work you’re earning less than generations before you so it takes longer to pay back your loans.

Is it a bubble though?

While these economic forces are unfortunate and make for hard reading – are they the basis for a bubble in student loan debt?

Well let’s see. Is there displacement? Are investors getting caught up in the luster of a new asset?

studet3

If you consider the students as investors in themselves (a college degree being the asset) then we’d have to say: potentially. The more impressive rise has been in the number of people with at least a high school degree, going from 25% of the population in 1940 to nearly 80% in 2009. In that same time frame, the amount of people with a college degree has gone from about 5% to 25%.

What about a boom? Is the price of a college degree increasing at a rate we’d expect of markets that are in a bubble?

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Take a look at what the subprime mortgage market was doing prior to the 2008 recession. It tripled market share in half a decade, growing from 8% of the overall mortgage market to nearly 24%. In dollar terms, it grew from $250 billion to about $650 billion.

So is this a boom? It’s likely. Student loan debt has tripled in the last 10 years or so, from $400 billion to $1.3 trillion. Since 1978, college tuition has increased by 1120%, outrunning inflation by a factor of 12.

So to recap: there’s some evidence for the existence of displacement and boom phases for a student loan bubble. What about euphoria?

There’s less evidence for this phase.  With subprime mortgages there was a secondary market of intense trading activity that helped fuel a bubble. People were buying and selling credit-default swaps (think of it like insurance contracts) worth many times the value of the subprime market. It’s a bit like sports betting. Imagine there’s a basketball game (the subprime market), and then there’s $13 trillion dollars’ worth of bets being placed on it and you get an idea of how crazy things got in 2008. This just isn’t happening in the student debt market.

On this evidence it’s hard to say that there’s a student debt bubble. There’s definitely increased pressure to pay off increasing amounts of debt – which manifests itself in higher than normal delinquency rates. We may see more defaults as the system works itself out but it’s hard to see an outright collapse.

If one wanted to play this theme as an investment gambit, it might be wise to slice and dice the market to search for areas that are the worst affected and bet against them. For instance while the overall three-year default rate is around 14% it is closer to 20% in New Mexico.

There may be no bubble, but there’s still cause for concern.

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