Slaying the ‘Head of the Snake’ in the $1.2T Student Loan Industry

The student loan crisis has just begun to capture the fear of the American public, but Taylor Mann of Pine Capital Partners has captured the interest of the hedge fund world with his investments in the sector. After a series of strikingly correct calls tied to the imminent collapse of the morally and fiscally bankrupt student loan industry, Mr. Mann’s user profile on SumZero, the world’s largest community of investing professionals, has recently become the most viewed.

Over the past five months Mann’s seven investment recommendations have averaged a 29% return, but in his opinion, the landslide in loans is only just beginning. We sat down with Mr. Mann to discuss the company he calls “the head of the snake” in the the student loan crisis: the spun-off Sallie Mae debt servicing and collection contractor Navient Corp.

SumZero: How did you get interested in the student loan industry?

Taylor Mann, Pine Capital Partners: I applied to law school during my senior year in
college – during my research for target schools, I realized law school was a giant bubble waiting
to explode. After conducting extensive research on for-profit colleges, I became addicted to student loans. I was trying to find a company with massive amounts of overexposure, the Lehman Brothers of student loans. Fortunately, it didn’t take long. Navient was massively overleveraged with $130B of liabilities that were among the most misunderstood in the market. The market, at least in this specific occasion, appeared to be drunk on sell-side kool-aid and Wall Street guesstimates. The fact is that things were changing, and no one cared to question why.

SumZero: So why Navient, and why now?

Taylor Mann, Pine Capital Partners: Initially, my grand idea behind the student loan short was to go after the head of the snake, which I thought to be Apollo Education, owner of the nefarious and now deteriorating University of Phoenix. As my research continued, I found out that Apollo was in fact not the head of the snake – it was actually a toxic mixture between the Department of Education and Sallie Mae’s spun-off collections arm Navient. After my thesis played out in the for-profits [Mr. Mann’s short recommendation on Apollo Education posted to SumZero five months ago has returned 54% thus far], I turned my attention to new opportunities. With an abnormal amount of leverage and regulatory oversight, Navient wasn’t just an opportunity, it was the opportunity. There are 40 million Americans with student loans and most of them have no clue how to pay them back.

SumZero: Has Navient indeed been the root cause of the problems within the student loan lending industry?

Taylor Mann, Pine Capital Partners: The root of this problem starts with the Department of Education which believed that by incentivizing the loan servicer they could eventually recover more delinquent funds. Turns out this was not the case, and the servicers ended up as the sole beneficiaries of that miscalculation. Servicers could make 30x the profit by allowing loans to go into default and then recover them. This has since changed, but with this type of profit margin, (much like those at for-profit colleges) predatory lending became ubiquitous throughout the industry. You see, prior to 2010, these servicers could originate federal loans with the government backing and there was zero incentive to check the creditworthiness of the borrower. Herein lies the moral hazard. To go back to for-profit colleges for a moment, students at these schools have racked up an astounding $280B worth of student loan debt. Despite only accounting for about 12 percent of total enrollment, these borrowers make up almost half of the defaulted loan total. Obviously, this is where the controversy comes in – what is the real reason behind the default? Academics and politicians can fight about this all day, but the fact is that these schools are nothing more than diploma mills that target vulnerable Americans who lack alternatives and/or any formal education.

SumZero: So Navient is actually incentivized to put student borrowers into delinquency?

Taylor Mann, Pine Capital Partners: That’s the one question that really cuts through and clarifies where the heart of this trade lies: the moral hazard. Prior to the contract renewal, the majority of Navient’s bottom-line stemmed through default collection – not debt servicing. Basically, when a borrower goes into delinquency, Navient actually gets paid a percentage of every dollar that it collects from the borrower instead of an extremely small fixed-fee for collecting a regular repayment.

Furthermore, it’s extremely expensive to place borrowers into Income-Based Repayment plans – these are federal plans that allow borrowers to pay a small percentage of their income in order to avoid default. Additionally, prior to the newer contracts, the success metrics for these servicers that was used as a formula to allocate the portfolio failed to consider consumer satisfaction. So basically, besides the goodness in their heart, there was zero reason to treat borrowers like human beings and they could manipulate and withhold valuable information from borrowers without any type of repercussion. This is like a server who gets paid a salary and is able to resell the food that his/her customers do not eat: if the customer satisfaction is irrelevant, isn’t it only rational to think that the server would treat them terribly in hopes they leave and not eat the food? It’s the same exact situation, and the customer in this case is both the borrower and the taxpayer. Which, to carry this analogy further, the manager is of course the Department of Education – the omnipresent big brother that watches the problems and does nothing to stop it.

SumZero: How has Navient gotten away with poor customer service practices for so long?

Taylor Mann, Pine Capital Partners: First off, this process is extremely complex and overwhelming, Navient services debt from twelve million customers, all with different payment options and in different circumstances. If they serviced this debt by the book, they couldn’t be profitable. The Department of Education is fully aware of these problems; however, they know that Navient is extremely good at collecting payments. Can you imagine the outcry if all that debt had to be transferred to other less efficient servicers?

Furthermore, I think there is more than meets the eye in regards to Navient’s spin-off from Sallie Mae. This spin-off just added to the complexity, exacerbating the problems with consumer satisfaction, and thus the late fees and the failed repayment option applications. Before I wrote my thesis, I read hundreds of complaints – which is incredibly biased, but I felt it was necessary in this case – and what I found is that they were all the same. Collectors were calling borrowers a dozen times per day, at all hours of the day and collectors would never confirm how much borrowers owed on each account with varying interest rates. For an agency to fully understand the manipulation, they would have to listen to the millions of calls which would take years to build a case. For me, I find it morally deplorable how the education system has treated our nation’s heroes. These brave men and women return home from protecting our freedoms and are immediately preyed upon. I understand human error; mistakes are going to happen, but I think the problem is that the Department of Education doesn’t want to find any problems. They want to avoid the dislocation problem, however the regulatory landscape is changing, and the student loan problem is growing larger each and every day. The question isn’t if Navient will pay a penalty, the question is when.

SumZero: Why haven’t borrowers simply defaulted as they do with private loans?

Taylor Mann, Pine Capital Partners: First off, private loans are not subject to the socialist-like recovering practices that we see in federal loans. For federal loans, collectors can garnish wages, offset tax refunds, and pretty much anything else you can think of. Conversely, with private loans, lenders are limited to other collection tactics like suing the borrower. It is also important to note that student loan borrowers are prohibited from filing for bankruptcy (I’ve seen like 3 cases where someone got away with this--about 1 in 14,000,000 or the likelihood of birthing quadruplets. Know many quadruplets? Yeah, me neither).

It’s also important to note that these loans are like fine wines – certain vintages are better than others, or in this case, worse. Those loans issued in the eighteen months prior to the 2008 credit crisis have performed relatively worse than others. When you look at the big picture, the reason for this seems oddly simple: an abnormal amount of borrowers that graduated right before the Great Recession eventually found shelter in graduate school because loans go into a grace period if you go back to school. Naturally, this exacerbated the problem as many went into uneconomical programs that lack any type of job prospects.

Finally, after realizing they had created a moral hazard factory, the Department of Education implemented Income-Based Repayment plans when they renewed contracts with debt servicers. Navient can no longer make the profit from delinquency retrieval fees and it's also expensive to place borrowers in these repayment options; it takes a lot of administrative paperwork of course. Navient’s investors would actually be better off if borrowers just defaulted, because then the Department of Education would have to reimburse the trust for the losses. However, if borrowers can stay in repayment at a lower Income Based rates, the DOE will not have to repay the ‘losses’ until much later. Participation in such plans has been growing exponentially.

This is really the core catalyst in regards to the income-based repayment problem: fewer people are in delinquency as they can afford discounted monthly payments. This decrease in payment strangles Navient’s cash-flow as they hold $100B in federal education loans in off-balance sheet assets and liabilities. This will lead to an eventual credit downgrade for Navient which will raise their cost of capital. Meanwhile the lack of delinquencies has hurt their most profitable business segment.

SumZero: This is great quote from your investment thesis on SumZero: “borrowing taxpayer money for free, lending it back to the taxpayers for a high interest rate, and then have the taxpayers assume all the risk”. How has this situation arisen twice now in recent memory?

Taylor Mann, Pine Capital Partners: It sounds a little familiar doesn’t it? If memory serves me right, it was Mark Twain who said, “History doesn’t repeat itself, but it does rhyme.” Fittingly, this claim continues to validate itself; namely, with moral hazard in the financial markets. Although disputable, I believe moral hazard was created on September 23, 1998 – when the Federal Reserve bailed out Long-Term Capital Management. This precedent would later become the foundation for what the mortgage crisis was built upon. The student loan crisis would later be built on the ashes of the preceding disasters. This quote summarizes the fundamental problems within our financial system: success is always an individual achievement; failure on the other hand is a social problem.

SumZero: So, will student debt cause the next recession?

Taylor Mann, Pine Capital Partners: This question is as interesting as it is difficult; the parallels between this bubble and the last are eerily similar. To paraphrase a letter I wrote to my Congressman (R-TX Jeb Hensarling – Head of the House Financial Services Committee), “In order to stimulate us out of the last stagnated economy, the American Dream was preached: everyone is entitled to own a home. In fact, we should borrow the money because real estate is the greatest investment on the planet. In order to stimulate ourselves out of the current stagnated economy, the American Dream was preached once more – almost simultaneously – telling us that everyone is entitled to a college education. In fact, we should borrow the money because a college education is the greatest investment on the planet.”

Let’s just look at the parallels for a moment: Countrywide has been replaced with University of Phoenix (remember the constant commercials?), the subprime borrowers are replaced by for-profit and community college students (predatory lending from moral hazard), Sallie Mae became the Freddie & Fannie (investors assumed zero risk since government promised repayment), and each crisis is coming in the last year of an eight term presidency – one being pro-business the other pro-government.

The crux of the problem is that we have this psychological denial problem that prohibits us from perceiving reality when it’s too painful for us to bear. No one wants to admit that they’re screwed. Think about it-- people want to feel as if they are bettering themselves, making an investment towards their future. Academic theories were ingrained in us to believe that real estate prices could never drop and that education will always payoff. Look at the escapade at Long Term Capital Management; academia continues to undermine the human condition. We’re not rational economic actors. We make extremely incompetent decisions with free money. As Vinny Daniel said, “How do you make poor people feel wealthy when wages are stagnate? You give them cheap loans.”

As for a catalyst, I think the “crisis” is already happening – borrowers have just been able to hide in delinquency and forbearance for the last several years. Even at $1.3T, the student loan debt is small relative to mortgage market, however, that doesn’t mean this is any less serious of an issue. These borrowers have accumulated this debt an extremely young age and most have next to nothing to show for it. In the near-term, I think we’re going to see credit downgrades across the board. Although these downgrades will be mostly technical in nature, the fact is that it’s highly unlikely that these bonds will be repaid at maturity. We can analyze each tranche on every security and run an endless amount of different scenarios, but at the end of the day, we know it doesn’t matter. Unless the taxpayer comes in, this debt will never be repaid.

SumZero: What key metrics should investors be paying attention to as your thesis matures?

Taylor Mann, Pine Capital Partners: Overall, there are three core catalyst that need to be watched over the near-term: 1) The potential downgrade of Naviant’s FFELP portfolio. The company has about $100B of federally backed student loans that could possibly be downgraded as more borrowers elect Income Based Repayment options that lowers the payment dramatically and allows them to avoid default. 2) The Consumer Financial Protection Bureau – the Orwellian-like agency that is in charge of closing loopholes within the sector. Aside from your political ideology, no one can deny that these guys are good at what they do. Finally, 3) Net Interest Margin – like a regular bank, this is the spread between what it cost to borrow and when they charge for lending. This margin has compressed severely over the last several months, and I fully believe that it will continue to do so.

SumZero: Is Navient still an attractive short at today’s prices? If so, why hasn’t the market acted on this situation?

Taylor Mann, Pine Capital Partners: Absolutely. This problem is systemic and we’re currently looking at the tip of the iceberg. To be completely honest, I thin kwhoever is driving on the other side of this trade is staring in the rear-view mirror. Per recent history, it seems that the more predictable the road is, the more unpredictable the crash is. Basically, I feel like I’m playing roulette and everyone is looking at the most recent spins – meanwhile, I’m looking at the dealer sliding a weighted ball under his cuff. A key catalyst that often goes overlooked is the fact that the federal government does not have to repay defaulted FFELP [Federal Family Education Loan Program] loans if they are improperly serviced which, according to some government agencies, is exactly what is happening. Also, if you really look at the data, virtually none of the principal is being repaid. Take the 2010 vintage loans for example: only 9 percent of the principal has been paid back. It doesn’t take a group of Nobel Prize winning economist to figure out how that one is going to play out.

SumZero: How have you executed your bet against Naviant?

Taylor Mann, Pine Capital Partners: That’s interesting question. I always believed the best way to trade this idea is through derivatives; namely, in credit default swaps. If you use swaps as the barometer for return, the swaps have almost doubled since the release of my report (300 bps to 533 bps). Of course, this is a trade that most investors lack access to – including me – so after failing to raise the capital to place the CDS trade, I ended up buying OCT 15 PUTS at $20 Strike Price.

SumZero: What were the biggest risks associated with this trade in your view?

Taylor Mann, Pine Capital Partners: From my perspective, I figured the near-term risk to be rather asymmetric, meaning I didn’t see any catalyst that could drive Navient stock much higher through year-end. The bull-case relies on the assumption that the company can continue to purchase FFELP loans from other banks, mainly because the margin is too low for them and Navient can leverage their infrastructure to make it profitable. This of course, in my mind, is a flawed premise. With Income-Based Repayment participation increasing, the likelihood of a downgrade is becoming more and more likely. Theoretically, the biggest risk is the oligopolistic nature of the servicing sector. There are virtually zero alternatives if Navient’s contract was to be discontinued. This goes back to the dislocation factor I discussed earlier: moving that many borrowers would be painful, hence the incentive for the Department of Education to overlook some of the problems at Navient.

SumZero: Is this thesis representative of the Taylor Mann and Pine Capital Partners investing style?

Taylor Mann, Pine Capital Partners: The thesis behind the deterioration of student loans epitomizes my investing style: macro to business cycle to industry to sector to firm. This top-down thematic approach allows me to focus in and identify the key catalyst in the investment. I like investing in “no brainers” and the problems with student loan debt are about as obvious as they come. The theory that asset bubbles can only be recognized in hindsight is ridiculous. People have a tendency to write-off these contentions as overdramatic until the bubble has already burst. The student loan problem is unlike any other in recent history: everyone is aware of the problem, but no one wants to do anything about it because it’s not a disaster yet. When it comes to debt, we have a proclivity to kick the can down the road – this short-term thinking obviously comes with consequences. In almost all cases, we’re never willing to change or make a sacrifice until the problem is at its precipice. At that point, we don’t have a choice. The reason I bring this is up is because Pine’s philosophy is based on this notion: that both consumers and investors alike are extremely emotional in their decision making. This mistake has, and always will, lead to an abundance of opportunities.