Subprime Goes to College

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Are we going to do this all over again?
-Steven Eisman, Testimony Before the U.S. Senate Committee on Health, Education, Labor and Pensions, June 24th, 2010

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Steven Eisman has a J'accuse moment with the for-profit education industry. He's talking about the excesses and misdeeds of the federally backed student loan industry (Title IV loans).

The for-profit education industry accounts for 9% of the students, 25% of all Title IV disbursements but 44% of all defaults. And the President of the largest for-profit institution is paid nearly 25x the compensation level of the President of Harvard. There is something wrong with this statistical progression....

Here is one of the more upsetting statistics. In fiscal 2009, Apollo, the largest company in the industry, grew 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 spent only an incremental $99 million on faculty compensation and instructional costs – that’s 9 cents on every dollar received from the government going towards actual education. The rest went to marketing and paying the executives. One 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 institutions in order to maximize the available Title IV loans and grants – thereby getting the most out of every dollar and minimizing debt burdens. Families with greater financial resources often seek higher cost institutions because they can afford it more easily. 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.

He also beats plenty hard on the for-profit education served up after families dive deep into debt.

If the [for-profit education] industry provided the right services, drop out rates and default rates should be low.

Let’s first look at drop out rates. Companies don’t fully disclose graduation rates, but using both DOE data, company-provided information and admittedly some of our own assumptions regarding the level of transfer students, we calculate drop out rates at most for-profit schools are 50%+ per year.

How good could the product be if drop out rates are so stratospheric? These statistics are quite alarming, especially given the enormous amount of debt most for-profit students must borrow to attend school.

But what about default rates? Eisner is convinced the industry manipulates the default rates, but he paints a truly horrifying picture with what information is available.

The federal government is covering defaults for the Title IV loans, so the lender has every incentive to write crap loans. After all, they're not stuck with the bill. This is awful for lots of reasons, but wait! There's more...

The companies who offer Title IV student loans also offer their own private loans as well. The loan loss provision for these loans is 50%-60%. That's money the bank is setting aside to cover defaults. When you're setting aside more than half the the amount you're loaning out to cover defaults - you're expecting a massive default rate. Under 10% is what you're looking for if you're planning on getting money out of your loans.

But why are Title IV lenders reporting that their private loans are tanking so hard?

According to Eisner, this is why:

There are two key statistics. No school can get more than 90% of its revenue from the government and 2 year cohort default rates cannot exceed 25% for 3 consecutive years. Failure to comply with either of these rules and you lose Title IV eligibility. Lose Title IV eligibility and you’re company’s a zero.

With respect to the default statistics, it is my belief that they are manipulated. Since the rule currently revolves around the 2 year default rate, the companies have every incentive to keep that statistic below 25%.

Isn’t it amazing that [leading Title IV lender] Apollo’s percentage of revenue from Title IV is 89% and not over 90%. How lucky can they be? We believe (and many recent lawsuits support) that schools actively manipulate the receipt, disbursement and especially the return of Title IV dollars to their students to remain under the 90/10 threshold. And again, unprofitable private student loans is also a way to keep below the 90/10 threshold.

Incredibly, it gets worse from there. Read Eisman's testimony (PDF)

(H/t Felix Salmon)

Late edit: Eisman's presentation is also available on Marketfolly.

A sample: