So What Will Be The Next Financial Bubble To Pop?

Now that it appears the real estate bubble has just about run its course, it is time to look for that next big bubble. Some financial analysts are pointing to Europe, and even the Euro currency, as the source of pending financial doom, but one analyst from Money Morning has another idea. He is pointing at student loan debt. With the costs of education rising, and wages not even remotely keeping pace, it seems to me that he has some valid points. For more on this, continue reading the following article from Money Morning.

Don't look now but there's another giant bubble out there. It's so big it rivals subprime.

I'm talking about the student loan bubble.

Recently, the outstanding volume of student loans passed $1 trillion. What's more bothersome is that the average individual amount owed by new college graduates has passed $25,000.

With college costs zooming upwards faster than inflation, this is rapidly becoming another subprime mortgage-like sinkhole.

Just like subprime, the problem is that people of modest means are being suckered by high-pressure salesmen into taking on too much debt.

The difference is that since student loans are government guaranteed and can't be released in bankruptcy, the burdens will be paid by the unfortunate ex-students and the U.S. taxpayer.

The standard justification for soaring higher education costs is a simple one.

The United States needs to maintain an educational lead in order for its wage levels to remain above those of its competitors.

I'm talking largely about emerging markets, which have been helped enormously by modern communications, making global sourcing much easier than it was.

There are two problems with this view.

First, the more esteemed colleges take great pride in not providing vocational training, and graduate large numbers of students with degrees that don't obviously qualify them for anything.

In what way is the U.S. being made more competitive by graduating students in (insert your favorite useless college major here)?

Second, even as the demand for a college education is increasing, the efficiency of providing it is declining. Both the Ivy League and state university systems increase tuition rates far more rapidly than overall inflation.

The Student Loan Bubble Drives Up Costs

In fact, there is considerable evidence that finance availability is itself pushing up college costs.

As college funding has become more readily available to the general population, it has reduced the financial pressure on colleges, since few of their students are today paying their way from part-time jobs and parent cash flow.

Huge endowments in the Ivy League, which allow those elite colleges to provide full scholarships for students, focus the competition between colleges ever more closely on league table "prestige" rather than costs.

The ranks of college administrators have also exploded since they are effectively insulated from market forces - not unlike those in medical professions.

So have their earnings - according to The New York Times, in the decade between the 1999-2000 and 2009-10 college years, the average college president's pay at the 50 wealthiest universities increased by 75%, to $876,792, while their average professorial pay increased by only 14%, to $179,970.

Meanwhile, the cost of tuition has increased by 65% while prices generally rose by 31% during the same decade.

That's precisely the opposite of what you'd want to happen, if you were concerned about college productivity and cost.

Buried in Debt by Student Loans

There are two factors pushing the escalation in student loan volume.

One is the nationalization of most student loan programs in 2009, providing government guarantees on most student loans.

That has altogether removed the risks of student loan provision from banks, as well as encouraging low-quality degree scams by for-profit colleges. For-profit colleges are a good idea, but not when combined with government-guaranteed student loans.

The other factor pushing up student loans is the Bankruptcy Act of 2005, which allowed consumers to relieve themselves of all debts in bankruptcy except student loans.

This special privilege for the student loan market has caused great hardship.

The Washington Post reported this week that Americans 60 and older still owe $36 billion on student loans, and gave one sad example of a 58-year old woman who had borrowed $21,000 to fund a graduate degree in clinical psychology in the late 1980s (which one would think was at least moderately useful), had never been able to earn more than $25,000 per annum and was now left with student loan debt of $54,000.

If government guarantees and bankruptcy exemption remain in place, the volume of student loans will continue soaring, as unscrupulous lenders provide them to naive students.

That will cause the cost of college to continue rising in real terms as college administrators pad their sinecures.

As with the subprime mortgage industry, an eventual crash is inevitable. But unlike subprime mortgage borrowers, student loan borrowers will be unable to start afresh after bankruptcy.

The solution is to eliminate the two unwarranted subsidies to the student loan industry. Student loans must no longer be guaranteed by the government.

And in bankruptcy, they must be treated like any other debt. The banks will scream, and student loans will be much more difficult to get.

For most students, that will return them to choosing a cheaper institution and working their way through college, in the traditional way - some of them might choose more marketable degree courses, too.

For the poor but brilliant, the Ivy League can continue providing full scholarships and the government can continue providing Pell grants - with their cost fully accounted for on-budget.

College costs will drop back to 1970s levels in real terms, as overstuffed bureaucracies are eliminated.

And for college administrators and student lending banks, life will get considerably harder - which is no bad thing.

All bubbles eventually burst. This one will be no different.

This article was republished with permission from Money Morning.

New Bank Regulation is Too Small to Succeed

The legislation in the Dodd-Frank financial reform bill allows regulators to avoid bailouts, but doesn't prevent the too-big-to-fail bank problem. Read more in this full blog post from Economist's View.

Would it surprise you to learn that if a bank like Lehman Brothers were to get into trouble today, we would have no choice but to bail it out? The Dodd-Frank financial reform bill includes resolution authority that supposedly allows regulators to avoid a bailout and dismantle large, systemically important banks that get into trouble without endangering the overall banking system. But this legislation does not end the problem of too big to fail banks.

If the banking system is threatened by the failure of a large bank, then resolution authority will not prevent the equivalent of a traditional bank run on the shadow banking system. Depositors can’t be certain that resolution authority will work as advertised, and as soon as they sense their funds are at risk, they will rush to withdraw them from endangered institutions. And as this fear spreads to counterparties worried about the ability of the troubled bank to meet its obligations, and in turn to the counterparties of counterparties, the overall system becomes threatened and the government has no choice but to step in to try to prevent collapse.

This is not the only problem with resolution authority. Most large, systemically important banks operate in many countries. For example, “When Lehman filed for bankruptcy protection in the United States, it had over 200 principal subsidiaries and participated in over 100 payment and settlement systems across the globe.” Since Dodd-Frank only applies to domestic operations, an international agreement would be needed to coordinate the response and prevent the trouble from spreading to additional banks and additional countries.

One solution to the too big to fail problem that is often proposed is to break large banks into smaller pieces. I’ve yet to hear a convincing argument why we can’t break large banks into smaller pieces – there do not appear to be any efficiency gains associated with mega-sized banks. However, this won’t solve the bank bailout problem. A large, widespread shock to the financial system could still create problems for smaller banks and require a bailout. Banks were relatively small at the time of the Great Depression, but that didn’t stop problems from developing in the banking sector. However, reducing bank size does reduce the political power of the large banks, an important consideration.

If breaking banks up isn’t the answer, then what can we do?

We should do our best to prevent financial breakdowns, but I don’t think we will ever be able to completely prevent bank crises. A system-wide collapse will always be a possibility, and we need to take steps limit the damage that occurs when a crisis hits despite our efforts to prevent it.

On the preventative side, regulators need to limit the ability of banks to take advantage of their too big to fail status. Too big to fail banks can take large risks, and if those risks pay off the banks win big. If they don’t, there’s a bailout and someone else takes the loss. With health, auto, and other insurance this problem is reduced through the use of deductibles that force the individual to share in the loss.

The same requirements can be placed on banks. If banks are forced to post substantial amounts of capital, and that capital is subject to “first loss” provisions, then they will be much more careful about the risks they take. So substantial capital requirements, even higher than required under Basel III, are needed. In addition, better transparency so that investors can monitor what the bank is up to, improved rating of assets, fees to establish a bailout fund and offset potential gains from exploiting too big to fail status, better consumer education, and prosecuting fraud would help as well. Beyond this, regulators also need to develop better early warning systems that tell us when risk is accumulating to dangerous levels.

If prevention fails, then it’s important to limit damages. One important way to reduce the severity of a financial collapse is to reduce the interconnectedness of financial institutions. This makes it more difficult for problems to spread. In addition, reducing leverage also helps to limit the damages in a financial crash. Basel III does impose leverage limits, but they are not strict enough and don’t become fully effective until 2018.

If the banking system gets into trouble, we will bail it out – no politician or regulator wants to be responsible for the next Great Depression. The resolution authority in the Dodd-Frank bill attempts to hide this reality. It avoids the need for strict regulation associated with the promise of a bailout, something that pleases banks, but leaves the system vulnerable to collapse. We should accept that bailouts cannot be avoided, impose the regulatory structure needed to limit problems, and do our best to reduce the damages associated with the inevitable crashes of the financial system.

This blog was republished with permission from Economist's View.

One Investors Strategy For The New Year

Are you trying to figure out what to invest in this year? Well Toni Straka from Prudent Investor, knows what his investment portfolio will be made up of in 2011. Read the following post to learn more about Straka's strategies and predictions for the new year.

BONDS: The 20-year interest rate downtrend reversed in 4Q10: Short all government bonds (and hope your counter party will remain solvent.)

Rising rates will become the tightening noose for all debtors. Mortgage holders may find comfort by switching to fixed rate contracts as far out as possible.

SHARES: As inflation heats up, go long energy, food stocks (and convert ensuing profits into gold.) Underweight consumer (durables) products in a cool economic environment, short debt-laden financials, especially the "dumb money" insurance sector.

DERIVATIVES: Stay away from all OTC instruments as your contract will ultimately only be worth as much as your counter party can pay. Square all derivatives in disguise like ETFs.

COMMODITIES: Buy silver as it is still 70% away from its nominal high seen in 1980 and has a dual use as money and industrial resource. Take profits once gold:silver ratio has descended to 1:30 and reenter after technical consolidation. All other commodities have reversed and have overshot the mean by now.

CURRENCIES: Buy the real stuff - gold. All other fiat currencies are just a claim on some central bank counter party and historically they have all wrecked their product via inflation in the last 300 years.

Once you have done this handful of trades, turn off the charts, lean back, contemplate the world and check back here in January 2012.

This post was republished with permission from The Prudent Investor.

Overleveraged Economy Not To Blame For Financial Crisis

According to MIT economics professor Ricardo Caballero, leverage is not the real problem that led to the financial collapse, but rather excessive concentration of risk. If he is right, could policy makers be chasing the wrong culprit as they create new regulation for the financial system? The following post from Economist's View, discusses this alternative view.

Ricardo Caballero hasn't given up on his argument that it was the excessive concentration or risk, not leverage, that caused problems in financial markets (and it's an argument I'm sympathetic to):

Economic Witch Hunting, by Ricardo Caballero, Commentary, Economists Forum: Perhaps one of the economic phenomena most akin to witch-hunting is the diagnostic and policy response that develops during the recovery phase of a financial crisis. Understandably, pressured politicians and policymakers rush to find culprits... All too often they find a ready supply of these in preconceptions and superficial analyses of correlations. This time around the scapegoats are global imbalances and leverage.

Global imbalances are the victim of preconceptions: Many economists and commentators argued before the crisis that large global imbalances would lead to the demise of the U.S. economy... The crisis indeed came, but rather than destabilizing the US economy, capital flows helped to stabilise it, as flight-to-quality capital sought rather than ran away from US assets. ...

The fact that the actual mechanism behind the crisis had nothing to do with that which was used to explain the forecast of doom has long being forgotten, false idols have been erected,... global imbalances have been indicted for witchcraft, and ever more exotic rebalancing and currency proposals make it to the front pages of newspapers around the world.

Leverage is the victim of superficial analyses of correlations: In my view one of the main factors behind the severity of the financial crisis was the excessive concentration of aggregate risk in highly-leveraged financial institutions. Note that the emphasis is on the concentration of aggregate risk rather than on the much-hyped leverage. The problem in the current crisis was not leverage per se, but the fact that banks had held on to AAA tranches of structured asset-backed securities which were more exposed to aggregate surprise shocks than their rating would, when misinterpreted, suggest.

Thus, when systemic confusion emerged, these complex financial instruments quickly soured, compromised the balance sheet of their leveraged holders, and triggered asset fire sales which ravaged balance sheets across financial institutions. The result was a vicious feedback loop between assets exposed to aggregate conditions and leveraged balance sheets.

The distinction emphasized in the previous paragraph may seem subtle, but it turns out to have a first order implication for economic policy... The optimal policy response to this problem is not to increase capital requirements (or to deleverage), as the current fashion has it, but to remove the aggregate risk from systemically important leveraged financial institutions’ balance sheets. This should be done through prepaid and often mandatory macro-insurance type arrangements, which can accommodate valid too-big or too-complex to fail concerns, but without crippling the financial industry with the burden of brute-force capital requirements. ...

We shouldn't assume that the next potential financial crisis will be identical to this one in terms of how it comes about or how it expresses itself, so we need to ensure that the system can withstand different types of financial shocks. Given that these shocks can come from unexpected places, it's not clear to me that insurance discussed above will stop all of the ways in which financial market problems can lead to harmful deleveraging. Hence, we may want to put the type of insurance plan Ricardo Caballero would like to see instituted in place, and then buttress that protection with enhanced capital requirements to safeguard against unexpected causes of harmful deleveraging.

This post has been republished from Mark Thoma's blog, Economist's View.