"It profits me but little that a vigilant authority always protects the tranquillity of my pleasures and constantly averts all dangers from my path, without my care or concern, if this same authority is the absolute master of my liberty and my life."

--Alexis de Tocqueville, Democracy in America

Monday, April 29, 2013

The Bubble Next Time - Student Loans

The 2008 recession and stock market crash was largely caused by the collapse of the mortgage-backed securities market.   Wall Street, abetted by the government entities Fannie Mae and Freddie Mac, had bundled millions of mortgages (and parts of mortgages like the interest components) into securities and derivatives of those securities, without much thought (or with active, willful neglect) of the merits of the underlying loans.   When the default rates for the home mortgages given to substandard borrowers (the so-called sub-prime mortgages) rose, the values of the MBSs collapsed, and almost brought our financial system down with them.

Stupidity can be defined as making the same mistake in the same way twice.   Well, is Wall Street stupid, or are we?

Worried by reports of rising defaults, investors turned up their noses at a new $225 million bond issue by Sallie Mae, the federal agency that packages individual student loans into large securities. The loan company canceled the offering after two weeks on the market. The WSJ reports:
…rising defaults could have crimped the cash flow of the federally backed loans supporting the new securities, because more defaults would mean less excess, or residual, income after holders of the original loans were paid.
What’s more, regulators and lawmakers have become concerned about growing levels of student debt, raising the risk political decisions could alter the bond market for student loans, said Jeffrey Klingelhofer, a portfolio manager at Thornburg Investment Management. For instance, a program that would allow borrowers to refinance their loans would reduce cash flow, Mr. Klingelhofer said.
Are student loans turning into junk bonds? With something like $1 trillion of student loan debt outstanding, investor skittishness is not good news.

Hmmmm.... government encouraging massive lending to people with little or no income to buy assets of little or no intrinsic value in an inflated market and then hedging those bad bets by creating complicated financial instruments that the market may eventually reject (and sooner rather than later)?   Haven't I seen this story before?  

And don't we all know how it ends?  

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