News Analysis date published New: 
Friday, March 8, 2013 - 13:00
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Friday, March 8, 2013 - 17:57
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Friday, March 8, 2013 - 13:00

The Next "Greatest Trade Ever" the Market is Completely Ignoring

Friday, March 8, 2013 - 1:00pm

The financial crisis of 2008 produced what many insiders consider the greatest trade ever.

With the economy and stock market buckling under the weight of the worst financial crisis in 70 years, the decline in the housing market that began in the second quarter of 2006 accelerated. No city or neighborhood was safe. High-growth areas such as Phoenix and Las Vegas saw home prices decline as much as 70% -- national home values were decimated, which have yet to fully recover.

But three steps ahead of the curve was John Paulson, a little-known hedge fund operator from New York. Years before, Paulson laid the foundation to profit from what he calculated as unsustainable prices: He placed huge, leveraged bets against the housing market.

Paulson and his small team of analysts would score a mind-blowing $15 billion profit, giving birth to what many insiders today call the "The Greatest Trade Ever" and a best-selling book by the same name.

Two key forces enabled Paulson to pull off the greatest trade ever. The first was a massive macro event that led to the boom and burst of the housing bubble. The second: He operated far ahead of the curve, relying on the public's willful ignorance of compelling data that signaled big trouble around the corner.

But if you missed the housing trade, don't worry.

History is about to repeat itself...

That's because the Great Recession caused many people to default on their credit card bills and loan payments. And now, this niche financial market is suffering the consequences of this high level of default.

I'm talking about student loans. The total student loan market is valued at more than $1 trillion. And in the last 12 months, it has shown signs of deterioration, with default rates skyrocketing.

The percentage of student loans more than 90 days delinquent rose to 11% during the fourth quarter of 2012, an all-time high and up 2.1% from the previous quarter, according to data from the Federal Reserve.

And while that's bad news on its own, the trend is accelerating. The three-year default rate climbed to 13.4%, including 250 schools with three-year default rates above 30%, according to the U.S. Department of Education.

Clearly, this is a macro event in the making. With outstanding student debt reaching $1 trillion, even an 11% default rate translates into a $110 billion loss. A 20% default rate pushes this number to $200 billion, and that would have a devastating effect on the Street.

But while there is no instrument to short the student loan market directly, I have found something even better.

SLM Corp. (NYSE: SLM), formerly known as Sallie Mae, is the nation's largest private lender of student loans. The company originates private loans, for which it retains full financial liability. But it is also the largest holder, servicer and collector of loans made under the Federal Family Education Loan program (FFEL), where it shares the financial liability with the federal government.

This makes SLM Corp. vulnerable to lower lending volumes, but particularly higher default rates. And with default rates jumping, the company is showing signs of stress.

Shares dropped in mid-January after SLM reported higher 2012 fourth-quarter charge-offs (when debtors deem a debt unlikely to be paid off), rising to 4.2% from 3.5% last year. Although the company said it expects recent increases in charge-offs to decline this year, it followed up by announcing it had increased provisions for private-loan losses to $296 million from $255 million.

Net interest income also fell, dropping roughly 9% to $3.21 billion in 2012 compared with the previous year. (Net interest income, another key performance metric, measures the profitability of the company's loan portfolio.)

Ratings agency Standard & Poor's put the company on negative watch after the sale of $3.8 billion in FFEL loans. Such a move is frequently a precursor to a credit downgrade.

SLM Corp. Chief Financial Officer Jonathan Clark also recently announced his resignation, set for the end of March, after joining the company in 2008. High-level officers jumping ship is rarely a signal of confidence.

These are cracks in the hull -- early signs as student loan defaults accelerate. But don't think the market has noticed it, because it hasn't. Shares of SLM are up 10% in the past month, 12% so far in 2013, 23% in the past year and more than 70% in the past two and a half years.

Take a look at the big gains below...

Risks to Consider: SLM Corp.'s loan servicing and origination divisions represent a significant portion of the company's revenue and profit, and are less vulnerable to higher student loan default rates. If these divisions can grow sales and earnings in the face of higher default rates, the company could potentially counter higher charge-off rates.

Action to Take --> Student loan default rates are soaring, and there are few companies more vulnerable to weakness in the market than SLM Corp. The troubling scenario is creating a huge opportunity for early investors. SLM Corp. topped off at $23.85 a share in 2008, before bottoming out at $3.28 at the height of the financial crisis in the spring of 2009. Place a stop just above the high from 2008, risking less than 20%, for a potential 80% gain if shares retrace to their recent low under soaring default rates.

Michael Vodicka does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.