Investing in the Pain of Student Debt Is a Tough but Tempting Play

As a college student in the early 1990s, Charles Trafton worked nights at a student-loan collection agency in Boston’s theater district, calling trucking and beauty school dropouts to ask them for money.

As a professional investor more than two decades later, he has bet that shares of companies like his former employer will sink, which has become one of his most lucrative investment ideas.

“My experience in call centers, specifically doing collections, I think gave me a huge interest in this space,” said Mr. Trafton, 48, who runs a small investment firm in Andover, Mass., called FlowPoint Capital. “I became fascinated that this is exactly the kind of creative destruction that hedge funds like ours are craving.”

In recent years, FlowPoint has generated fivefold returns through so-called short bets, or wagers in the stock and options market that shares of certain student-loan-related companies will fall, according to company documents. The fund has also made comparable returns from other education-related short trades.

It is part of a broader investment theory that inflated stock prices in for-profit college companies, textbook makers, lenders and loan collectors — all of whom have roles in what Mr. Trafton calls “the college bubble” of the last seven or eight years — have a long way to fall.

Mr. Trafton isn’t the only market participant who is skeptical of the $1.4 trillion student-loan market. The outspoken hedge-fund manager William A. Ackman has called student debt a big threat to the United States credit markets, saying, “I think that the government’s going to lose hundreds of millions of dollars.” JPMorgan Chase’s chief executive, Jamie Dimon, warned last year that student-debt defaults were a looming problem.

More recently, some hedge funds — concerned about default rates and state and federal lawsuits accusing a major student-loan collector of abuses — have considered shorting shares of the company or its competitors in various ways.

But it isn’t an easy trade to execute.

For one thing, the relevant stocks are moving in the wrong direction. Shares of companies that deal with student loans, including Navient and SLM Corporation, otherwise known as Sallie Mae, have risen since early November, reflecting expectations that the Trump administration may establish a friendlier regulatory environment for student lenders.

The student-loan market also benefits from having an implicit taxpayer backstop. Since the 2008 financial crisis, most loans are carried on the government’s balance sheet, and, because of wage-garnishment capabilities and other aggressive tools for collecting student debts, they are repaid at fairly high rates, making a rash of unpaid debts less likely.

And there’s not a ready investment available that would allow one to bet against securities backed by student loans — no index like the one that hedge fund managers depicted in “The Big Short” used to bet against mortgages before the crisis.

“There’s always been fervent interest about how to profit off the pain of the student-loan market,” said Rohit Chopra, who oversaw the industry as an assistant director of the Consumer Financial Protection Bureau. Now a senior fellow at the Consumer Federation of America, he has fielded many inquiries from investors looking for insight on how the market works.

“For credit-focused hedge funds, they see a trillion-dollar asset class, but have struggled to engage in the same casinolike activities that they were able to on mortgage,” he said.

One big hurdle for the would-be shorters is the lack of credit-default swaps, or C.D.S. — insurance policies that pay a holder when certain slices, or tranches, of a student-loan-backed security go bad. Such swaps were popular before the financial crisis and created fortunes when swaths of mortgage-backed bonds defaulted.

But people on Wall Street say a combination of banks’ worries about sullying their reputations by appearing to benefit from the financial struggles of students, the relatively small number of market participants who use complex shorting tools, and the expense of constructing such idiosyncratic trades has made firms reluctant to build the products that hedge funds want.

“If I could have gone to Goldman Sachs ‘R’ Us and said, ‘I’ll take a short on this tranche, a short on that tranche,’ I would have done that, all day, every day,” said Taylor Mann, a researcher who has studied the student-loan market in granular detail, over a recent taco dinner in Athens, Tex., near where he lives. “The day I found out that, no, C.D.S. isn’t available, no, we don’t have any bespoke investment products,” he added, “it was like, ‘I’ve got to move on.’”

Mr. Mann is now focused on starting a hedge fund that looks for compelling trades in currencies and stocks, rather than just trades related to student loans. Still, his take on the student-loan market, which he has described in a research paper as an “education bubble” backed by “unambiguously toxic” loans, has resonated for some: Mr. Trafton admires his work, and on SumZero, an online platform catering to investment professionals, Mr. Mann’s short recommendations on stocks like Capella Education, Apollo Education and Navient attracted top popularity ratings. (Apollo was recently taken private.)

A spokesman for Goldman Sachs said the firm had not created investments to help short student-loan-backed bonds. (Goldman was, however, one of the best-known players in mortgage-backed securities in the years before the financial crisis).

A spokesman for Citigroup, another bank historically known for developing products to help short complex bond securities, declined to respond to questions about whether it had done so in the student-loan market.

Greg Lippmann, a former Deutsche Bank trader who helped conceive some of the lucrative short transactions on subprime-mortgage securities in the precrisis period, said he now saw a long, or buy-and-hold, opportunity in certain student-loan-backed bonds.

“Our view has always been that on a long-term basis, the fundamentals were going to bear out to where the return on these bonds would be strong,” said Mr. Lippmann, the chief investment officer of the New York-based hedge fund LibreMax Capital.

While acknowledging that the bond securities he owns have experienced “a bumpier ride than I would have anticipated,” he added that “we are confident about future returns, so we don’t short them.”

Even Mr. Trafton, whose FlowPoint Capital has benefited greatly from its short positions, is also making more optimistic investments. The place he sees the most potential at the moment, he said, is in student payment arrangements called income-share agreements.

Under those pacts, FlowPoint pays a portion of the student’s college fees, then is guaranteed a percentage of the student’s future earnings for a predetermined period of years.

And with the election of President Trump, who has said he is committed to reducing regulatory burdens for business, and who once owned a majority stake in a for-profit college, the broad picture for student lenders, loan collectors and for-profit colleges could be brighter in the coming years, some analysts and investors say.

Under the Trump administration, a decline in federal spending, possibly paired with new opportunities for private-lender involvement, would not be a surprise, said Michael Tarkan, a senior analyst at Compass Point Research who studies student loans.

“A lot of people are calling now to buy the stocks as opposed to shorting them,” he said.