Worst Business Idea of the Decade

Rodney Johnson | Friday, August 23, 2013 >>

Imagine you get a call from an uncle pitching an investment idea. He wants you to join him in bankrolling a pool of start-up ventures with a very high payoff potential. In the past, businesses like those in the pool have earned around 500% over their lifetimes. Of course, there have been some failures.

It sounds pretty good, so you ask some questions.

Do the entrepreneurs have experience in their businesses? No.

Is there a high rate of success in the pool? No, in fact about one-third fails.

As an investor, do you get control over the businesses? No.

Do you have a clear equity position? No, actually, you’re a lender and the loans are unsecured.

Do you earn above market returns? No, in fact you lend at some of the lowest rates in the country, so the 500% return goes to the business owners, not the investors.

Do the borrowers have a great repayment record? Nope, instead they default at a much higher rate than most other types of loans.

Hmmm.

At this point, you’d think your uncle was crazy. Who in their right mind would make an unsecured loan to an inexperienced business person where the rate of failure is high, the rate of default is high, and the rate of return for the loan itself is extraordinarily low?

Unfortunately, more people than you’d think… because this story isn’t very hypothetical. It’s actually how federal student loans work, and Uncle Sam is coercing us into joining the program.

The Consumer Finance Protection Board (CFPB) recently released statistics on how the Federal Student Loan program is working out…

Given the market is now over $1 trillion and still growing rapidly, understanding the repayment history of the program can be instructive and important for those of us footing the bill.

The findings are not encouraging.

About $315 billion of all student loans are held by people still in school or in some other way deferred, meaning the repayment process hasn’t begun.

Of the $685 billion remaining, $180 billion are in forbearance or default. That’s a forbearance/default rate of 26% of the total value of loans outstanding that are currently in the repayment period. This is close to the same percentage of borrowers behind on their loans, at 22%.

Over the last several years, the U.S. has experienced an explosion in college applications and attendance. It seems everyone got the message that education is required for success later in life. This is why so many student-loan borrowers have yet to enter the repayment phase… but they will.

In the years ahead, millions of new graduates – who are also new student-loan borrowers – will hit the streets looking for jobs. Right now our economy is creating around 150,000 jobs per month, most of which are part-time and being filled by workers aged 55 to 64.

To say that recent graduates are struggling to find financially rewarding careers would be a gross understatement. That means down the road we can expect the student-loan default rate to at least remain the same, if not get worse. But there is a caveat…

As lenders, you and I gave borrowers a way to pay back less than they owe.

The federal government set up income-based repayment plans, where borrowers can contract to pay back a percentage of their income, no matter how small the absolute amount is, for a set number of years. When the time frame has passed, the remaining student loans are forgiven.

To give this program even more horsepower, the government made it so those in public-service jobs can be finished with their loans over a shorter time frame… which means they pay back even less.

As an investor, this is akin to allowing your borrowers to make variable payments based on their profit, where the payments will always be less than you would have received under the original terms of the notes, and then forgiving any loan balances remaining after 20 years.

This of course makes no business sense, and it makes no sense for our government. But that’s okay. We’ll do it anyway. Maybe we can make up any losses by increasing our lending volume.

This situation is going to boil over in the years ahead.

We’re creating a growing class of educated young people who are willfully choosing to saddle themselves with unaffordable debt because they’re too young to understand the reality of economics… and because they’ve been brainwashed all their lives to believe this is the path to a better life.

As they reach their late 20s and early 30s without being able to afford to grow their personal lives through getting married, having kids or simply buying the trappings of the middle class, they’ll get frustrated and demand relief. The only way they’ll find that relief is if government saddles American taxpayers with yet another burden.

If you pay taxes… watch out.


Rodney

 

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Categories: Purchasing Power

About Author

Rodney Johnson works closely with Harry Dent to study how people spend their money as they go through predictable stages of life, how that spending drives our economy and how you can use this information to invest successfully in any market. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. He’s a regular guest on several radio programs such as America’s Wealth Management, Savvy Investor Radio, and has been featured on CNBC, Fox News and Fox Business’s “America’s Nightly Scorecard, where he discusses economic trends ranging from the price of oil to the direction of the U.S. economy. He holds degrees from Georgetown University and Southern Methodist University.