Like many other Americans, I had my share of student loans, and was fortunate enough to consolidate them at a 2.75% rate back in 2003. So at first I didn’t understand why there was so much concern surrounding student loan debt today. 

But after I saw the reality of today’s student loan debt — the building mountain of debt and the relatively high interest rates — I see the enormity of the problem. 

#-ad_banner-#In fact, there are some fairly uncanny similarities between the student loan issue and the 2007/2008 housing bubble that sent our economy into the worst financial crisis in recent memory. 

Could student loans be the next crisis for the markets? Is there anywhere an investor could hide when it happens? The impact on the economy and investments may be profound. Let’s explore further. 

Are Student Loans A Bubble?
Student loan debt approached nearly $1.3 trillion in the second quarter this year, having grown at a compound annual rate of 11% since 2006. That total is double the amount of credit card loans held by commercial banks (see the chart, below). It costs an average of $26,828 for tuition at a four-year public university with the average interest rate of 6.8%, meaning many young adults are burdened with more than $1,800 a year in interest.

While an average rate of 6.8% may not start alarms ringing, new grads are opting for repayment plans that allow them to significantly reduce payments early in their career. Income-based repayment plans even allow grads to defer payments if their income is below a threshold. That means their debt is only going to grow larger as accumulated deferred interest piles higher.

That growing burden of interest on younger generations could mean lower consumer spending down the road for the U.S. economy. This is already being seen in home ownership. Home ownership dipped to 63.8% in the first quarter, the lowest since 1989, as younger buyers focus on school loans instead of taking on more debt in the form of a mortgage. 

Hedge fund guru Bill Ackman has called the student loan bubble the biggest risk in the credit markets today and that, “there’s no way students are going to pay it back.” Legislation in the form of the Public Service Loan Forgiveness program, is aimed at preventing massive defaults in this market by forgiving student loans after ten years of public or federal service for certain professions. But the threat of default remains for many others under the burden of this debt remains.

Winners And Losers In The Student Loan Bubble
SLM Corporation (Nasdaq: SLM), also known as Sallie Mae, guarantees student debt much like Fannie Mae (OTC: FNMA) guarantees mortgage debt. As was the case in the mortgage market, ominous early warning signs are appearing in the student loan market. Delinquency rates on student loans doubled to 12% in 2013 from just 6% a decade prior. 

Investors are already responding, pushing shares of Sallie Mae down more than 25% so far this year. In a worst case scenario, shares could be worthless as the company is placed in conservatorship. Even if the bubble doesn’t burst, Sallie Mae may take a hit on loan forgiveness programs as debt is written off.

However, traditional banks and lenders may actually derive a near-term benefit from the issue. Bank of America (NYSE: BAC) may see more consumers look to consolidate their student loan and other debt into one loan product. 

The bank cut its exposure to student loans to just $632 million in 2014 from $4.1 billion the year before, almost a negligible amount of the bank’s total $881 billion in loans and leases. With its mortgage-related problems in the rearview mirror, the bank should benefit from a diversified mix of retail banking, consumer & commercial loans, and wealth management. 

Shares of BAC are down more than 13% this year, thanks to the broader market selloff, and trade for 0.7 times book value, a discount of 22% against the industry multiple of 0.9 times book. Full year earnings are expected to jump from $0.36 a share last year to $1.44 per share this year as the bank is no longer subject to large litigation expenses. 

Risks To Consider: If the student debt crisis spirals deeply out of control, all financial institutions would feel some impact, though Bank of America would still be relatively better off than Sallie Mae and other significant holders of student debt. The mega-cap bank should be relatively well-protected from a slow deflating in the student loan bubble.

Action To Take: Avoid shares of Sallie Mae ahead of what could be the biggest risk to credit markets while benefiting from upside in other traditional loans sold by Bank of America (NYSE: BAC) and other large retail banks.

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