Dan Amoss

It’s May 2013 on an ivy-draped college campus. You just graduated with a degree in English. In 2009, you borrowed $50,000 from the US Department of Education’s Direct Loan Program. Job searches for teaching and journalism positions have been fruitless. Within a matter of weeks, you must start making loan payments on a waiter’s wages and tips. On sleepless nights, you fear what defaulting on this loan will mean down the road.

Signing up for a huge student loan was a mistake. Both you and the lender had assumed a certain type of job market would exist four years into the future. Your lender — the US government — has long subsidized unsustainable activity. In 2009, economists encouraged politicians to promote even more nonsensical spending than usual. “Spending on something — anything — is valuable and necessary stimulus!” they said.

We got government spending in 2009 — spending that worsened imbalances. Now the gap between a self-sustaining economy and today’s stimulus-addicted economy is so wide that policy fixers must commit ever more resources to prop up past spending mistakes.

People are smart and adaptive; governments are dumb and reactive. Markets often fail. Supply and demand mismatches bring about rising and falling prices. Assuming we have flexible capital and labor markets, market failures can get corrected quickly. But in today’s bailout-heavy, politics-driven economic system, market failures are not corrected quickly, and are usually made worse. This has huge implications for the government budget — and the investing environment staring us all in the face…

Let’s return to the student loan mistake facing the English graduate and why it’s bad news for the future of many investments. According to Labor Department statistics, 1.9 million Americans between the ages of 20 and 24 not in school are officially unemployed. The size of this age group working part time is the biggest since 1985.

Unless recent college grads hold degrees in high-demand fields like computer science, engineering or geology, they aren’t finding jobs; they aren’t buying new cars; they aren’t starting families; and they aren’t buying houses, absorbing the excess supply in a sluggish housing market.

“We’re smothering aspiration at a very early age,” Candace Corlett, president of WSL/Strategic Retail, recently told Bloomberg News. “Retailers used to be able to count on young adults to be the first to buy whatever was new and to purchase the bigger brands at better stores. Now they can’t afford that, and they’re so comfortable with mobile technology, they’ve become the savviest at getting the best prices.”

Those born in the 1980s and early 1990s make up a large demographic bulge; these are the “echo boomers” — the baby boomers’ kids. This generation, after a coddled upbringing, appears to be soft. Many of them have adopted the worst of their parents’ habits during an era of credit excess. And many feel entitled to pursue career dreams regardless of practicality.

It may not seem like it now, but we may be witnessing the maturing of a new generation with Great Depression-era values, including thrift, selflessness, stoicism and, most importantly for investors, an attitude that debt is dangerous and saving is “cool.” Harsh job market reality and a tsunami of student loan defaults will alter a generation’s behavior.

The real fallout from the student loan crisis will hit in mid-2013, four years after the volume of government-funded student loans surged. Like the infamous option ARMs (adjustable-rate mortgages) during the housing bubble, these loans have precisely timed fuses: Four years after the loans are made, borrowers must start making payments.

The US Department of Education has become the Countrywide of student lending. After a lending binge started in 2009, it now holds a massive $452 billion portfolio of student loan receivables, according to Federal Reserve data. This so-called “asset” will become a liability by next year.

Thanks to the punk job market, a huge percentage of these loans will go bad or have to be restructured. When that happens, Congress will have to appropriate money to make up for the loan-payment shortfall. What was quietly off budget will soon make a big splash on the federal budget. I expect defaults on government student loans to reach tens of billions of dollars per year starting in late 2013.

Like Countrywide, the government is not honestly accounting for its portfolio risks. This $452 billion portfolio doesn’t even include a few hundred billion more in guaranteed student loans. The chief accountant of the Government Accountability Office (GAO) wrote a report dated December 2011 on the federal government’s accounting deficiencies: “The deficiencies, for the most part, involved credit subsidy estimation and related financial reporting processes.” In other words, accounting for below-market loan interest rate subsidies is complex, and the government is not adequately disclosing the risks it is taking.

What conclusions can we draw for your portfolio? Right now, even professional investors aren’t talking about the ticking time bomb of off-balance sheet student loan defaults. This, along with other unreformed entitlement programs, will swell the federal budget deficit far beyond even the biggest projections.

The ultimate losses on the Department of Education lending binge will probably be north of $100 billion. This is bad news for savers waiting for a return to reasonable interest rates on savings. The exploding deficit will force the Federal Reserve to not only keep rates at zero for the rest of the decade, but also to print trillions more dollars in order to buy the Treasury bonds floated to fund these deficits.

This scenario argues in favor of a healthy allocation to tangible stores of value, including precious metals and stocks of companies with pricing power. You must be picky in this sideways, grinding bear market, but not go all to cash, in which you’ll lose purchasing power over time. The younger you are, the higher your allocation to noncash investments should be.

Companies with pricing power include those with powerful brands, those with lasting competitive advantages, those that haven’t participated in any bubbles over the past decade and low-cost producers of energy and other necessities.

On the other hand, you want to avoid the following types of stocks: many in the banking and insurance sectors that will suffer a relentless decline in earnings as high-interest-rate bonds and loans roll off, only to be replaced by assets with lower yields. These stocks may look cheap, but they deserve to get even cheaper in a future of consumer frugality, near-zero interest rates, exploding deficits and persistently high consumer prices.

Regards,

Dan Amoss
for The Daily Reckoning

Dan Amoss

Dan Amoss, CFA, is a student of the Austrian school of economics, a discipline that he uses to identify imbalances in specific sectors of the market. He tracks aggressive accounting and other red flags that the market typically misses. Amoss is a Maryland native, a graduate of Loyola University Maryland, and earned his CFA charter in 2005. In spring 2008, he recommended Lehman Brothers puts, advising readers to hold the position as the stock fell from $45 to $12. Amoss is our macro strategist and guardian of The 5 Min. Forecast PRO.

  • gman

    “most importantly for investors, an attitude that debt is dangerous and saving is ‘cool.'”

    sounds like a target-rich environment for infestors! the first, primary, sin-qua-non requirement for infestment: someone else has to have money.

  • Bennet Cecil

    Defeat the democrats. Sell the current student loans to investors. Repeal the law about not being able to bankrupt your student loans. If you want to go to college you should have good grades or cash. Why should the taxpayer subsidize a lazy student who graduated with a C minus average from high school? Get the federal government out of education and let the private market and the state governments handle this. Like Social Security, Medicare, Medicaid, and all of the rest of the bloated federal government, Sallie Mae is unsustainable. Reform or blow up the entire economy with the crack up boom.

  • ken

    “Defeat the democrats. Sell the current student loans to investors.”

    Think you can find enough stupid people to buy them? I doubt it,,,even given our horrifying school system.

  • deegee

    It doesn’t matter a damn if there are no jobs at the end if it !!!

  • OBSERVER

    Where in the constitution does it say the Fed. Gov. is to make loans?

    Where does it say the Fed.Gov. can loan money for anybody to buy a house?

    Sadly, it is the MORE intelligent young people who will now have no children, while the millions of illegal women are PAID to grind out peasant kids who, in turn, will drain the nation even more.

    America is going to be one hell of an awful place in just a short time.

  • Daniel

    It’s sad that so many young people have listened to the preachings of their teachers. It’s almost as if everyone has been brainwashed in believing we all need a degree and work in a nice clean office job. Not everyone should go to college. Some people must learn mechanical jobs and manufacturing jobs. There is nothing wrong with a blue collar job!! It can be just as rewarding and put food on the table. I feel very sorry for the young people that have listened and now have a worthless college degree and owe so much money for student loans while working as a waiter or can’t find any job at all. These people will be dissilutioned and eventually the protests will become bigger and violent.
    We are stocking up on food storage to prepare for what is surely to come. Check out srmarketplace.com The food is fantastic and the prices low (… for now). They have a shelf live of up to 25 years without refrigeration needed. I’ve got car insurance, and home insurance…. food insurance is the logical next step. Even if things are getting better, which I doubt, we can always eat the food!

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