You are on page 1of 4



Student debt bubble: Myth or reality?

By Matt Parmett
For many Americans, the prospect of a student debt bubble evokes nightmares about another financial collapse. In May of this year, Business Insider claimed, the student debt crisis is the biggest economic problem in America. The student loan market does indeed share certain key characteristics with the overheated housing market of 2007. Low interest rates on student loans created by government regulation and legislation make it easy to borrow significant sums of money to pay college tuition. Because student loan money is so easy to come by, universities can justifiably raise tuition rates. Students are then forced to borrow more to offset the higher costs of education. Those who fear a student debt bubble note that this cycle is eerily similar to the pre-recession housing market, where low mortgage rates and rising housing prices culminated in widespread default and the collapse of several banks and insurance providers. Soon, these people fear, excessive student borrowing and rising tuition costs will result in large-scale student default, which would severely hurt banks and the federal government, which subsidizes a large portion of student debt. Lets first take a closer look at the student loan market, which is uniquely complex compared to other capital markets. Student loans can be broken down into two types: federal and private loans. Private loans are made by privately-owned banks, while federal loans are made by the national government under the Higher Education Act. Federal student loans make up about 75% of the market, and about half of all university students receive a federal loan package. During the recent recession, interest rates on student loans were regulated downward, hurting private banks returns on student debt and motivating many banks to exit the student loan market altogether. Additionally, in 2010 the federal government stopped guaranteeing privately funded student loans, increasing the risk profile of many banks student loan portfolios. Private student loans are negotiated with private banks and are subject to the same risk-determination procedures as other financial products like term loans and mortgages. Interest rates on private loans vary widely based on perceived risk and may be fixed or floating. Some federal student loans are subsidized, with interest not charged until the student graduates from college. Students are classified based on their financial need as measured by the Free Application for Federal Student Aid (FAFSA), and interest rates are determined for each classification. Generally, federal student loans are repayable in a 10-year term with fixed payments. Under some conditions, such as the student entering public service, most or all of the federal student loan may be forgiven. The main driver of the perceived student debt crisis is the rapidly increasing level of aggregate student debt among American college students. Over the last seven years, aggregate student debt has increased from $364 billion to $904 billion a 13.9% annual growth rate. Although the number of student borrowers has also increased over this period, in Q1 2012 the median debt per student was $13,662 and the average debt per student was $24,218. These figures have increased in the last decade, and the skewed distribution suggests that there are students with unsuitably high levels of student debt. This problem is compounded by the unusually high delinquency rate on student debt: 10.6% of student loans were delinquent as of Q1 2012. (For comparison, the average delinquency rate on all other accounts, according to the New York Fed, was 6.1%.) Perhaps more frightening is the default rate on student loans - in 2009, 8.8% of student loans were in default. High delinquency rates on student debt are compounded by high unemployment among recent graduates, the federal governments lack of consideration of future repayment capacity, and the lack of student knowledge about financial markets. Default can have serious consequences for students. Immediately upon default, the entire unpaid amount of the loan package comes due and the government can garnish students wages and tax refunds to collect payment and fees. More importantly, default severely impacts students credit scores, which in most cases

Story continued on page 3, Student Debt MORTGAGE-BACKED SECURITIES Tony Murphy

Page 4


Page 2


Page 3


Wharton undergraduate FinanCe Club

February 2013

interVieW PriMer: high yield bondS

By Teddy Xiong
After the post-election sell-off, much attention was focused on the stock market and the inevitable (further) decrease in government yields as a result of the so-called flight to safety. However, not all bonds are created equal, and high yield bonds moved inversely to their investment grade counterparts. Unlike investment grade bonds, which saw an increase in demand, high yield bonds were dumped as investors sought to unload risk. Although this is one small example, it is true that high yield bonds share many characteristics with equities that regular bonds do not. The discovery of these similarities was one of the main theoretical foundations that led to the exponential expansion of the high yield market in the 1980s. Let us start with the basics: a high yield bond, or a junk bond, as they are sometimes called, is a fixed income security that has been awarded a credit rating below BBB (or its equivalent, Baa, in Moodys case) by the rating agencies. Implicit in this rating is the assumption that these companies are significantly more likely to default on their obligations than the companies that have been awarded investment grade (IG). Usually, when we are talking about AAA rated companies or treasuries, the practical default risk is basically zero. This implies that the company has been historically able to service all of its debt and there is no reason as to why it will not be able to do the same in the future. In other words, the expectations are fairly constant. With high yield bonds, these expectations are anything but certain. In these cases, the high yield issuer will usually only be able to service its debt payments if their future cash flows are sufficient. To justify this risk to investors, companies and investment banks offer yields that are much higher than those found in investment grade companies, usually with a spread of 4-5% over government treasuries. IG companies yields, in contrast, average a 2% spread over the comparable government security. High yield bonds end up, very much like stocks, depending on future cash flows for their valuation. This is different from an IG bond, where future cash flows are often inconsequential to the debt payments (the companys balance sheet is so strong they can service debt notwithstanding future performance). If the company registers particularly strong results, there will be higher chance of fulfilling its obligations, and as a result, high yield bonds price will increase, as their yields decrease after adjusting for the new risk levels. A positive aspect of high yield bonds is that, if the company does well, there is a chance the companys ratings will be upgraded, significantly increasing its price and effectively allowing its investors to register big capital gains. Inversely, these bonds are also significantly more sensitive to bad news and will perform poorly in the wake of bad earnings reports. To summarize, there can be significant capital gains from high yield bonds, somewhat less than equities but definitively greater than gains from investment grade bonds. High yield bonds, then, provide investors with a hybrid security - one that acts as a regular bond but shares many characteristics with common stock. A number of empirical studies have been conducted to test these assumptions, and the results have been largely positive. In the 40-year period from 1971 to 2011, corporate high yield bonds have had a correlation of 0.469 with the S&P 500, showing a strong link between the two. Furthermore, correlations usually increase in down markets and decrease or remain constant in up markets. The reason as to why the correlations are higher in down markets is somewhat obvious: as the markets fare worse, there is a higher chance the company will not fulfill its obligations. In upwards trending markets, there is a limit to the effect positive earnings can have: there is little difference if a company earns $1,000 or $10,000 if it only needs enough to service $100 of debt. Another reason for this is that high yield bonds are not nearly as exposed to interest rate risk as other bonds. These bonds have low duration (it takes less time for the investors initial investment to be repaid), and, due to the fact that interest rate changes have a greater effect on future rather than shortterm cash flows, show very little sensitivity to changes in rates. By now, you are probably asking why people would even bother holding equity (or any other security for that matter), but the story on these high yield bonds is not as rosy as it seems. Before the 1980s, institutional investors (the main buyers of fixed income securities) and rating agencies did not acknowledge the influence of future cash flows on junk bonds. Their rating only represented historical data, and they categorized a company based solely on past performance. Institutional investors, bound by statutes that prohibited the buying of junk bonds, stayed away from these securities. Today, the ratings issued by the agencies tend to incorporate future cash flow forecasts, and the market is much more efficient in categorizing certain issues as high yield, making it much harder for a high yield investor to realize positive returns (alpha) on these rating inefficiencies. Furthermore, these securities are still riskier than your average securities. Future cash flows can still come below what is necessary to pay the debt, and the debt holders can lose a significant percentage of the bonds value. The fact remains, however, that high yield bonds fit into a very unique niche, right between equities and investment grade bonds - they provide relatively lower risk than equities while still providing the security of fixed cash flows. These bonds are thus invaluable in terms of portfolio diversification and every conscientious investor should consider holding some junk in their portfolios.

your one-stop shop for finance

February 2013

Wharton undergraduate FinanCe Club

trade oF the Month: buy uSd/noK

By Kevin Goldfarb
In our October Newsletter, I pitched to go short the Euro/Krone pair, a trade which entailed selling Euros and buying Norwegian Kroner. If taken at modest leverage (10x is considered modest in FX trading), this trade would have returned around 28% profit plus around a 3% interest return, summing to roughly 31% profit. Now, however, I think it is due time to close out this trade and take another: BUY USD/NOK, essentially buying US Dollars and selling Norwegian Kroner. The Rationale: Why should you change your position now? First of all, the Euro crisis has become boring (not the equivalent of solved), so I dont expect much movement on that end of the trade. Secondly, things in Norway have stopped getting better, and the country is beginning to look eerily reminiscent of the US five years ago. The price of Norways main export oil hasnt gone up, and there is an expected decline in output. Overall, exports are expected to decrease 9.7% year over year. Most importantly, housing prices are starting to exceed 150% of the average home price-to-income ratio, a figure 50% higher than the most recent historical highs, and the household debt-to-income ratio is around 200%. All of this spells two things: high inflation and low or negative growth. Dealing with just one of these is manageable for most central banks, but the combination of the two puts the Norwegians in the difficult position, knowing that any steps taken to rein in inflation will hurt an already soft economy. As part of the trade, I dont expect the Norges Bank to make a rate change to step on the housing bubble. Instead, I expect them to choose to support the weak economy, thus leading to a weaker Krone. In addition, the opposite decision (raising interest rates to cut lending and stop the housing bubble) would also lead to a lower Krone, but through the avenue of lower domestic demand and output. Why the US Dollar?: Currently, most are of the mindset that the USD is going to be hurt by our ever-so-efficient politicians in Washington. While I do agree that their partisan bickering is a burden on the dollar, I also see the dollar continuing to be the safe-haven currency of a world that has not yet left the age of the financial crisis. In short, recovery is tremulous, and people are always going to want to have some money in dollars. This trade isnt based on the premise of the Krone losing value and the dollar gaining value, in fact, Im merely using the dollar as a low-volatility proxy in order to participate in the short-NOK trade. The Trade: First of all, swap out of the first trade from October that I discussed above enjoy the 30% profit, and dont spend it all in one place. Next, place a long USD/NOK trade at 10x leverage (modest, as I had mentioned before) and look for a 3- to 6-month trade
your one-stop shop for finance

horizon. Make sure not to hold on to this trade too long because there will be a rollover charge on the trade (this occurs when the short-currency has a higher interest rate than the long-currency) of around 0.3% p.a. but at 10x leverage is equal to 3%. This article was written on January 04, 2013, when: EUR/NOK traded at 7.2576 USD/NOK traded at 5.5897 Disclosure: I may or may not take a position in this trade in the near future. All data is sourced from CNBC or Yahoo! Finance.

Student Debt, story continued from front page

consist entirely of student debt. Therefore, students with large loan packages are at a high risk of restricted access to credit after copmleting their education. Although there are several flexible methods of postponing payment on student debt, the federal government does not allow students to settle student debt by entering bankruptcy. The feedback loop driving the supposed student loan bubble is completed by the unprecedented rise in the costs of education. Since 1980, the cost of college has increased by more than 1,000%, outgrowing the CPI, gasoline, and health care costs. The recession has worsened this trend, as public spending costs have caused a dramatic increase in the price of public education. Above and beyond the exogenous motivators of rising tuition, universities are raising their prices because students are increasingly willing and able to incur large amounts of debt at cheap rates to purchase a college education. As the cost of a college degree increases, students who are unable to pay full tuition are forced to borrow more and more money, further increasing aggregate student debt and the average amount of debt per student. As loan packages increase in size, students will have more difficulty repaying their loans, and loan payments will extend farther past the end of college. Higher delinquency and default rates will increase the risk profile of banks student debt portfolios, similar to the infamous toxic mortgages of the housing crisis. Increased default will cause banks to take huge write-offs on their loan portfolios. Banks and buyers of bundled student debt-backed securities will encounter massive losses, and these institutions will face the same stresses as Lehman and AIG did during the recent housing crisis. In the long run, interest rates on student debt will rise, deterring students from taking on expensive loans and encouraging them to forego education and directly enter the workforce. Generally, as the wages of uneducated youths decrease and students are faced with enormous levels of debt to repay after graduation, graduates will push back the purchase of big-ticket items like houses and cars that drive the US economy. While this may not have a catastrophic impact on the US economy, the effects will be felt.

Wharton undergraduate FinanCe Club

February 2013

Mortgage-baCKed SeCuritieS
Theyre back!
By Tony Murphy
Not too long ago, almost everyone thought mortgage-backed securities were evil. After all, the securities, backed by mortgages including subprime home loans, nearly wrecked the U.S. financial system in 2008. Well, theyre back, and banks are profiting. Mortgage-backed securities (MBS) are investments whose value is secured, or backed, by the value of an underlying bundle of mortgages. When investors buy an MBS, they are not buying the actual mortgage. Instead, they are buying a promise to be paid the return that the bundle will receive. Banks make their money from taking the mortgages and bundling them into bonds that they then sell to investors. After they bundle the mortgages into bonds, the banks transfer nearly all of the loans to government-controlled entities like Fannie Mae or Freddie Mac. These entities, in turn, guarantee the bond investors a steady stream of payments. The banks that originated the loans take the guaranteed bonds and sell them to investors. The higher the mortgage rate paid by homeowners and the lower the interest paid on the bonds, the bigger the profit for the bank. For example, a bank may lend money to homeowners at a 3.5 percent interest rate. After bundling those mortgages, the bank could then sell them in bonds that have an interest rate of 2.5 percent. This 100 basis point difference is known as the MBS spread. The banks pocket this markup when they sell the bonds. The MBS spread has been historically high in recent months, as mortgage rates have fallen much more slowly than the bond interest rates. From January to June 2012, the average difference between the two rates was 1.1 percent. From 2000 to 2010, it was about 0.5 percent. For investors, the lower bond yields are still attractive because long-term interest rates are close to zero. For banks, the extra mortgage revenue has covered new costs. As a result of more stringent conditions since the housing bust, bankers are required to be more diligent in approving loan applications, which has made MBS issuance more expensive. Indeed, the mortgage bond market is very different from what it was before the financial crisis. For one, it is much smaller. Very few residential mortgage-backed securities have been issued since the crisis. The market, at $1.3 trillion, is half the size it was at its peak. However, as housing recovers, so will demand for mortgage-backed securities.

Kevin goldfarb Editor-in-Chief
Vice President of Financial Analysis

Shruti Shah
Managing Editor

Jasmine azizi & alejandro Villero

Assistant Editors

guilherme baiardi, tony Murphy, Matt Parmett & teddy Xiong

Senior Financial Analysts

Charles bagley, JeonKang,Karan Parekh &Matt evans

Financial Analysts Questions or comments? Please send your suggestions to

your one-stop shop for finance