The Next Bubble?

If Steve Eisman's name rings a bell, it should. He's well-known in financial circles as the portfolio manager who took a huge bet against the sub-prime mortgage industry and made millions, as chronicled in Michael Lewis's recent book The Big Short.

I recently picked up a copy of The Big Short, and (like Mr. Lewis's other books), it's a compelling read. Suffice it to say that Steve Eisman emerges as one of the few clear-thinking individuals in the book. As an exceedingly blunt Wall Street analyst, Eisman began sounding the alarm about sub-prime loans in the late 1990s and when no one paid attention, he positioned himself to profit from the inevitable collapse.

Now, Mr. Eisman has found a new bubble, err target, the for-profit education industry. In a speech delivered to an investment conference late last month, he blasted the business, comparing it to the bankers, investment firms, government regulators and yes, borrowers, who created the sub-prime mess. His remarks have been widely circulated in recent weeks, in forums ranging from Mother Jones to the New York Post. He sees clear parallels between sub-prime lending and for-profit education, which is dominated by a handful of of "corporate" schools:

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.

Using hyper-aggressive recruiting and marketing strategies, the for-profits have signed up students by the thousands, encouraging them to use federal student loans (and other forms of government assistance) to pay for their educations. Eisman estimates that more than 50% of these students will never graduate, but they will rack up thousands of dollars in student loan debt. Ultimately, of course, the taxpayer is on the hook for these federally-guaranteed obligations. In the coming years, Mr. Eisman believes that students at the for-profits may default on as much as $275 billion in student loans, creating conditions for the next sub-prime bubble and bailout.

Is Steve Eisman correct? Certainly, his warning should not be ignored, given the continued growth of schools that specialize in adult learners, and recent Congressional action that gives the federal government a near-total monopoly in the student loan business. That legislative act is already being compared to the federal directives in the housing market, programs that mandated mortgage loans for customers who really couldn't afford them. Now, with a college loan available to virtually everyone, more students will incur debt for degrees they never complete and many will default once the note comes due, leaving the taxpayers to clean up the mess.

But in reality, the situation in sub-prime education is more complex that Eisman describes, and it extends beyond the mega-schools that dominate the for-profit market. But first, a bit of disclosure. Your humble correspondent currently works as an executive for a private, non-profit college. My institution competes against for "corporate" schools on a daily basis, across many of the market segments targeted by the for-profits. We've watched (and felt) the impact of the mega-schools, for better and for worse.

And, in fairness, the for-profits deserve some credit for helping students who were previously ignored (or under-served) by traditional, brick-and-mortar institutions. Before the advent of the University of Phoenix, Strayer University and the other corporate universities, few schools (other than community colleges) actively targeted adult learners, military personnel and other students trying to complete their education while holding down a full-time job and juggling family responsibilities.

In the past, when these "non-traditional" students tried to enroll at traditional universities, they often found course schedules that conflicted with their work hours. The few classes offered at night or on weekends were often limited in scope, and many schools offered no academic credit for military education, DATES or CLEP tests, or professional experience. The for-profits moved quickly to fill this gap, offering dozens of degree programs on-line, or at regional locations with accelerated course schedules tailored for adult learners.

Corporate schools also harnessed the power of marketing and advertising. To attract new students, they blitzed television, radio and the internet with ads touting their flexibility and accessibility. The biggest for-profit schools have literally become a "brand," backed by multi-million dollar advertising and marketing campaigns. A colleague told me that University of Phoenix's budget for education fair "give-aways" (pens, key rings, cup holders, etc) dwarfs our entire expenditure for advertising, marketing and promotion.

But the explosive growth of the corporate schools has come at a price. Students can literally call a mega-school and move from "interest" to actual "enrollment" in a single, 30-minute phone call. The result is a lot of students who ill-prepared to continue their education. When problems arise, they're (typically) referred to a call center, and conversations with academic "advisers" or financial aid counselors who know the student as only another "profit center" or number in the system. Other students are turned off by unresponsive instructors, or the outrageous fees charged for simple services (one of the biggest on-line schools charges $45 for a copy of the student's transcript).

Ironically, these practices create openings for other schools, including my employer. Our on-line program grew out of a traditional, brick-and-mortar campus, and we've worked hard to provide superior support and assistance to our students. In fact, we've attracted a number of one-line students who "began" with the mega-schools and grew disaffected. In that sense, we don't want the big boys to change their business model, because they're creating legions of unhappy students who move on to more responsive institutions.

Ordinarily, competition is a good thing and for all their faults, the mega-schools have created more choices and options for students. For example, U.S. military personnel can use tuition assistance or GI Bill benefits to "shop" among literally thousands of institutions, offering degree programs on-campus, on-base or on-line, allowing members of the armed forces to pursue a degree on the battlefields of Iraq and Afghanistan. As a result, we have the best-educated military in the nation's history, a pool of soldiers, sailors, airmen and Marines that constitute one of our greatest national resources.

Still, the high drop-out rates (and potential loan defaults) among mega-school students bear watching. But so do similar trends at "traditional" schools. The 432% increase in the cost of a higher education (since 1982) is not limited to for-profit institutions. Plenty of public and private colleges now eagerly pursue adult learners, offering on-line and "hybrid" programs, in addition to their on-campus degrees.

And these institutions still attract large numbers of students. At last report, the State University of New York (SUNY) was still the nation's largest university system, with more than 400,000 students. State-supported college systems in places California and Texas aren't far behind. Mr. Eisman might want to keep an eye on those "flagship" universities which churn out thousands of graduates every year with high-priced--but largely worthless--degrees. The New York Times recently profiled a college graduate who took out $70,000 in student loans to finance a degree in religious and women's studies. Now, she can't find a job. Are such programs the best use of federal student loan dollars? Ironically, most of the mega-schools focus on degrees (business, education, computer science) that have some value.

Truth be told, there is much that can be done to clean up the student loan program before it becomes a crisis. For starters, the feds need to give students a financial stake in their own education before the first loan payment comes due. Reduce the amount of tuition and fees covered by a loan to say, 75% of the total cost. The military did this for years with its tuition assistance program for active duty personnel and it was highly successful. With service members financing part of their education, they were (generally) more careful about finding the right course of study and sticking with it.

Similar effects could be achieved with civilian students. Not only will students shop around for the best deal, colleges and universities will determine how much students can afford to pay out-of-pocket, and price accordingly. Some institutions may still charge premium rates (based on prestige and their academic reputations), but the vast majority will be forced to hold the line on tuition costs--or even reduce them--to remain competitive.

Here's another idea: take a portion of the money currently allocated for federal student loans and put it into scholarship programs, pegged to programs and degrees that have a future, or meet specific needs. The Air Force been doing this for years with its ROTC scholarship program. Not only do applicants have to meet academic criteria, they must also agree to major in a subject (engineering or the hard sciences) that fills a projected requirement for the service. Who knows? Perhaps the prospect of a free education might entice some students to think beyond ethnic studies and interpretative dance in selecting a major.

Additionally, Congress should revoke the federal government's recently-implemented monopoly in student loans. Under the new arrangement, education finance programs will begin to resemble Medicare; the government will set reimbursement and paying bills with no regard for cost containment or efficiency. Look at the rampant fraud that permeates Medicare, and you'll get a look at the student loan program, circa 2015. Increasing choice in the student loan program--along with other reforms--will help hold down tuition costs for the next generation of college students.

One reform we oppose is a planned debt-service-to-income ratio proposed by the Department of Education, and scheduled to take effect next summer. Under that system, debt service on an individual's student loans could not exceed eight percent of their income, a rule that will (supposedly) force the schools to charge less, or see their enrollments decline.

But the ratio rule strikes us as arbitrary and impractical. Should Yale and Princeton be forced to charge less so their drama majors-turned-starving actors--pay only 8% towards student loan repayment? Or what about doctors or lawyers who attend top-flight schools and then volunteer for military service, earning far less than their civilian counterparts? In both cases, the effect will be the same: students will be repaying college loans for most of their adult lives. We believe a better reform package can be built around market-based incentives that encourages students (and parents) to borrow less, and seek academic programs that offer greater rewards, before and after graduation.

Mr. Eisman deserves credit for highlighting the looming crisis in federally-backed student loans. But the problems go well beyond the handful of for-profit schools that now dominate certain segments of the education industry. Traditional colleges and universities have been just as responsible for the spiraling cost of a higher education, taking advantage of the financial aid system as it now exists. We need a system that promotes choice and individual responsibility, regardless of where a student pursues their college degree.
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ADDENDUM: One reform we can support involves changes in the accreditation process. To receive federal Title IV funds (from the student loan program), institutions must be regionally accredited. To meet that requirement, some of the for-profits have acquired small, financially-distressed schools that have a regional accreditation. The mega-schools buy all of the institution's assets, but they're really after the accreditation, which transfers to the new owners. While accreditation bodies are private, they should mandate a new review when a school changes ownership. That would force (some) of the rapidly-growing corporate schools to improve their own academic programs, and end the process of buying schools simply for their accreditation.