February 21, 2019

Education May Be a Worse Bet Than You Thought

Harvard Law School

While Harvard may be an exception, loans backed by law school student loans are risky bets as of late.

Hedge fund managers are known as overseers of investors’ alternative investments. One unusual area where some hedge funds are exploring is student loans. There has been debate in the past few years over whether the cost and benefit received from higher education is worth it. And from a report by Matt Wirz in The Wall Street Journal, managers say education may be a worse bet than you thought.

Hedge fund manager, Daniel Ades, has become an expert in the $242 billion market for bonds backed by bundles of student loans. “We know all these deals inside out and we know their default rates,” he said. Investors like Mr. Ades have a unique view on the future for America’s job-seekers. Their investments depend on accurately predicting young people’s ability to repay their loans, which means they obsess about everything from employment rates by profession to the long-term earning potential of young graduates.

Historically, investors have assumed 25% to 30% of student loans bundled into their bonds will default. But today they are baking in between 30% and 40% default rates among the current crop of graduates, said Chris Haid, a director in asset backed trading at Barclays Capital. Even those assumptions are a best guess and defaults could ultimately go higher if unemployment rises, Mr. Haid said.

Failure to graduate is the single most important predictor of whether a student will default on loans, which stands to reason since the unemployment rate is 8% for Americans between the ages of 20 and 24 with four-year college degrees, compared to 21% for those without.

“It’s not just about where you can get the best education,” Ades said at his hedge fund, Kawa Capital Management. Students should pick schools where the payoff from higher salaries upon graduation exceeds the cost of the education by the widest margin, he contends, especially when the job market contracts.

By that arithmetic, technical colleges come out on top, Mr. Ades said. “We’re in a skills based economy and what we need is more computer programmers, more [nurses],” he said. “It’s less glamorous but it’s what we need.”

Law school, on the other hand, can end up a sucker’s bet in periods of high unemployment, experts in student loan-backed bonds say.

While college students often enroll in professional programs to wait out economic soft patches, the U.S. has far more law schools than other professional schools, resulting in an excess supply of lawyers, argue investors and analysts.

In recessions, law school graduates have a harder time finding work than other graduates from professional programs and are more likely to default on their student loans.

Given the state of the economy, Milwaukee, Wis.-based Stark Investments is staying away from all student loan bonds right now. It is instead focusing on mortgage-backed debt with comparable yields and less risk, said portfolio manager Anup Agarwal. “We don’t expect unemployment rates to go down for the next year or two so it’s difficult to get excited about student loans against that backdrop.”

Uncertainty about student defaults has essentially frozen the market for bonds backed by student loans that aren’t guaranteed by the government. The volume of such bonds secured by loans made by SLM Corp., also known as Sallie Mae, is at just 16% of the level in 2009, according to rating firm DBRS Inc.

While investors may take notes on investing in asset-backed bonds, they should take note on a more fundamental investment: what they spend on education. “It shouldn’t cost this amount of money for higher education,” Ades said. “A class size of 10 is not necessary for students to learn.” So whether you’re betting on bonds backed by student loans or your child’s college degree, right now education may be a worse bet than you thought.

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