Tuesday, May 4, 2010

Government Sponsored Leveraged Equity Bets...On College??

I've explained before why I think 529 Plans should go away.  They only benefit the very wealthy, and probably they feed the ever increasing costs of college education. 

Melissa Bean of Illinois, has introduced HR5030, which seeks to allow the use of 529 Plan assets to cover student loan interest payments.  From her website:
"With one daughter in college and another to follow, I keenly understand the financial challenges parents face to fund college education,” Bean said. “This bill allows those who’ve saved in 529 accounts and played by the rules to allow their investments to recover before using them to finance those costs."
This bill reflects a fundamental misunderstanding of just about every aspect of finance, from investing through tax.

Let's make this very simple.  Bean bought a risky portfolio to save, tax free, for her daughters' college costs.  This portfolio went south. 

H.R. 5030 would allow her to use the risky plan assets to finance student loan debt, not just direct educational expense.  If she were a Goldman instead of a Bean, we'd call this proprietary trading

She believes she can invest her 529 Plan assets in such a way as to earn a spread above the borrowing rate on student loans.  That's a bold assumption.

We could just stop there.  Why should the government encourage more leveraged risky bets than they already encourage? 

But, we have more ground to cover, for the more patient amongst you.  Two questions:  First, can she do it?  Second, does she need her bill to get there?  To the first question I'll say "seems risky."  Oddly enough, to the second, the answer is a definitive no...unless you think (a) capital gains taxes are going up, and (b) student loan costs are going down.  Two very reasonable assumptions.

First, can she do it?  Start with her risky assets.  She probably isn't taking much bond market risk.  Why do I assume that?  She wouldn't have lost much money, and she wouldn't think five years would be enough time to make up her losses. 

Also, she'd have to be completely clueless to think that holding investment grade bonds could outperform the cost of student loans.  Student loans reflect high cost consumer credit origination and servicing.  (Think high origination costs, fees, etc.)  Investment grade bonds reflect liquid, efficient capital markets activities. (Think origination costs and fees paid to investment bankers, but spread over huge loans so they cost less as a percentage of the loan!)  Even if they're duration matched, she's losing on the spread.

So, let's assume she's taking substantial equity market risk.  That means she must be engaged in "leveraged prop trading" because she's borrowing money to invest in the stock market.  She must carry mismatched assets and liabilities.  Her expected return on her investments must exceed, with some significant margin, her expected costs of borrowing because its a risky bet. 

According to her website, Bean's daughters are 16 and 18.  And, according to Sallie Mae, Stafford Loans carry a rate of 3.4% now, and 6.8% starting in 2012.  Plus loans carry 8.5%.  Private loans exceed those levels.  For her daughters, let's guesstimate a rate of 8.5%.  I'm no expert, but I will assume that since she makes enough to have funded 529s in the first place, she's not getting the lowest Stafford rates on her borrowing.  And, she'll probably end up with some higher rate debt through private sources.

[Why else is 8.5% an interesting choice?  The bankrupt Illinois public retirement plans all assume they will earn 8.5% returns!!!  Nice coincidence.  Yet virtually all professional investors know this is near impossible.  So, if Bean can pull of her personal financial shenanigans at retail prices using 529 Plans, then take her out of Congress, and put her in charge of the Illinois retirement programs!!  But again I digress.]

Who wants to take the bet over the next five years: 8.5% guaranteed return (that's her certain cost of capital) or the risky outcome of Bean's investing?

Second, do we need her bill?  Complicated question, I know.  The 529 grows tax free.  But, she invested (and intends to invest) in equities.  When you own equities, you defer all taxes until you sell (except small dividends now), and then you pay capital gains rates.  And, along the way if you are down, you may sell, and realize losses.  You can't do that with your 529.  So, it's not very clear when capital gains taxes remain low that the 529 gives you any help on the asset side.

What about the interest expense?  Many people deduct student loan interest on their taxes.  But guess what?  Everyone who borrows money to make investments may deduct the interest expense.

So, if Bean instead of saving through a 529 Plan would simply leverage up her equity investments like a real prop trader, she would lower her interest expense (margin lending has far lower cost than student loans, and there's no limit on deductability), not materially impact her upside.  She wouldn't need to waste her efforts on a useless bill leaving more time for her investing activities...and you wouldn't spend your time reading my too long post! 

No comments:

Post a Comment