Issue XVIII - For-Profit Education

Dear Readers,

As the job market has gotten tighter and more competitive over the past decade, it has become well known that a high school diploma or GED is no longer sufficient to provide a secure future. Consequently, one of the largest growth sectors this decade has been the for-profit education sector. A few of the biggest publicly-traded providers of for profit-education are Apollo Group (University of Phoenix, APOL), DeVry Inc. (DeVry College, DV), and Corinthian Colleges (Everest University, COCO). These schools claim that due to their setup as for-profit institutions, they are able to systematically make teaching more efficient and more responsive to the needs of adult learners.

Recent developments, along with higher unemployment, have shed light on the practices of these institutions. Stories range from inadequate career training to degrees of limited value because they are from non-accredited programs (although the school itself may be accredited) to countless students who are unable to find jobs while being saddled with debt. As these problems have surfaced, concerns about the business model of these institutions have been voiced by everyone from investors to the Department of Education. The problems, however, are much deeper. Unbeknownst to many outside the realm of education, US taxpayers may be on the hook for these students’ debts if they default on their loans. With these problems and the increasing possibility of more regulation, the stocks of publicly-traded for-profit colleges have dropped in recent months. Although the plight of many for-profit alumni is a story in and of itself, I will be focusing on the financial side of this business and the outlook regarding the for-profit business model.

Due to continuing high unemployment and the rising cost of private colleges and even state universities, community colleges across the nation have been filling up in record numbers. Therefore, a sector that had primarily been “open enrollment” is suddenly more selective. For those who are left out, many have chosen to enter the realm of for-profit education. Advertisements for these colleges are everywhere, as are their campuses, despite the fact that many of their degrees can be earned online. The ads inspire visions of an education sufficient to achieve a stable, even prestigious, career.

A major point of attraction to many working adults, the for-profit's target demographic, is convenience. For example, classes often begin each month as opposed to the perceived constraint of the semester system. Additionally, prospective students are offered easy access to loans. The reason it is so easy to obtain financing is because the schools aggressively encourage students to take them out, often utilizing high-pressure sales tactics to maintain enrollment through granting loans. The root of the concern among most observers is that the constant need to increase enrollment (translation: profits) is resulting in the overall commercialization or “McDonaldization” of the educational experience.

In May, hedge fund manager Steve Eisman made a presentation at the Ira Sohn Research Conference in which he characterized the for-profit sector as a group of “marketing machines with the purpose of sucking up government funds disguised as universities.” This came as a surprise, considering that many others at the conference, such as John Paulson and Stephen Mandel of Lone Pine Capital, are long-term investors in the sector. Thus, a clear dichotomy exists between investors' opinions about the sector, its growth prospects, and its business model. It’s not surprising that most investors are long. Since Apollo Group (APOL), the parent company of the University of Phoenix, went public in 1994, it has produced a nearly 4,000% return for investors. However, it is currently down 50% since peaking in April 2004. By any measure, that is a remarkable run. However, as Eisen put forth in his presentation, a look at the company’s business model reveals eerie parallels to the housing crisis that rocked the economy several years ago, and from which we have not recovered.

One of the root causes of the housing crisis was the fact that mortgage originators were paid based on the volume of loans that they provided to the big banks, regardless of how those loans performed down the road. In the same way, for-profit school admissions counselors are paid based on the number of students that they “close.” In the May 4, 2010 edition of PBS’s Frontline, former University of Phoenix admissions counselors reflected on the high-pressure sales tactics they were required to use to get students to sign off on loans needed for enrollment. One counselor, who wished not to be named, reflected on closing individuals who were clearly not prepared to do college-level work. Despite having basic admissions standards (e.g. a high school diploma or GED), the lack of preparation of many students leads to a much higher dropout rate at the for-profits, and this drives defaults higher as these dropouts are stuck with the debt.

It’s no surprise that the for-profits engage in these practices. Just as the housing market needed people to continue taking out mortgages to keep growing, for-profit education needs to keep growing to satisfy the growth expectations of investors. Another reason the loans are so aggressively pushed is not solely because of the need for volume, but because Federal Pell grants and Stafford loans are the lifeblood of many for-profit institutions. The schools, like the mortgage originators, get paid and then have no further liability. The students are stuck with the loan, and the taxpayers with the bill if they default. While there is currently no financial penalty for the schools if their students are unable to attain what is increasingly being referred to as “gainful employment” after graduation, changes could be on the horizon.

What for-profit schools don’t have is the luxury of no financial penalty if student enrollment drops. Thus far, consistently increasing enrollment has not been an insurmountable problem for them. However, one of two scenarios could trigger a downward spiral for the for-profits. First, if the employment situation improves markedly, then enrollment will drop. Second, and more likely in the short-term, for-profits will be in trouble if Congress limits their access to student loans. According to the US Department of Education, in the 2008-09 school year, nearly 24% of federal Pell grants financed students at for-profit schools. This is nearly double the percentage of a decade ago.

In addition, Federal Stafford loans to for-profit institutions jumped from under $5 billion in 2000 to $26.5 billion last year. At some for-profits, this accounts for nearly 80% of their overall revenue. According to the College Board, community college students made up only 10% of the total Stafford loan volume in 2007-08, and usually take out less than $10,000 per student. In the case of for-profit colleges, that number was 88%, and nearly 20% of students graduate with at least $30,000 in debt. These borrowing rates reflect the higher costs and lack of financial aid associated with for-profit colleges, where tuition costs are typically higher than at public or non-profit colleges. If the government limits for-profits' access to students loans in any small way, then the schools' ability to churn out loan volume will be cut. Without this ability, enrollment at the for-profits will inevitably drop precipitously, and so will their earnings. With a disproportionate amount of federal loan money currently going toward for-profit schools that offer educations of questionable value, it is time to take a serious look at whether for-profit colleges in their current form are good for America. Eisen noted in his presentation that the taxpayers could be on the hook for $275 billion in for-profit student loan defaults over the next decade if current trends continue unabated. Considering the government's large current deficits, a comprehensive review would be prudent.

Although congressional scrutiny of the for-profits has increased over the past several years, such inquiry is not new. The first hearings on this topic were spearheaded by Georgia Senator Sam Nunn in early 1990. An excerpt from the 1990 hearing could very easily have come from the congressional hearings this year. Nunn said,

"Unwary Americans are being lured into so-called educational schools by sophisticated sales pitches that offer promises of bright futures, high paying jobs and Federal loans for financing. In fact, the students often end up with little or no training, no job and a large bill to repay the student loan. In some cases the students recognize the training is useless and they withdraw midway and end up liable for the entire loan while the school operators pocket a handsome profit. As a result, the student is worse off than ever, often defaults on the loan, and the American taxpayer ultimately picks up the tab.”

In more recent Congressional hearings, lobbyists for the industry have testified that the rate of default for students that graduate from these institutions is no different than graduates from community and public colleges. However, the manner in which the data is measured renders these readings nearly meaningless. Under current laws, the official measurement of educational loan risk used by the US government is the “cohort-default rate.” Published by the Dept. of Education, the rate measures the percentage of borrowers who default in the first two years of repayment. While this is used to penalize underperforming colleges, defaults outside of the two-year window are not taken into account.

Therefore, only a portion of the loans that eventually default are measured. As any lender knows, it usually takes more than two years for a borrower to default. Using the housing crisis as a comparison, even the worst subprime loans that were made during the housing bubble took 18-24 months to default. Even after the expiration of so-called introductory “teaser” rates, many buyers pushed back default as long as possible. Therefore, you can expect the for-profit lobbying camp to fight any proposed changes in measuring default rates so as to mask the true default rate of their group.

According to data from the Dept. of Education, 11.9% of federal loan recipients who attended for-profit colleges have defaulted on their loans within two years. This compares to 6.2% among recipients who attended public colleges, and 4.1% who attended private colleges. When the time frame is extended beyond the two-year cohort period, the for-profit figure jumps to 21.2% of federal loan recipients. This trend continues as the years pass. For-profit colleges made up 16% of all federal Stafford Loans issued from 1995 to 2007. However, they made up 34% of the defaults over the same period. Compare that to public and private four-year colleges, with rates of 15.1% and 13.6%, respectively.

A for-profit lobbyist at the 2010 congressional hearing was quoted as saying that it would be “unfair” for the government to penalize them for serving a riskier sector of the population. That is akin to mortgage lenders saying that it would be unfair to penalize them for originating the “liar” and “ninja” (no jobs, no income) home loans to a risky sector of the population that clearly did not have the ability to pay them back. For-profit institutions clearly want to maintain their image of providing a necessary service to working class students, despite providing a substandard level of instruction and then expecting them to pay back debts which they cannot handle with the jobs they end up getting.

Yet, Congress is more likely to take the case of predatory student lending much more seriously than some might think because student loan debt cannot be discarded under current bankruptcy law. Unlike an underwater mortgage, students can’t just walk away from them. If they default, they are disqualified from further federal aid, thus becoming ineligible for further education. Additionally, they may have their tax refunds and wages seized by the government. Their negative credit makes it harder to obtain housing, cars, etc. When they can get a loan/consolidation, they pay higher interest rates. This situation is happening with alarming frequency as the job market has tightened.

Less than two years removed from the failure of Lehman Brothers and the subsequent bailout, the US taxpayer could potentially be on the hook for another few hundred billion dollars if alumni of for-profit institutions continue to default and Congress passes a relief bill. As this debate has hit the news over the past few months, the stocks of Apollo Group, DeVry University, and Corinthian Colleges have plummeted in the range of 30-50%. It should be noted that these stocks were top performers throughout 2008, when they were viewed as beneficiaries of the recession which has sent many back to school. The more Congress scrutinizes these companies’ business models and practices, the more likely it is that their stocks will continue to go down. As we know from oil and financials in 2008, when a sector is targeted by a group of short sellers, it can go down swiftly and relentlessly, regardless of how far below equity or enterprise value the resultant stock valuations might be.

The current situation was not always the norm with for-profits, even at the Apollo Group’s University of Phoenix. When my family lived in Arizona in the 1980s, my mother taught nursing at the University of Phoenix before it began its massive national expansion. Even though it was a for-profit institution, it had not yet McDonaldized college education via watered-down online coursework, short term schedules, and convenient, office-like campuses. Back then, it was similar to a normal community college experience, offering day or evening classes. Students were given a great amount of individual attention and adhered to a normal two-term and/or summer semester. However, after Apollo Group went public and the focus shifted to profit growth, it was akin to a successful small-town business expanding and in the process losing focus on its core mission. Therefore, Congress should view its mission as focusing on measures that make sure the level of instruction is sufficient, and to prevent the objective of these colleges from simply expanding enrollment to ensure profit growth.

America's leaders have pledged for America have the highest percentage of college graduates in the world by 2020. As the world economy changes and US-based jobs become more knowledge-oriented, a college education is all but mandatory for individual success. Despite their problems, for-profit institutions are likely not going away. After all, since community colleges have been unable to accommodate the demand for spots, for-profit institutions are picking up the slack, as they are able to expand capacity more quickly. That said, in their current form their business model is unsustainable and arguably not beneficial for America. We the People and Congress need to recognize them for what they currently are: for-profit corporations. A for-profit’s board of directors has a fiduciary obligation to the shareholders, not to the students or alumni. They will stay for-profit, but we need to make sure the pursuit of profit does not overtake their stated mission to educate Americans for the future.

Respectfully yours,
Matthew R. Green
July 19, 2010