In the last 15 years, outstanding student debt in the United States has grown from $240 billion to an astonishing $1.2 trillion, driven largely by rapidly accelerating tuition rates. During the same time period, average wages have only grown a mere 10%, making student debt an increasingly uncomfortable topic. In fact, JP Morgan deemed the student loan market so overladen with risk that in October of 2013, the firm stopped issuing any additional student loans.
Based on these signs, I agree with a recent Huffington Post article that relates the higher education bubble to the housing bubble America experienced in 2008. The loose lending standards (low down payments), securitization of mortgages (MBS), and high levels of speculation (overwhelming belief that the housings values will continue to rise) that contributed to 2008 bubble burst all have parallels in the higher education market. Many students pay no downpayment and have poor (if any) credit history. Student loans are being packaged and resold as student loan asset backed securities (SLABS) to hedge lender risk. And despite the 44% undermployment rate of young college graduates, most Americans continue to believe that a college education is an ideal (if not necessary) investment. All these factors suggest another bubble is about to burst, and in an attempt to offer a partial solution, this post will focus on the speculation involved in the higher education market.
However before considering a solution, it is important to first understand the route cause of asset bubbles. In A Random Walk Down Wall Street, Burton Malkiel makes the cause of asset bubbles very clear in his explanation of the tulip-bulb craze that plagued Holland in the early 1600s. After the mosaic virus created striped tulips in the late 1500s, Dutch citizens desperately wanted the most unique tulips in their gardens, and they were willing to pay a handsome premium for them. As more and more people bid up the price of tulip bulbs, more and more believed these bulbs were a smart investment. Indeed, by the 1620’s people were selling their jewels, furniture, and even land to buy tulips! Nevertheless, no bubble can grow forever, and in February 1637, Dutch public opinion changed. The price of bulbs fell more than 20-fold that month, and despite the government’s best attempt to prevent a sell-off, the bulb bubble burst, leaving an abundance of disappointed and bankrupt investors.
The Tulip-Bulb craze perfectly illustrates the result of what Malkiel refers to as “Castle-in-the-Air” investment theory. Under this theory, an investment’s value is based on public opinion, and decisions to buy and sell are based on random guesses about changes in public opinion. When public opinion changes, bubbles can burst and investors can suffer huge losses. In my opinion, the “Castle-in-the-Air” investment theory applies perfectly to college education (tuition costs are rising despite the fact that tuition benefits, ie: employment and wages, are falling).
I’d argue, and I think Malkiel would agree, that a switch in investment theory could reduce the risk of asset bubbles. In addition to “Castle-in-the-Air” theory, Malkiel also explains the “Firm-Foundation” theory, which is an investment strategy based on the intrinsic value of investments. When the price of an investment is less than its intrinsic value, you should buy; when the price is more than intrinsic value, you should sell. Because this form of investing is based on data and not public opinion, it is arguably less susceptible to speculative attack. Indeed, Malkiel points out that firm-foundation investing is how Warren Buffet made his fortune.
It therefore seems that to reduce the risk of a student loan bubble, we need to switch investment in higher education from a “Castle-in-the-Air” model to a “Firm-Foundation” Model. But how? I believe the answer lies in a recent Wall Street Journal article. In “Colleges Are Tested by Push to Prove Graduates’ Career Success,” author Melissa Korn points out a trend in prospective students requesting information on graduates’ salaries. Given that college is an investment (that should generate a real return after an initial payment), this request seems extremely logical! Why would anybody spend $200,000 on out-of-state tuition at UM without assurance (or at least data supporting) a sizable income stream after graduation?
If firms are required to release GAAP-audited financial statements to give prospective investors a prediction of future cash flows, I believe universities should have to do the same. While there is currently significant push back from universities to release this data, I think that reporting graduate salaries based on school, major, GPA, etc. is an essential step in changing college education from a “Castle-in-the-Air” investment to a “Firm-Foundation” investment. (The implications of this are consequential indeed, as it would likely force the cost of well-paying majors like business and engineering higher than the cost of low-paying majors like anthropology and agriculture. That said, this is a consequence that is completely in line and appropriate given a “Firm-Foundation” investing environment, and it is one that I am comfortable with.). Personally, I believe if we can successfully alter the way students choose to invest in college education (by reducing speculation), we can effectively reduce the risk involved in student loans and prevent student debt from repeating the Dutch Tulip Crisis and pushing America back into recession.