Monday, July 19, 2010

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

Monday, July 5, 2010

Issue XVII - Municipal Finances

Dear Readers,

As renewed uneasiness about the economy creeps into the public consciousness, one subject of rising concern among economists and government officials alike is the public finances of all levels of government. The range of specific concerns is vast, from underfunded state pension funds to the increasingly precarious task of financing municipalities by issuing bonds. With the increased scrutiny, many questions have been raised about the viability of local and state debt, and rightfully so, as municipal and state bonds are investments to which a great portion of the investing public has direct or indirect exposure. In a few recent issues, I have focused on the situation in Europe, which is potentially a harbinger for what could eventually happen in the US. This issue focuses on municipal governments, whose problems seem to get progressively more unflattering with each new story that makes the news. With the current legal framework regarding local and state bankruptcies, this situation is potentially another problem where the strains will work their way up to the states, and eventually the federal government will be forced to take on the burden.

While it is making its way to the forefront of the public consciousness, the fact of the matter is that municipalities declaring bankruptcy is nothing new. What is different this time, and at the heart of many concerns, is the sheer number of municipalities that are potentially facing bankruptcy. While Chapter 9 filings are much less common than personal and corporate bankruptcies and the ramifications are not as severe as one might think, what carries severe consequences is the possibility of many happening at once. The US Bankruptcy Code for municipalities, collectively known as Chapter 9, ensures that the repercussions are not immediate in nature.

Prior to the 1930s, there was very little in terms of legal infrastructure designed to address municipal bankruptcies. Once the US entered the throes of the Depression, a growing number of municipalities across the nation (particularly in the Dust Bowl, which suffered from crop loss and the subsequent exodus of population) became unable to pay their workers and outstanding debts. To remedy this, laws were altered within the US Bankruptcy Code beginning in 1934-35. Because the 10th Amendment of the US Constitution places limits on the influence the federal government can exert upon the states, Chapter 9 filings are by and large local issues and are resolved on that level. The Chapter 9 process involves several steps. First, a municipality must go to their state for approval (this process varies by state). Second, the municipality generally must prove itself to be insolvent, unable to meet present and/or future obligations. Finally, it must make a good faith effort to negotiate with its creditors before filing. As is the case with corporate bankruptcies, it is often in the creditors’ best interest to do this as well, since they could both potentially lose more in a bankruptcy.

The primary duty of the judge in a Chapter 9 filing is to ensure a municipality is eligible to file, and then place a stamp of approval on its plan for paying off the debt. Judges cannot force a municipality to liquidate assets to pay its creditors. Slate magazine, while reporting on San Diego’s financial debacle in 2005, quoted a lawyer who worked on Miami’s 1996 Chapter 9 filing as saying, “They can’t come and pick up the fire engine(s).” Furthermore, unlike a personal or business bankruptcy, a Chapter 9 filing is not made with the intention of ridding a municipality of its debt. Instead, its purpose is to allow reorganization by assisting a municipality in terminating unsustainable contracts and to ease the process of raising lower-interest financing. For this reason, the city does not need approval of the judge to borrow money and/or engage in other financial transactions, which would be necessary in a corporate or personal bankruptcy.

As is the case with personal and corporate bankruptcy, the causes are predictable and often years, if not decades, in the making. Faced with falling revenue from the loss of an industry or population, a city begins to operate with a deficit, and more often than not gets in the habit of it. This is not a bad thing in and of itself, as utilizing debt markets allows a city to sustain its credit. While this is commonplace in the short-term, during economic downturns it is a situation that can quickly turn ugly, particularly if a government has not planned accordingly.

As mentioned, while municipal bankruptcies occur much less frequently than personal or corporate bankruptcies, they are never out of the question. During the 20th century, there were over 400 municipal bankruptcies in the US, including the near-filings of a few major cities. One of the reasons Chapter 9 is not frequently used is that for politicians, the ends often do not justify the means. In other words, many municipalities that could potentially benefit from Chapter 9 might be hesitant to file because the process would involve tax increases and unpopular service cuts. Thus, the risk of political fallout is extremely high. As is well-known and remembered, in 1975 New York City came close to filing for Chapter 9. This is most remembered by New Yorkers for the cuts in the police force and sanitation departments, and also for the famous New York Post headline covering President Ford’s reluctance to bail out the city: “Ford to City - Drop Dead.” However, at the time it was actually quite difficult for a large city to meet the eligibility requirements for Chapter 9. In response, Congress altered the Chapter 9 bankruptcy codes in early 1976, making it easier for large cities to utilize Chapter 9. A few years later, in 1978, Cleveland defaulted on a few short-term loans, but through the valiant work of their city council managed to push through an 11th hour increase in the city’s income tax to avoid Chapter 9.

Today, California has been attracting attention as one of the hubs of public finance debacles on both the local and state level. Besides the well-publicized state budget problems, the Golden State has a long recent history of financial problems on the local level. The 1976 revisions in the Chapter 9 code are what enabled Orange County to file for bankruptcy in 1994. One of the county’s investment managers had parked its pension funds in derivatives that went sour, causing a sudden $2 billion loss. Even while the real estate market in Southern California was flying high in 2005, candidates campaigning for mayor in San Diego openly talked about filing for bankruptcy to close a swelling pension deficit. Four years later, they haven’t closed the gap. After teetering precariously on the edge of Chapter 9 for the last few years, recent news stories have reported that grand jury investigations into the city’s finances found that San Diego regularly skipped payments destined for the pension fund, while continuing to raise the pensions and benefits of public employees. Each year, avoiding Chapter 9 in San Diego has become a more arduous task, yet politicians seem to be playing the classic game of kick the can down the road.

Another California city brought to its knees by public pensions was the Northern California city of Vallejo in 2008. In this case, it was rather simple, brought about via high fixed costs in employee salaries and pension expenses. This reflects a greater problem throughout California and much of the United States. Due to the fact that California is generally a desirable place to live, the cost of living is high. As a result, public employee unions, which especially in Northern California have the ears of left-leaning politicians, have repeatedly secured lucrative contracts for their members, often in the form of campaign promises. Over the next few years, look for Chapter 9 to be used more often by municipalities across the nation to force renegotiations on public employees.

Obviously, this problem isn’t solely caused by generous contracts for public employees, nor is it confined to California. Along with the recent troubles in California, cities such as Harrisburg, Detroit, Phoenix, Cleveland, and even New York City are struggling to balance their budgets, and will likely witness budget standoffs on a yearly basis until the US experiences a sustained economic recovery. In response to the problems at local levels, states are emerging as the ones who seem willing to initiate cuts. The problems, as is the case on the municipal level, range from the usual suspects of underfunded pensions to outdated governmental structures and bureaucracies. Time magazine recently reported on the efforts of Nebraska state senator Rich Pahls to merge many of his state’s 93 counties. Similar programs in England during the 1960s and 1970s brought about today’s system of counties, while the old borders became “historic” counties. In Nebraska, this means forcing consolidation of road services, vehicle registration, and law enforcement, eliminating many local government jobs in the process. Pahl’s efforts have been quashed thus far, in part because “it seemed too frank an acknowledgement of the passing of small-town America.” With 16 of Nebraska’s counties having less than 20,000 residents, with a handful under 2,000, such measures will no doubt be necessary in the coming years.

Pensions, just as they are on a local level, are increasingly being revealed as dead weight that needs to be reduced in the new economic climate. For years, politicians have wooed public employee unions’ votes via promises of pension raises and benefit security, assuming the funds would always be there. In a tabloid mecca like New York City, there has been no shortage of stories covering relatively lavish retirements for selected public employees. The New York Times recently reported that nearly 3,700 retired New York State public employees earn more than $100,000 a year in pension payments, many who are barely in their 50s. Other such tales have made the news all over the nation recently. It is reflective of a growing public divide between public and private employees and the fact that public employees have found themselves living in parallel, yet separate, economic realities over the past decade. It is unfortunate to potentially need to cut the benefits of those who protect our property and teach our children. However, the fact is that during the past decade private sector employees, particularly in the auto, airline and a slew of other industries, have experienced constant downsizing, stagnant or decreasing wages, and are paying more for health care. Traditional pensions are a thing of the past for the private sector, now almost solely confined to the tax-supported public sector. Private sector employees fund their own retirement via 401(k)s and other such plans, which are subject to the oscillations of the economy. On top of that, public sector workers have always enjoyed a higher level of job security, which is one reason that it has always been a big deal when these sectors have experienced cuts.

As the economy remains uneasy, there is no doubt in my mind that a number of cities will end up filing for Chapter 9 as local and state budgets continue to deteriorate. However, this is unlikely to create a state of anarchy, although there will no doubt be a public outcry by any number of affected parties. With the way such occurrences have played out in the past, business will go on as usual for everyone except those who hold large portfolios of municipal bonds, and of course municipal employees. For practical reasons, when a city declares Chapter 9, it is able to continue its operations. The bigger problem with a Chapter 9 bankruptcy lies in store for a city’s creditors. Municipal bonds, due to their tax advantages, have long been a preferred investment for institutions all the way down to individual investors. While a Chapter 9 filing does not free a city from its debt obligations, it can be a mechanism through which municipal bonds can be terminated before their maturity. The last time so many municipalities had problems at once was, not surprisingly, the Great Depression. Considering that we have just experienced the worst economic downturn since the Great Depression, and municipalities across the country are currently reporting financial troubles, it is reasonable to surmise that municipalities are not out of the woods.

The day of reckoning is closest for municipalities, simply because the ramifications of an individual Chapter 9 filing are much less than a state becoming insolvent. Thus far, states have shown a better ability to push back their problems, while the municipalities deal with them first. Unless a true economic recovery takes hold, things will continue to make their way up the totem pole. A rash of local bankruptcies would place added pressure on states like California to fix the problems on the state level, and do it quickly. However, if that doesn’t happen, the problem would then be passed to the federal level. In the same way that when mortgage originators went bankrupt, next in line were banks that bought the soured loans and repackaged them. When the banks had trouble, eventually the government had to bail them out, adding to its own debt. The public finance debacle could shape up in a similar way. While I am not a doomsayer with regard to the possibility of high inflation from the debasement of our currency, if the government ends up bailing out the states in one way or another, the chances of higher inflation will immediately increase. This provides a reason to hope that governments on the local and state level, employees and elected officials alike, can get their act together. Just as the private sector has been forced to cut and hunker down, all levels of government also need to learn to live with the new realities.

Respectfully yours,
Matthew R. Green
July 5, 2010