Student Debt - The Next Sub-Prime Crisis?

As far as I am currently aware, very active institutional trading of student debt isn't currently occurring, however I'm going to discuss some reasons why I think it almost certainly will happen over the next decade:



In order to understand this theory, we have to go back seven years to the 2008 financial crisis and the rise of Collateralised Debt Obligations (CDOs).


In effect, a CDO is a group of loans that are packaged together to make a tradable product that can be sold between banking institutions and hedge funds. CDOs have been used in financial markets since 1987, when junk bonds were grouped together by Drexel Burnham Lambert and were initially intended to make the trade of assets with predictable income streams easier (credit card debt, auto loans, etc).


CDOs remained a niche financial instrument until 2004, when the U.S. led housing boom caused a boom in the sale of CDOs, which in turn led to the creation of CDO derivatives (options and swaps) and eventually to the issuing of sub-prime CDOs in the run up to the 2008 crisis.


The use of CDOs to package student debt has been used for the past five years in the U.S., with companies like SLM Corporation leading the way with these products and this is presumably what Arrow Global are doing with the UK student they sold to them in 2013.


The use of CDOs in this fashion remains an excellent idea for the issuers, when we are in a low yield environment in combination with globally low interest rates. However, the nature of many student loans being index linked in some form, means that when either growth or interest rates begin to rise substantially (which regarding economic cycle dynamics means at some point they inevitably will), the default rate and or the rated value on these loans will also fall.


With U.S. student debt now totalling over one-trillion dollars in value, small increases in default rates begin to have much larger value in monetary terms than they otherwise would in smaller markets. This combined with the leverage that derivatives on these CDOs can carry in the over-the-counter markets means that the potential for volatility is likely to high in this debt market over the coming years.




Food for thought....

The Masked Stock Trader