Bitcoin is Going Nowhere — A Quick Guide to Cryptocurrency

bitcoinatmBitcoin continues to gain greater traction in the media as a potential investment vehicle. Proponents praise their decentralization, convenience, and transparency. Over the past year, they have transformed from black market currencies to viable alternatives for traditional investments and existing currencies.

Bitcoin has soared from 10 cents in its early days to more than $1,200 by December 2013 as its exploding demand fascinated the media. Most people still have limited knowledge of how to use Bitcoin, let alone invest in it. Given its dual potential as both an investment and an electronic currency, it is important to understand the risks of this largely unregulated marketplace.

Growing Up is Hard to Do

Originally used as a way to barter on the black market site Silk Road, Bitcoin has now grown to cover several sectors and a variety of uses. It has spawned a multitude of imitations since its origins in 2009 and helped pave the way for cryptocurrency’s rapid growth as its market cap now exceeds $6 billion.

In February 2014, Mt. Gox, a major exchange that once handled over 70% of Bitcoin transactions, announced its loss of around 850,000 Bitcoins, valued at over $500 million. The collapse of this platform called into question the security of cryptocurrency and its ability to emerge into a mainstream currency.  The value of Bitcoins crashed overnight causing China to ban it as a currency, likely scaring off many potential investors.

Mining sacrifices your computer’s computational processes to solve complex problems that keep the respective cryptocurrency’s peer-to-peer infrastructure secure. “Miners” essentially validate every transaction in history, preventing double-spending and counterfeiting. For their contributions, miners are rewarded pieces of Bitcoins for transactions they have validated.

Because mining requires a substantial investment in computer hardware, energy, and time, many people prefer to obtain cryptocurrencies through exchange platforms. Currently, only the top ranking cryptocurrencies, such as Bitcoin, Peercoin, Dogecoin, or Litecoin, can be purchased through fiat currencies on major exchanges like VaultofSatoshi, Kraken, Coinex, and BTC-e. Not surprisingly, there are only a handful of platforms such as GoCoin that can efficiently process cryptocurrency transactions in what is still a fairly limited market.

Investment Alternative or the New PayPal?

Bitcoin is unique in the sense that it can be both an investment tool and a transactional platform. There are an estimated two to three million users of Bitcoin, many of whom hold the currency as an investment. There are real risks involved with investing in Bitcoin, as its value can fluctuate wildly. Many consumers and tech startups have supported the growth of Bitcoin as a transactional platform. The endorsement and consumption of Bitcoin spans across a multitude of categories including Virgin Galactic,, car dealerships, restaurants, and boutique shops. Spend Bitcoins, a currency directory, has nearly 6,000 companies on its database of retailers that accept Bitcoin.

Bitcoin transactions are like cash payments and do not require the customer to hand over substantial personal information, eliminating identity theft and chargeback issues. Some institutions claim Bitcoin is the new and superior PayPal and praise it for its low transaction costs. Recent IRS regulations denoting Bitcoin as “property” rather than currency for tax purposes will bring more transparency and security into the system. Some financial experts view this regulation as a move that puts Bitcoin on the path to becoming a true financial asset.

A Limitless Future

Overall, cryptocurrencies have a long way to go before they eclipse credit cards and traditional currencies as a tool for global commerce. They have displayed potential as an investment alternative, but are still not a must have asset class in your portfolio. In the next several years, cryptocurrencies are likely to evolve into a niche electronic currency that could become a realistic alternative to other electronic payment processing platforms.

VCs need to fund an official Exchange for Bitcoin

De_Waag_BitcoinOver the years, I have argued that venture capitalists should fund a regulated, US-based, preferable New York or San Francisco, Bitcoin exchange. Not necessarily for direct ROI, but to solidify the footing underneath their many Bitcoin-related portfolio companies. I also wrote that “one VC-backed company is in serious talks to move forward this something like this, likely via a ‘seat’ model.”

That VC-backed company is SecondMarket, whose investors include FirstMark Capital and The Social+Capital Partnership. The New York-based company, which once was known primarily as a middleman for pre-IPO Facebook trades, plans to spin its existing Bitcoin business out into a stand-alone company that eventually will include a New York-based exchange for the cryptocurrency. The current assets include an 11-person trading desk, the Bitcoin Investment Trust (kind of like a currency ETF) and $20 million of cash and Bitcoin.

The exchange’s goal would be to reduce Bitcoin price volatility, by using spot pricing once or twice per day (like gold spot pricing) and serving as a clearing company in which member firms would clear all transactions by day’s end. Members also would keep enough cash in Bitcoin to maintain exchange liquidity.

SecondMarket CEO Barry Silbert says that he’s modeling it after the early days of The IntercontinentalExchange, and that he hopes to have a set of founding members in place by the end of March. Expect them to include Wall Street banks and well-funded Bitcoin startups (but not, interesting, VC firms). Non-member firms or individuals would not be allowed to trade — at least at the outset — but likely could do business indirectly via the member firms.

All of this comes amid reports that one of the world’s most popular Bitcoin exchanges, Mount Gox, is shutting down after a hack that has cost its users more than $400 million. Silbert declined to comment on the developing situation at Mount Gox, except to say that SecondMarket employees were prohibited from buying/selling Bitcoin once the company learned of what was happening at Gox (a discovery that seems to have occurred hours before it became public knowledge).

From my perspective, Gox’s collapse is both a challenge and opportunity for SecondMarket’s spin-out; a challenge because Gox’s collapse could cause even the most ardent Bitcoin enthusiasts to distrust the cryptocurrency. And opportunity because there is now a market void that could a trusted entrepreneur like Silbert may be well-poised to fill. The exchange, which does not yet have a name, would launch as a self-regulated organization. But Silbert recognizes that its ultimate future is likely to be under the auspices of the New York Department of Financial Services, which recently held a Bitcoin hearing at which Silbert testified.

How America is dividing itself between Wall Street, Main Street and DC

Wall-Street-vs.-Main-StreetJulius Caesar’s treatise on the war that the Roman Empire fought against the Gauls famously starts with the words: “All Gaul is divided into three parts.” The same is true for the United States of America today.

In contrast to Caesar’s division of what is today known as France, which went along ethnic lines (Belgians, Celts and Gauls), America’s division today splits the country into the disjointed politics in DC, the real economy on Main Street and the return to old glory on Wall Street.

Trouble in Washington

The dysfunction on the inside of the Washington Beltway by now has gone from the ridiculous to the absurd. Elected federal politicians that get paid with taxpayers’ dollars continue to ignore the business of governing while nobody holds them to account for anything. They are mainly busy with raising campaign funds for re-election.

Meanwhile, President Obama’s White House is stumbling from one scandal to the next. Admissions of excessive NSA surveillance of U.S. citizens and foreign leaders are chased by the disastrous launch of “Obamacare”. What will be the next fumble?

Last month, Mr. Obama’s approval rating in year five of his presidency fell to below 40% and to the same level as George W. Bush’s was at the equivalent point in his tenure (in November 2005). The President’s only solace in this could possibly come from the fact that 39% is still a whole lot better than the 9% that Congress is getting these days.

Slow recovery and a nation of tenants

As Washington is stuck in a high stakes poker game between elephants and donkeys, the real U.S. economy displays difficulties of its own. Statistically, the Wall Street-induced Great Recession has been over for four years, but the economy is still recovering.

This most sluggish of recoveries also comes with a U.S. labor participation rate that sits at less than 63%, the lowest level since 1978. More than a third of the U.S. population that could technically be working is not. They either dropped out of the workforce permanently, or they haven’t started entering it because there are no jobs and would rather stay in school.

The drop in labor market participation marks the flip side of the relatively stable official unemployment rate at or above 7.0%. As the participation rate shows us, the unemployment rate dropping from the record highs of 2009 is not an indication of more jobs, but of more folks staying out of the workforce. That is troublesome.

Job creation in America is not just slower than expected. The jobs that are being created often come with fewer hours and a lesser wage. The recovery is agonizingly slow, both quantitatively and qualitatively.

 Today, people with poorer quality jobs are spending their hard earned money to reduce their credit card balances which is good for their credit rating but bad for an economy where consumer spending accounts for over 70% of output.

Less easily available credit is also one of the root causes why the United States is slowly turning from a society where the majority of families own their homes to one where the majority are tenants.

At near record-low prices for single and multi-family residences, this situation benefits a new generation of landlords that are picking up deals of the century to rent apartments at rates dictated by limited supply and growing demand.

Wall Street is back!

The contrast to a broken political system and a struggling real economy can be found on Wall Street these days. Mega-IPOs and mergers are back and with them the bonuses for those investment bankers that survived the recession purge.

U.S. corporations have cleaned up their balance sheets and used the recovery to improve corporate earnings. This is the stuff that markets like.

While the economy overall is still struggling with job creation and solid growth, the Federal Reserve’s generous quantitative easing and asset purchasing program made sure that there is enough liquidity around to make sure Wall Street could enjoy an almost magical recovery before anybody else.

The idea was that a fast recovery on Wall Street would eventually trickle down into the real economy, create new jobs and get GDP growth back to the 3-4% that everybody wants to see.

The reality is that the few with the means to invest in the markets are enjoying incremental wealth from the Dow Jones at record levels. Meanwhile, the many stuck in their daily struggles of getting by are still waiting for better jobs and more opportunity.

We are also likely to see a continuation of the erosion of the American middle class. The silver lining for those that still have money left in their 401k plans will be that the bulls keep roaming on Wall Street and whatever their retirement plans are invested in will help growing their nest egg.

Bubble in the Market, I think not just yet BUT…

Edward Tj Gerety BubbleOver the last few weeks, I’ve been chatting with friends about the potential formation of a bubble in the US equity market as represented by major indices and index ETFs such as the S&P 500 (SPY) and Dow Jones Industrial Average (DIA), driven by the conjunction of both record quantities of excess liquidity and declining liquidity preferences.

Starting two or three weeks ago, a flood of analysts have been falling over themselves trying to characterize the current stock market as a “bubble,” or variously as “bubbly.” So has the bubble that I have presaged aging already started?

I believe that this talk of a current bubble in the stock market is exaggerated and mostly unfounded.

This Market Ain’t A Bubble

Current consensus 12 Month Forward operating EPS for the S&P 500 is around 113. A reasonably conservative estimate would be 110. This implies a forward PE of 15.9. While this forward operating P/E is rich on a historical basis, it is not indicative of a bubble.

The analysis of historical P/E valuation does not change much if we base the P/E on trailing GAAP EPS. Assuming a trailing GAAP EPS of 94.00 at the end of the third quarter, this implies a trailing P/E of 18.6 versus a historical average of 15.5 since 1871 and a median of 17.4 since 1960. I believe that the latter figure is a more relevant basis for comparison. Either way, the current trailing P/E is not representative of bubble conditions.

Anecdotal approaches to characterizing the current market as a bubble does not work either. Let’s assume for a moment that Tesla (TSLA), Facebook (FB) and Twitter (TWTR) are bubbles. So what? There are always a few bubbly stocks in any market.

Cherry picking high P/Es as a method of “analysis” does not work either. One article I read a few weeks ago claimed that US large caps were a bubble based on citing three or four stocks with P/Es in the high teens and the low 20s. But if you objectively survey the largest 50 US stocks by market capitalization, less than 25% have forward P/Es of over 15. And less than 10% have P/Es of over 20.

Here are just a few examples of the top stocks in the US by market cap and their forward P/Es: Apple (AAPL) 11.1, Exxon (XOM) 10.8, General Electric (GE) 13.5, Chevron (CVX) 9.9, IBM (IBM) 10.3, Microsoft (MSFT) 12.1, AT&T (T) 12.9, Pfizer (PFE) 12.7, JPMorgan (JPM) 8.6, Oracle (ORCL) 11.1, Wal-Mart (WMT) 13.3. There is no bubble going on here.

In fact, the overall forward P/E for the 50 largest US large caps is less than 14. This compares to the forward P/E of the Nifty Fifty in 1972 which peaked at around 35. The top 50 US stocks by market cap also traded at a forward P/E of around 35 in 2000. Clearly, by any reasonable absolute or historical measure, there is currently no bubble in US large cap stocks.

And there is no generalized bubble in the US equity market as a whole.

Will Talk of Bubbles Prevent Them?

One potential consequence of all of this bubble talk is that it could actually serve to prevent one by placing investors on guard and getting them defensive.

However, if historical experience is a guide, I would not bet on this loose talk about bubbles actually preventing one from ultimately forming. People were loudly proclaiming bubbles in 1997, a full two years before the real bubble took off in 1999.

An important step in bubble formation is capitulation by various bears that were previously proclaiming a bubble and the simultaneous development of a narrative about a “new era” that justifies higher-than-normal valuations. Valuations are not much higher than normal now, so that sort of hyper-bullish argument would not even make any sense at present.

Bubble-Like Speculation About Profit Margins

If anything, the predominant narrative today is one of skepticism about the economic fundamentals and corporate earnings that underlie current P/E ratios.

To illustrate just one example of such skepticism, analysts such as John Hussman and James Montier have been arguing loudly that profit margins are currently in a bubble and will revert to their means of the last 30 years as soon as the US budget deficit as a percent of GDP declines. Unfortunately, while appearing theoretically plausible, this line of argumentation has virtually no empirical basis and is based on flawed theoretical constructs that were first developed in the mid 20th century by an obscure Marxist economist from Poland by the name of Michal Kalecki, and which have largely been discredited.

Contrary to Kalecki’s theoretical speculations, and general popular belief, there is no consistent history of mean reverting profit margins for corporations. To the contrary, the available empirical evidence directly contradicts the theory. For example, profit margins remained very high throughout the 1950s despite rapidly declining budget deficits as a percent of GDP. Similarly, profit margins did not exhibit any mean reverting behavior in the 1960s and 1970s. In fact, contrary to the Kalecki theory, profit margins experienced a secular decline in the 1960s and 1970s through periods of both rising and falling deficits, but mainly through rising deficits. During the ’80s, profit margins did not show any great mean-reverting behavior nor any tight relationship to budget deficits. During the 1990s, budget deficits plummeted throughout the decade while profit margins soared, in total contradiction to the Kalecki theorem. In fact, profit margins have not mean reverted at all in the past three decades regardless of budget deficits!

Profit margins have been in a secular uptrend for over 30 years through periods of both rising and declining budget deficits (as a percent of GDP). Furthermore, these increases in profit margins are based on empirically identifiable and likely sustainable developments such as globalization (capital and labor arbitrage), lower effective corporate taxation, lowered capital intensity of modern industry, cost-saving technologies, barriers to entry via intellectual property, oligopolistic industry concentration global branding and a host of other factors that have been empirically quantified in various detailed reports published by analyst such as James Bianco at Deutsche Bank, Tobias Levkovich at Citi and Dan Suzuki at Merrill Lynch.

Indeed, it may seem ironic to say so, but Hussman’s and Montier’s theories about declining budget deficits driving profit margins down, or even more simplistic mean-reversion arguments by commentators such as Doug Kass, are far more speculative and empirically unfounded than the much-maligned consensus forward EPS estimates that currently underpin the market value of stocks in the US equity market.

Speculation about a profit margin bubble in US stocks has become almost a bubble onto itself.


US stocks are currently not in any sort of generalized bubble. There are some signs of “frothy” behavior in a few isolated segments of the market. However, the stock market as a whole is still within 1 standard deviation of its historical mean in terms of forward and trailing P/Es.

When we stop hearing all the talk about bubbles and start to hear widespread talk about how much-higher-than-average P/E multiples are justified, then we can start to seriously suspect that a bubble might be in the works.

Before then, the possibility of a bubble forming in the US stock market is just that: A possibility. While I think the probabilities of the formation of a future stock market bubble are quite high, the fact is that it is not yet a reality.


World likely to have 11 trillionaires within two generations

In the past year, aggregate global household wealth increased by 4.9% to reach $241 trillion, a sign that even as the tepid economic recovery plays out, households are still accumulating wealth.  And that number is poised to grow over the next five years by 40%, reaching $334 trillion, according to Credit Suisse’s annual Global Wealth Report, out Wednesday.

Here’s what the distribution of that wealth looks like in pyramid form:

It’s pretty disconcerting to see over two-thirds of the world’s adults have wealth of less than $10,000, while the wealthiest 0.7% hold 41% of the world’s wealth.

But there are some heartening signs in the report. One suggests that some measures of mobility are high. Future projections of growth rates based on historical averages show that the fraction in the bottom category of wealth will fall steadily over a 60-year time-frame. After the first 30 years, the number of people currently at the bottom will be cut nearly in half. The authors write:

“Two generations ahead, future extrapolation of current wealth growth rates yields almost a billion millionaires, equivalent to 20% of the total adult population. If this scenario unfolds, then billionaires will be commonplace, and there is likely to be a few trillionaires too – eleven according to our best estimate.”

Here’s what it looks like in colorful chart form:

Wealth mobility within the period works the other way as well. The top 100 billionaires in the Forbes billionaire list in any given year tends to fall in consecutive years, the authors found. So, for example, of the top 100 billionaires on the list in 2011, only 37 remain. It’s a small sample size that hinges on a number of factors, but it goes to show that just because you’re perched on the top of the pyramid doesn’t mean you’ll stay there.

This chart shows the trajectory:

Graphs created by Credit Suisse

How the Market Views the Debt Ceiling

marketmoneyThe financial markets digested the Administration’s scare tactics on Thursday and quickly rebounded on Friday.  Apparently, the sentiment tone remains that investors want to be long for the deal that everyone knows must be made. The lack of a deal has the S&P 500 futures down 50 basis points tonight. Continuing with the trend thus far in 2013, the shallow nature of most sell offs has reinforced the “buy the dip” mentality.  Now it appears the purchases are being made more enthusiastically, with the mindset that a deal announcement would create an immediate 1-1.5% rally.  As the S&P 500 remains within a stone’s throw of all-time highs, it is safe to say the equity market has not priced in any potential ill effects of the Government shutdown and Debt Limit battle.

This is right. With just over a week to go, the market is incredibly sanguine about how this all plays out. Nobody thinks anything can go wrong, and everybody is afraid to be short or to sell lest they miss the “deal.”

This is pretty different from recent fiscal shenanigans.

This kind of blind bullishness and fear of missing even a shred of the rally speaks to a worrisome level of confidence.

For the market’s sake, DC better navigate this smoothly.


The United States looks like the “Land of Oz run by the Munchkins”

government-shutdownIt is an embarrassing manifestation of U.S. political malfunctioning could become economic disaster if the market gets spooked about the debt ceiling and the potential of a sovereign default.

Washington politicians have become “irresponsible” over trying to maintain a health system that no one really wants anymore except the politicians who are not forced to join it.

The most serious potential consequence of the current situation is that markets will become alerted to the “danger” of the approaching U.S. debt ceiling. However, that the current situation “need not be too serious”.

Echoing comments made by ratings agency Standard & Poor’s on Monday. The agency warned that if the warring Republican and Democrat factions don’t reach an agreement by Oct. 17, the Treasury would probably miss debt repayments and default on the U.S.’s nearly $17 trillion national debt.

That in turn could lead to a downgrade of the country’s rating. And the fallout would not be confined to the world’s biggest economy.

“If the U.S. is to default on even a small portion of its debt it could pull the rug under the global economy, U.S. sovereign debt is the linchpin of the global economy.”

650 Fifth Ave seized by the Feds due to links to Iran

650 5th AveThe United States is set to seize control of a midtown Manhattan skyscraper prosecutors claim is secretly owned by Iran, the justice department said, though the ruling is to be appealed.

The seizure and sale of the 36-story building, in the heart of New York City on Fifth Avenue, would be “the largest-ever terrorism-related forfeiture,” the statement added.

A federal judge ruled in favor of the government’s suit this week, saying the building’s owners had violated Iran sanctions and money laundering laws.

Manhattan Federal Prosecutor Preet Bharara said the decision upholds the justice department claims the owner of the building “was (and is) a front for Bank Melli, and thus a front for the Government of Iran.”

Bharara said the funds from selling the building would provide “a means of compensating victims of Iranian-sponsored terrorism.”

Prosecutors allege the building’s owners, the Alavi Foundation and Assa Corporation, transferred rental income and other funds to Iran’s state-owned Bank Melli.

Alavi also ran a charitable organization for Iran and managed the building for the Iranian government, the statement said.

Built in the 1970s by a non-profit operated by the Shah of Iran — and financed with a Bank Melli loan — the building was expropriated by the new Iranian government after the 1979 revolution, prosecutors allege.

They said the Shah’s non-profit, the Pahlavi Foundation, was renamed the Mostazafan Foundation of New York and then the Alavi Foundation.

A former president of the Alavi foundation pleaded guilty in 2009 to obstructing justice in destroying evidence related to the case, which was first filed in 2008.

The Alavi foundation plans to appeal, saying on its website it was “disappointed” with the ruling and that “it did not have the opportunity to rebut the Government evidence before a jury.”

The US Treasury Department has instituted tight sanctions against Iran, blacklisting a number of Iranian companies and organizations and putting controls on the ability of any group or business to transfer funds into Iran.

The restrictions seek to pressure Tehran into giving up what the West says is a program to develop nuclear weapons.

Market move indicators flash warning for stocks

stock_market_crashSome important momentum indicators are flashing warnings after the stock market’s explosive move to new highs this week.

Traders look at a plethora of signs and indicators to help guide their decisions. One particular area has to do with momentum, or whether the prevailing trend in prices will continue or is due for a reversal.

A number of these momentum indicators have reached a point that’s indicative of a reversal of prevailing trends. You’ll hear terms like Bollinger Bands, Relative Strength and MACD, among others. Simply put, these are statistical measures that tell a trader when prices have gone too far, too fast.

As the S&P 500 hovers near record highs, many traders are heeding some of these caution flags. Over the course of the year, we’ve seen near-term peaks like we’re seeing now two other times. A common point between the three peaks is that these statistical indicators have shown that momentum was due for a reversal.

“From a technical perspective, the S&P is in or near overbought territory, as are several sectors such as Industrials, Consumer, Tech and Materials,” said Max Breier, a senior equity derivatives trader at BMO Capital Markets.

During the market peak in early August, we saw signs that stocks were overbought. The market did eventually pull back, but not enough to be characterized as a correction. From that peak Aug. 2 to the trough Aug. 28, the S&P 500 fell 4.8 percent. From the market peak May 22 to the trough June 24, it fell 7.5 percent.

So, the average drop over those 2 occurrences was 6.2 percent. Hypothetically, if the market were to fall by that amount from the record high, that would put the S&P 500 at around 1,625. Even if the market were to pull back to that level, the longer-term uptrend would still be in place.

As of now, 26 are being set, or 25 percent of the index. Back around the August highs, we saw a similar number of new highs. We saw 187 of them before the market peak in May. Those last two surges in the number of fresh yearly highs also preceded drops in the stock market.

“The S&P is now up 23 percent year to date and has risen a whopping 36 percent since June 2012, in almost a straight line ” said Matt Maley, strategist at Miller Tabak Equity. “We just think the market is getting a little ahead of itself.”

The Federal Reserve shocked just about everyone in its September interest rate decision. The investing world fully expected the central bank to pull back on some of its stimulus measures, or to “taper” its bond purchases. Instead, the Fed chose to keep the bond-buying program in full effect, and markets rocketed higher.

Full stimulus measures will be here until the economy really starts showing improvement. Stocks hit a record high, but traders and investors are left wondering if the upside move can be sustained.

Experts will provide well-researched theories on what comes next. History may or may not be able to provide insight into the future, but some traders will look to the past for clues. And these are just a couple of the data points that are helping to provide a moment of pause.

“When you put all the pieces together, it feels like the market is at a stalemate, without any catalyst to push us in one direction or another,” Breier said.

If you’ve been long during the rally, you’ve done well. There’s no real dispute that stocks have surged since the lows of the financial crisis. Maley advises patience for his clients looking to get in on the market.

“Investors might want to buy on weakness,” he said, “rather than chase the market at these levels.”

To use a shopping analogy: Traders are looking at stocks right now like they’d look at buying the hot gift item of this holiday season. Those items are pricey now, but they could be on sale later. On the other hand, if you don’t get them now, you may end up paying even more for them if supplies dry up.

That’s why traders are taking a breather. They’re thinking about whether to chase prices higher, or wait for Black Friday or clearances around Christmas.

Student loan deal may have unintended consequences

A government program designed to help students deal with crushing debt loads could have the unintended consequence of encouraging some students to borrow more – and some schools to charge more – than they would have otherwise.

Under the public service loan forgiveness program, if you make payments on your federal direct student loans under certain payment plans for 10 years while you are working for a government or nonprofit employer, after 10 years any debt remaining will be forgiven.

About one-quarter of U.S. workers are in public service jobs that might qualify, according to the Consumer Financial Protection Bureau.

One caveat: If you are working at a government agency or nonprofit as a contractor through a private-sector company, you do not qualify, says Lauren Asher, president of the Institute for College Access & Success.

There is no limit on the amount of debt that can be forgiven. The biggest winners are those who attend expensive graduate and professional schools.

That’s because there is a limit on the amount of federal student loans undergrads can take out each year. Dependent undergraduates who take out the maximum allowable Stafford loans will leave school with about $32,000 in qualifying debt. (Their debt will be higher if they also took out Perkins loans, but most students don’t qualify for them.)

Federal Plus loans that parents take out for their children’s college generally do not qualify for public service loan forgiveness, nor do any private loans that are not federally guaranteed. Plus loans that graduate students take out themselves do qualify for forgiveness.

Forgiveness criteria

Unlike undergrads, students in graduate or professional schools can borrow up to their school’s full cost of attendance – including living expenses – with federal Stafford and Grad Plus loans. In the case of law school, this could be $75,000 per year.

Students with large debt loads could have some forgiven even if they end up making more than $100,000 per year, says Jason Delisle, director of the New America Foundation‘s federal education budget project.

“The program is a safety net for undergraduates and a very large tuition assistance program for graduate students.”

To qualify for forgiveness, you must make 120 on-time monthly payments while working in public service, under either a standard 10-year repayment plan or one of the government’s income-linked payment plans. The latter include income-based repayment, income-contingent payment and pay as you earn. The 120 payments do not have to be consecutive.

If you make 120 payments under a standard 10-year repayment plan, there is nothing left to forgive after 10 years. So in reality, you must make at least some of your payments under one of these reduced-payment plans.

Repay based on income

Income-based repayment, or IBR, is available to any borrower with federal student loans, no matter where they work.

Under IBR, your payment is based on your income and family size. If your IBR payment is lower than your standard 10-year plan, you can enroll in IBR and make the lower payments. Unpaid interest accrues, but is not necessarily added to your loan balance.

If your income rises to the point where your IBR payment equals or exceeds your standard payment, you can stay in IBR, but make the standard payment instead. However, at this point, unpaid interest is capitalized, or added to your loan balance, Asher says. After 25 years, any remaining principal and interest is forgiven.

Under pay as you earn, a newer version of IBR for recent grads and current students, your payments are even smaller and remaining debt is forgiven after 20 years.

If you work in public service and make 120 monthly payments under either program, your remaining balance is forgiven after 10 years.

Delisle gives an example of two people who graduate from college. Each enters public service making $50,000 a year and get a 3 percent annual raise thereafter. Both qualify for pay as you earn.

The only difference is that John graduates with $32,000 in debt, Mary with only $26,600 in debt.

Over 10 years, both make payments totaling $32,270. But John has $18,740 forgiven while Mary has only $8,206 forgiven.

High debtors benefit

The benefits only get bigger as debt mounts.

The Association of American Medical Colleges, on its website, gives an example of a doctor who takes out $170,000 in federal student loans and owes $195,000 when he begins repayment. He works for a nonprofit employer and qualifies for IBR.

His first three years, he makes a little over $50,000 as a resident and pays $410 to $490 per month on his federal student loans. In year four, his salary jumps to $120,000 and goes up a moderate amount thereafter. In years four through 10, his payments are $1,400 to $1,700.

Over 10 years, he will have made about $144,000 in loan payments and had $169,000 forgiven.

These examples ignore “one more crazy loophole” borrowers can take advantage of, Delisle says. If you graduate in June, your first-year IBR payment will be based on the previous year’s tax return. If you were in school and earned little or nothing the previous year (and were not claimed as a dependent on your parent’s return), your first-year IBR payment is zero.

If you worked only six months your first year out of school, your second-year IBR payment would be very low. Yet these first two years of payments will count toward public service loan forgiveness.

‘Word is spreading’

The public service program is still new. Only payments made after Oct. 1, 2007, count toward the 120 required payments. It will be 2017 before borrowers have any debt forgiven. Many students still don’t know about the program, “but word is spreading,” Delisle says.

Cost of College EducationSome graduate and professional schools are promoting it as way to afford their lofty tuition. Delisle fears it could keep upward pressure on college costs at a time when President Obama is urging colleges to provide better value.

Delisle is in favor of loan forgiveness, but says it should be for all borrowers and “the amount you can have forgiven should be about what the government would give someone in Pell Grants,” which go to the neediest undergraduate students. The maximum Pell Grant this year is $5,645.

Deborah Fox of Fox College Funding, which helps families find ways to pay for college, says he would never encourage clients to take on debt just to have it forgiven because there is no guarantee a student will stay in public service for 10 years. “We try to keep people out of debt, no matter what,” she says.