Wall Street Sees Big Money in Student-Loan Defaults

Leave it to Wall Street to figure out how to make a quick buck from the burgeoning student-loan crisis.

The FOX Business Network has learned that investment firms such as private-equity powerhouse Carlyle Group are weighing whether they should snap up student-loan collection agencies -- companies that help lenders recover funds from borrowers who default on their loans.

It is unclear where Carlyle and other firms stand in terms of their investments in any of the nearly two dozen companies that specialize in collecting student debt (a Carlyle spokesman declined to comment). Some experts say investors have been spooked by some of President Obama’s recent initiatives to forgive student loans, while others say these are short-term fixes that won’t have much impact on the business of collecting on student debt.

Either way, one thing is certain: With nearly $1.11 trillion in outstanding student loans and a slow job market, Wall Street believes higher student loan default rates are inevitable and companies that collect on this debt are a good investment.

“There has been a significant growth in student loans and in defaults over time so it has been a nice area to invest,” said Richard Close, senior research analyst at Avondale Partners. “The growth in student loans over the past five years has been significant.”

With college costs rising and incomes falling, particularly for college grads in industries other than technology and finance, many economists are predicting massive student loan defaults in the years to come. Already $121 billion of the more than $1 trillion in loans are 90-plus days delinquent or in default and those numbers are expected to grow, making collection companies even more important.

There are around two dozen such outfits; four of these collection agencies are publicly traded and three of them are subsidiaries of larger companies such as JPMorgan Chase (NYSE:JPM) and Sallie Mae. Wall Street executives eyeing such investments say loans that are already in default generate the biggest profit margins for debt collectors. Getting students to repay defaulted loans means potentially huge profits since the companies’ fees are based on a percentage of the loan’s total balance, as opposed to a fee based on servicing a loan.

According to industry experts, profit margins for collection agencies are roughly 30% as opposed to the loan servicers earning roughly 20%. “Servicers earn roughly $21 per borrower each year,” said Michael Tarkan, senior vice president at Compass Point, an investment bank in Washington, DC. “Collection agencies can earn 10% to 15% of the entire loan balance,” which is a larger payout, Tarkan added.

One such company, Performant Recovery (NASDAQ:PFMT), earned $36 million last year and its shares have risen nearly 20% in the past three months, indicating that investors believe higher default rates will make the company more profitable.

Last week, President Obama unveiled legislation that would extend a program called “Pay As You Earn,” which caps borrowers' monthly student-loan bills at 10% of their income. Some investors said the move could dampen the appetite for collection companies among private equity firms like Carlyle.

“There is a strong push by the administration and both sides of congress to lower the number of loans that enter default (meaning fewer loans will be sent to the collection agencies),” one Wall Street executive said. “This could slow the growth in defaults and cause investors to determine these firms are no longer a good investment,” he added.

Others say that the president’s legislation won’t lead to a notable change since the size of the problem is enormous, and growing. The share of 25-year-old Americans with student debt increased to 43% in 2012 from 25% in 2003, and the average loan balance rose 91%, to $20,326 from $10,649, according to data from the New York Federal Reserve Bank.

Household debt from student loans has risen at a faster pace than any other form of household debt, according to a report by Goldman Sachs.

“I don’t think there will be much of an impact on the market since they have already passed legislation like this before” and it hasn’t stopped student debt or default rates from increasing, said Tom Crosson, director of media relations and communications at the Consumer Bankers Association.