Until recently, I thought that there would never again be an opportunity to be involved with an industry as socially destructive and morally bankrupt as the subprime mortgage industry. I was wrong. The for-profit education industry has proven equal to the task.
The for-profit industry has grown at an extreme and unusual rate, driven by easy access to government sponsored debt in the form of Title IV student loans, where the credit is guaranteed by the government. Thus, the government, the students and the taxpayer bear all the risk, and the for-profit industry reaps all the rewards. This is similar to the subprime mortgage sector in that the subprime originators bore far less risk than the investors in their mortgage paper.
In the past 10 years, the for-profit education industry has grown 5-10 times the historical rate of traditional post secondary education. As of 2009, the industry had almost 10% of enrolled students but claimed nearly 25% of the $89 billion of federal Title IV student loans and grant disbursements. At the current pace of growth, for-profit schools will draw 40% of all Title IV aid in 10 years.
How has this been allowed to happen?
The simple answer is that they’ve hired every lobbyist in Washington, DC. There has been a revolving door between the people who work for this industry and the halls of government. One example is Sally Stroup. In 2001-2002, she was the head lobbyist for the Apollo Group — the company behind the University of Phoenix and the largest for-profit educator. But from 2002-2006 she became assistant secretary of post-secondary education for the Department of Education under President Bush. In other words, she was directly in charge of regulating the industry she had previously lobbied for.
From 1987 through 2000, the amount of total Title IV dollars received by students of for-profit schools fluctuated between $2 billion and $4 billion per annum. But when the Bush administration took over, the DOE gutted many of the rules that governed the conduct of this industry. Once the floodgates were opened, the industry embarked on 10 years of unrestricted massive growth. Federal dollars flowing to the industry exploded to over $21 billion, a 450% increase.
At many major-for profit institutions, federal Title IV loan and grant dollars now comprise close to 90% of total revenues. And this growth has resulted in spectacular profits and executive salaries. For example, ITT Educational Services, or ESI, has a roughly 40% operating margin vs. the 7%-12% margins of other companies that receive major government contracts. ESI is more profitable on a margin basis than even Apple.
This growth is purely a function of government largesse, as Title IV has accounted for more than 100% of revenue growth.
Here is one of the more upsetting statistics. In fiscal 2009, Apollo increased total revenues by $833 million. Of that amount, $1.1 billion came from Title IV federally funded student loans and grants. More than 100% of the revenue growth came from the federal government. But of this incremental $1.1 billion in federal loan and grant dollars, the company only spent an incremental $99 million on faculty compensation and instructional costs — that’s 9 cents on every dollar received from the government going toward actual education. The rest went to marketing and paying executives.
Leaving politics aside for a moment, the other major reason why the industry has taken an ever increasing share of government dollars is that it has turned the typical education model on its head. And here is where the subprime analogy becomes very clear.
There is a traditional relationship between matching means and cost in education. Typically, families of lesser financial means seek lower cost colleges in order to maximize the available Title IV loans and grants — thereby getting the most out of every dollar and minimizing debt burdens.
The for-profit model seeks to recruit those with the greatest financial need and put them in high cost institutions. This formula maximizes the amount of Title IV loans and grants that these students receive.
With billboards lining the poorest neighborhoods in America and recruiters trolling casinos and homeless shelters (and I mean that literally), the for-profits have become increasingly adept at pitching the dream of a better life and higher earnings to the most vulnerable of society.
If the industry in fact educated its students and got them good jobs that enabled them to receive higher incomes and to pay off their student loans, everything I’ve just said would be irrelevant.
So the key question to ask is — what do these students get for their education? In many cases, NOT much, not much at all.
At one Corinthian Colleges-owned Everest College campus in California, students paid $16,000 for an eight-month course in medical assisting. Upon nearing completion, the students learned that not only would their credits not transfer to any community or four-year college, but also that their degree is not recognized by the American Association for Medical Assistants. Hospitals refuse to even interview graduates.
And look at drop-out rates. Companies don’t fully disclose graduation rates, but using both DOE data and company-provided information, I calculate drop out rates of most schools are 50%-plus per year.
Default rates on student loans are already starting to skyrocket. It’s just like subprime — which grew at any cost and kept weakening its underwriting standards to grow.
The bottom line is that as long as the government continues to flood the for-profit education industry with loan dollars and the risk for these loans is borne solely by the students and the government, then the industry has every incentive to grow at all costs, compensate employees based on enrollment, influence key regulatory bodies and manipulate reported statistics — all to maintain access to the government’s money.
In a sense, these companies are marketing machines masquerading as universities. Let me quote a bit from a former employee of Bridgepoint Education, operators of Ashford University:
“Ashford is a for-profit school and makes a majority of its money on federal loans students take out. They conveniently price tuition at the exact amount that a student can qualify for in federal loan money. There is no regard to whether a student really belongs in school, the goal is to enroll as many as possible. They also go after GI Bill money and currently have separate teams set up to specifically target military students. If a person has money available for school Ashford finds a way to go after them. Ashford is just the middle man, profiting off this money, like milking a cow and working the system within the limits of what’s technically legal, and paying huge salaries while the student suffers with debt that can’t even be forgiven by bankruptcy. We mention tuition prices as little as possible . . . this may cause the student to change their mind.
“It’s a boiler room — selling education to people who really don’t want it.”
How do such schools stay in business? The answer is to control the accreditation process. The scandal here is exactly akin to the rating agency role in subprime securitizations.
In order to be eligible for Title IV programs, the universities must be accredited. But accreditation bodies are non-governmental, non-profit peer-reviewing groups. In many instances, the for-profit institutions sit on the boards of the accrediting body. The inmates run the asylum.
The latest trend of for-profit institutions, meanwhile, is to acquire accreditation through the outright purchase of small, financially distressed non-profit institutions. In March 2005, Bridgepoint acquired the regionally accredited Franciscan University of the Prairies and renamed it Ashford University. On the date of purchase, Franciscan (now Ashford) had 312 students. Bridgepoint took that school online and at the end of 2009 it had 54,000 students.
So what is the government going to do?
Most importantly, the DOE has proposed a rule known as “Gainful Employment.” The idea behind the rule is to limit student debt to a certain level. Specifically, the suggested rule is that the debt service-to-income-ratio not exceed 8%. The industry has gotten hysterical over this rule because it knows that to comply, it will probably have to reduce tuition.
I cannot emphasize enough that gainful employment changes the business model. Gainful employment will cause enrollment levels to grow less quickly. And the days of raising tuition would be over; in many cases, tuition will go down
By late 2004, it was clear to me and my partners that the mortgage industry had lost its mind and a society-wide calamity was going to occur. It was like watching a train wreck with no ability to stop it. Who could you complain to? The rating agencies? They were part of the machine. Alan Greenspan? He was busy making speeches that every American should take out an ARM mortgage loan.
Are we going to do this all over again? We just loaded up one generation of Americans with mortgage debt they can’t afford to pay back. Are we going to load up a new generation with student loan debt they can never afford to pay back?
If nothing is done, then we are on the cusp of a new social disaster. If present trends continue, over the next 10 years almost $500 billion of Title IV loans will have been funneled to this industry. We estimate total defaults of $275 billion, and because of fees associated with defaults, for-profit students will owe $330 billion on defaulted loans over the next 10 years.
Steven Eisman is the portfolio manager of the FrontPoint Financial Services Fund, and one of the first people to predict the subprime mortgage crisis. Adapted from a speech he gave to the Ira Sohn Investment Conference.
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