Snap! Crackle! Pop!...Goes the Student Loan Bubble!

It’s May 2013 on an ivy-draped college campus. You just graduated with a degree in English. In 2009, you borrowed $50,000 from the US Department of Education’s Direct Loan Program. Job searches for teaching and journalism positions have been fruitless. Within a matter of weeks, you must start making loan payments on a waiter’s wages and tips. On sleepless nights, you fear what defaulting on this loan will mean down the road.

Signing up for a huge student loan was a mistake. Both you and the lender had assumed a certain type of job market would exist four years into the future. Your lender — the US government — has long subsidized unsustainable activity. In 2009, economists encouraged politicians to promote even more nonsensical spending than usual. “Spending on something — anything — is valuable and necessary stimulus!” they said.

We got government spending in 2009 — spending that worsened imbalances. Now the gap between a self-sustaining economy and today’s stimulus-addicted economy is so wide that policy fixers must commit ever more resources to prop up past spending mistakes.

People are smart and adaptive; governments are dumb and reactive. Markets often fail. Supply and demand mismatches bring about rising and falling prices. Assuming we have flexible capital and labor markets, market failures can get corrected quickly. But in today’s bailout-heavy, politics-driven economic system, market failures are not corrected quickly, and are usually made worse. This has huge implications for the government budget — and the investing environment staring us all in the face…

Let’s return to the student loan mistake facing the English graduate and why it’s bad news for the future of many investments. According to Labor Department statistics, 1.9 million Americans between the ages of 20 and 24 not in school are officially unemployed. The size of this age group working part time is the biggest since 1985.

Unless recent college grads hold degrees in high-demand fields like computer science, engineering or geology, they aren’t finding jobs; they aren’t buying new cars; they aren’t starting families; and they aren’t buying houses, absorbing the excess supply in a sluggish housing market.

“We’re smothering aspiration at a very early age,” Candace Corlett, president of WSL/Strategic Retail, recently told Bloomberg News. “Retailers used to be able to count on young adults to be the first to buy whatever was new and to purchase the bigger brands at better stores. Now they can’t afford that, and they’re so comfortable with mobile technology, they’ve become the savviest at getting the best prices.”

Those born in the 1980s and early 1990s make up a large demographic bulge; these are the “echo boomers” — the baby boomers’ kids. This generation, after a coddled upbringing, appears to be soft. Many of them have adopted the worst of their parents’ habits during an era of credit excess. And many feel entitled to pursue career dreams regardless of practicality.

It may not seem like it now, but we may be witnessing the maturing of a new generation with Great Depression-era values, including thrift, selflessness, stoicism and, most importantly for investors, an attitude that debt is dangerous and saving is “cool.” Harsh job market reality and a tsunami of student loan defaults will alter a generation’s behavior.

The real fallout from the student loan crisis will hit in mid-2013, four years after the volume of government-funded student loans surged. Like the infamous option ARMs (adjustable-rate mortgages) during the housing bubble, these loans have precisely timed fuses: Four years after the loans are made, borrowers must start making payments.

The US Department of Education has become the Countrywide of student lending. After a lending binge started in 2009, it now holds a massive $452 billion portfolio of student loan receivables, according to Federal Reserve data. This so-called “asset” will become a liability by next year.

Thanks to the punk job market, a huge percentage of these loans will go bad or have to be restructured. When that happens, Congress will have to appropriate money to make up for the loan-payment shortfall. What was quietly off budget will soon make a big splash on the federal budget. I expect defaults on government student loans to reach tens of billions of dollars per year starting in late 2013.

Like Countrywide, the government is not honestly accounting for its portfolio risks. This $452 billion portfolio doesn’t even include a few hundred billion more in guaranteed student loans. The chief accountant of the Government Accountability Office (GAO) wrote a report dated December 2011 on the federal government’s accounting deficiencies: “The deficiencies, for the most part, involved credit subsidy estimation and related financial reporting processes.” In other words, accounting for below-market loan interest rate subsidies is complex, and the government is not adequately disclosing the risks it is taking.

What conclusions can we draw for your portfolio? Right now, even professional investors aren’t talking about the ticking time bomb of off-balance sheet student loan defaults. This, along with other unreformed entitlement programs, will swell the federal budget deficit far beyond even the biggest projections.

The ultimate losses on the Department of Education lending binge will probably be north of $100 billion. This is bad news for savers waiting for a return to reasonable interest rates on savings. The exploding deficit will force the Federal Reserve to not only keep rates at zero for the rest of the decade, but also to print trillions more dollars in order to buy the Treasury bonds floated to fund these deficits.

This scenario argues in favor of a healthy allocation to tangible stores of value, including precious metals and stocks of companies with pricing power. You must be picky in this sideways, grinding bear market, but not go all to cash, in which you’ll lose purchasing power over time. The younger you are, the higher your allocation to noncash investments should be.

Companies with pricing power include those with powerful brands, those with lasting competitive advantages, those that haven’t participated in any bubbles over the past decade and low-cost producers of energy and other necessities.

On the other hand, you want to avoid the following types of stocks: many in the banking and insurance sectors that will suffer a relentless decline in earnings as high-interest-rate bonds and loans roll off, only to be replaced by assets with lower yields. These stocks may look cheap, but they deserve to get even cheaper in a future of consumer frugality, near-zero interest rates, exploding deficits and persistently high consumer prices.

Regards,

Dan Amoss

for The Daily Reckoning