Thu, Jun 17, 2010
U.S. for-profit colleges should eat own cooking

NEW YORK, UNITED STATES - Higher education, like home ownership, has long had a nearly religious hold on America because schooling benefits both recipient and society. So there's been strong political support for programs to enroll new college students. Yet the housing debacle, and the rise of education spending, has raised legitimate questions in Washington over the costs of pursuing this dream while the for-profit sector has grown fat on subsidies.

The Department of Education on June 16 proposed that for-profit colleges must disclose graduation rates and job-placement rates. In addition, rules that prohibit recruiter pay being linked to student enrollments would be tightened. Yet the most important reform - an effort to lower student debt defaults - has been deferred for now.

For-profit colleges, and the companies that run them, including ITT Educational Services ESI.N , Apollo Group APOL.O and Corinthian Colleges COCO.O , now account for almost a quarter of U.S. Title IV loans for higher education. Their share has more than doubled over the past decade, as total loans extended to institutions increased to more than $70 billion. Moreover, federal aid makes up three-quarters of revenue, or more, at many for-profits.

Trouble is, the Government Accountability Office estimates nearly a quarter of loans made to students at for-profit colleges will default within four years into repayment. That's well over twice the rate for private non-profit and public rivals. And this study used December 2007 data, so the true default rates may be understated, as the economy has seriously deteriorated since then.

The Obama administration is weighing cutting off loans to programs that leave graduates with debt service costs greater than 8 percent of expected starting salary. Institutions that may fall afoul of this so-called "gainful employment" rule could increase quality, lower tuition, accept fewer students who take out large amounts of debt, or cut programs. Either way, the impact would sock margins, growth or both.

FrontPoint Partners, a hedge fund that advocates betting against for-profit educational stocks, estimates these changes could wipe out 74 percent of ITT Educational's earnings and cause nearly $5 a share of losses for Education Management Corp EDMC.O . Investors have partially baked in lower earnings - post-secondary education stocks trade around 12 times estimated earnings, less than half their 10 year average, according to Stifel Nicolaus.

Yet gainful employment is at best a blunt proxy for defaults. Education pays off over a lifetime, so students with a good one may not default even with very high levels of debt, while those with a poor education can default with little indebtedness. Forcing colleges to eat some of their own cooking, say, holding them accountable for 10 percent of the value of defaults, would be a better policy solution.

Institutions with the most soured loans - and those that provide the poorest education - would be penalized the worst.

For-profit colleges counter that they already have "skin in the game". Students have to pay from their own pockets or rely on private loans if tuition exceeds the amount they can get in federal aid. For those who can't find sufficient funds, for-profits often make up the gap. They say they are forced to count them as loans to keep in compliance with a law that mandates schools cannot rely on federal aid for more than 90 percent of revenue. Yet schools don't expect repayment. Default rates on these loans can be 50 percent.

These loans/gifts from colleges, however, have uncomfortable parallels with the "down payment assistance" payments that subprime lenders and home builders offered to give potential buyers a nest egg. The borrower put in nothing up front. The builders of the home sold an overpriced house and lenders a mortgage with hefty fees.

The resulting loans went bad at horrendous rates, because the borrowers were often living in houses far beyond their means. The practice was belatedly cracked down upon by regulators. To complete the analogy, students in some for-profit programs may simply be getting an overpriced education - and saddled with student loans they cannot afford.

To be fair, if students at for-profits drop out quickly after enrollment, the institutions must give back the aid. And they are also out the costs of recruiting the student. Of course, colleges can make courses easy to retain students and the revenue that goes with them, so these caveats may not apply to the truly bad actors.

Assessing the efficacy of an "eat your own cooking" rule isn't easy. Colleges usually track defaults for only two years.

Critics claim these figures are gamed, and defaults spike further down the road. But if a quarter of loans go bad, as per the GAO study, it could reduce earnings at for-profit colleges up to 30 percent - although some of this hit could be recovered if students repay a portion of the defaulted debt.

Under such a scenario, the real diploma mills would see harsher hits, which is only right. But this would require legislation. And lobbying efforts by for-profits, and the fact few lawmakers wish to be painted as restricting educational access, means such a rule would face an uphill climb. If lawmakers - and quality for-profit colleges - want to weed out the bad apples, though, it's in their best interest to implement change. -Reuters

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