Shorting Student Debt Is The World's Hottest Completely Hypothetical Trade

Ravenous hedge funders are scheming to profit from the misery of a student loan meltdown, according to some imaginations.
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How do you spot a bubble? Two steps. First, find a big scary number. $1.4 billion is a good one. Then spin a terrifying narrative. Bill Ackman, take it away: “If you think about the trillion dollars of student loans we have outstanding, there’s no way students are going to pay it back.” Bam! There's your bubble. Now it's time to short it.

student debt

That might not be so easy. In what's become somewhat of a recurring story, here's the New York Times digging into the seedy underworld of investors looking to do profit off of the eventual, though still hypothetical, collapse of the student loan bubble.

As a college student in the early 1990s, Charles Trafton worked nights at a student-loan collection agency in Boston’s theater district, calling trucking and beauty school dropouts to ask them for money.

As a professional investor more than two decades later, he has bet that shares of companies like his former employer will sink, which has become one of his most lucrative investment ideas.

Trafton's fund, the Boston-based FlowPoint Capital, has apparently earned returns topping 500 percent on shorts of companies related to the student loan market. But there's a funny twist at the end of the article. Even though young people continue to rack up giant debts in order to pursue dead-end careers like problematizing Elizabethan poetry and conducting investment bank analysis, further inflating the bubble, the investors who are closest to the industry are actually turning bullish.

Even Mr. Trafton, whose FlowPoint Capital has benefited greatly from its short positions, is also making more optimistic investments. The place he sees the most potential at the moment, he said, is in student payment arrangements called income-share agreements.

Under those pacts, FlowPoint pays a portion of the student’s college fees, then is guaranteed a percentage of the student’s future earnings for a predetermined period of years.

Even star characters from the subprime era are warming to student loans. Here's Greg Lippmann:

Greg Lippmann, a former Deutsche Bank trader who helped conceive some of the lucrative short transactions on subprime-mortgage securities in the precrisis period, said he now saw a long, or buy-and-hold, opportunity in certain student-loan-backed bonds.

“Our view has always been that on a long-term basis, the fundamentals were going to bear out to where the return on these bonds would be strong,” said Mr. Lippmann, the chief investment officer of the New York-based hedge fund LibreMax Capital.

So, uh, not a bubble?

Despite passing the big-scary-number and terrifying-narrative tests, the college debt burden just doesn't quite analogize so well with the housing collapse. Though there are some factors that weigh on the side of eventual catastrophe – the debt can't be extinguished in bankruptcy, the population of borrowers are particularly vulnerable to suasion and fraud – there are more differences than similarities.

For one thing, Goldman won't build a credit-default swap for you based on some student loan metric. Without a universe of CDS's and CDOs floating around, the industry doesn't face the same threat of systemic rupture in the event that millions of students stop making payments. Moreover, the government backs up most student loans, making the bubble, in the worst scenario, “a fiscal headache rather than a financial risk,” as one Wall Street economist told Business Insider.

So where did these big profits for our Boston hedge fund friend come from? Certainly not the bursting of any trillion-dollar bubble, which we might have noticed. Instead, it seems like a narrower play around regulatory changes.

In 2015, FlowPoint wrote investors that companies “levered to runaway inflation in post-secondary education are susceptible to growth and margin shocks,” particularly from regulatory changes that made it less profitable for servicers to let students go into default and then rack up fees hounding them for cash. But the incentives that Navient and others allegedly exploited were eliminated in 2014, and the industry has already absorbed the impact.

This isn't to say there's no possibility of a subprime-style meltdown in the student debt world, which is regularly hit with lawsuits alleging predatory lending and other transgressions. But images of profit-hungry hedge funders devising the next Big Short don't quite hit the mark.

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