2/17/2017 Investing in the Pain of Student Debt Is a Tough but Tempting Play - The New York Times

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Investing in the Pain of Student Debt Is a

Tough but Tempting Play
By KATE KELLY FEB. 9, 2017
As a college student in the early 1990s, Charles Trafton worked nights at a student-
loan collection agency in Bostons 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.

My experience in call centers, specifically doing collections, I think gave me a

huge interest in this space, said Mr. Trafton, 48, who runs a small investment firm
in Andover, Mass., called FlowPoint Capital. I became fascinated that this is exactly
the kind of creative destruction that hedge funds like ours are craving.

In recent years, FlowPoint has generated fivefold returns through so-called

short bets, or wagers in the stock and options market that shares of certain student-
loan-related companies will fall, according to company documents. The fund has
also made comparable returns from other education-related short trades.

It is part of a broader investment theory that inflated stock prices in for-profit

college companies, textbook makers, lenders and loan collectors all of whom have
roles in what Mr. Trafton calls the college bubble of the last seven or eight years
have a long way to fall.

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Mr. Trafton isnt the only market participant who is skeptical of the $1.4 trillion
student-loan market. The outspoken hedge-fund manager William A. Ackman has
called student debt a big threat to the United States credit markets, saying, I think
that the governments going to lose hundreds of millions of dollars. JPMorgan
Chases chief executive, Jamie Dimon, warned last year that student-debt defaults
were a looming problem.

More recently, some hedge funds concerned about default rates and state and
federal lawsuits accusing a major student-loan collector of abuses have considered
shorting shares of the company or its competitors in various ways.

But it isnt an easy trade to execute.

For one thing, the relevant stocks are moving in the wrong direction. Shares of
companies that deal with student loans, including Navient and SLM Corporation,
otherwise known as Sallie Mae, have risen since early November, reflecting
expectations that the Trump administration may establish a friendlier regulatory
environment for student lenders.

The student-loan market also benefits from having an implicit taxpayer

backstop. Since the 2008 financial crisis, most loans are carried on the governments
balance sheet, and, because of wage-garnishment capabilities and other aggressive
tools for collecting student debts, they are repaid at fairly high rates, making a rash
of unpaid debts less likely.

And theres not a ready investment available that would allow one to bet against
securities backed by student loans no index like the one that hedge fund managers
depicted in The Big Short used to bet against mortgages before the crisis.

Theres always been fervent interest about how to profit off the pain of the
student-loan market, said Rohit Chopra, who oversaw the industry as an assistant
director of the Consumer Financial Protection Bureau. Now a senior fellow at the
Consumer Federation of America, he has fielded many inquiries from investors
looking for insight on how the market works.

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For credit-focused hedge funds, they see a trillion-dollar asset class, but have
struggled to engage in the same casinolike activities that they were able to on
mortgage, he said.

One big hurdle for the would-be shorters is the lack of credit-default swaps, or
C.D.S. insurance policies that pay a holder when certain slices, or tranches, of a
student-loan-backed security go bad. Such swaps were popular before the financial
crisis and created fortunes when swaths of mortgage-backed bonds defaulted.

But people on Wall Street say a combination of banks worries about sullying
their reputations by appearing to benefit from the financial struggles of students, the
relatively small number of market participants who use complex shorting tools, and
the expense of constructing such idiosyncratic trades has made firms reluctant to
build the products that hedge funds want.

If I could have gone to Goldman Sachs R Us and said, Ill take a short on this
tranche, a short on that tranche, I would have done that, all day, every day, said
Taylor Mann, a researcher who has studied the student-loan market in granular
detail, over a recent taco dinner in Athens, Tex., near where he lives. The day I
found out that, no, C.D.S. isnt available, no, we dont have any bespoke investment
products, he added, it was like, Ive got to move on.

Mr. Mann is now focused on starting a hedge fund that looks for compelling
trades in currencies and stocks, rather than just trades related to student loans. Still,
his take on the student-loan market, which he has described in a research paper as
an education bubble backed by unambiguously toxic loans, has resonated for
some: Mr. Trafton admires his work, and on SumZero, an online platform catering
to investment professionals, Mr. Manns short recommendations on stocks like
Capella Education, Apollo Education and Navient attracted top popularity ratings.
(Apollo was recently taken private.)

A spokesman for Goldman Sachs said the firm had not created investments to
help short student-loan-backed bonds. (Goldman was, however, one of the best-
known players in mortgage-backed securities in the years before the financial crisis).

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A spokesman for Citigroup, another bank historically known for developing

products to help short complex bond securities, declined to respond to questions
about whether it had done so in the student-loan market.

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.

While acknowledging that the bond securities he owns have experienced a

bumpier ride than I would have anticipated, he added that we are confident about
future returns, so we dont short them.

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 students college fees, then is
guaranteed a percentage of the students future earnings for a predetermined period
of years.

And with the election of President Trump, who has said he is committed to
reducing regulatory burdens for business, and who once owned a majority stake in a
for-profit college, the broad picture for student lenders, loan collectors and for-profit
colleges could be brighter in the coming years, some analysts and investors say.

Under the Trump administration, a decline in federal spending, possibly paired

with new opportunities for private-lender involvement, would not be a surprise, said
Michael Tarkan, a senior analyst at Compass Point Research who studies student
loans.

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A lot of people are calling now to buy the stocks as opposed to shorting them,
he said.

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