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Gainful Employment Rules Ignore Demographic Realities

One of the biggest risks facing publicly traded for-profit educational institutions is the Department of Education's (DoE) proposed "gainful employment" rule. Under the proposed rule, schools where less than 35% of students are repaying the principal on federal education loans would essentially become ineligible. Schools with 35-45% would face restrictions on their ability to receive these loans. There are some additional income stipulations, where if debt is 8% or less of income, then the above restrictions can be waived.

Notably, the rule is set to only apply to for-profit institutions, not publicly funded 2 or 4-year schools.

The rationale for these rules is noble. The government wants to insure their investment in education is resulting in employment where the student is making enough incremental salary to show the value of the education received.

Private Sector Education Repayment Rates

Shortly after announcing the proposed rules, the DoE released a report that detailed the repayment rates at over 8,400 institutions, both for-profit and not (download it here). This release caused the share prices of many for-profit companies to tank, as several of them fell well below the 35% threshold. The consolidated repayment rates and weighted average federal debt per student at some of the larger companies were:

Corinthian Colleges (COCO) 24% ($6,794)
Strayer (STRA) 25% ($14,908)
Washington Post's Kaplan Division (WPO) 28% ($7,458)
ITT Education (ESI) 32% ($10,608)
DeVry (DV) 35% ($13,373)
Career Education (CECO) 36% ($10,775)
Apollo Group (APOL) 44% ($13,324)

Those are unquestionably some poor numbers, leading to an explosion of reactionary journalism and "analysis" that immediately concluded that the bear case on for-profit educators, of being "churn and burn" marketing institutions, must be true. In fact, a New York Times article had a quote from Debbie Frankle Cochrane, program director at the Institute for College Access and Success, that read “I think it’s notable that the for-profits are the only type of school where the majority of students are unable to repay their loans”.

With several of these companies a part of Magic Formula Investing, the issue is important to followers of the strategy (as well as investors at large). Is it really true that for-profit institutions are wholly unconcerned with educating their students? Is the problem just that the insatiable greed of capitalism is to blame for low repayment rates at private sector schools?

All Students Are Not The Same

For the purposes of this article, I'll put aside the objections raised by firms like Strayer that argue that consolidation loans, which are often structured as interest-only or graduated income repayment, are not considered in the repayment rates. That is fine, but if the methodology was the same for all schools, the net effect should be similar and bring down repayment rates for all schools.

More of interest to me was raised on Corinthian's conference call last Friday. Corinthian raised a very salient point: these companies, particularly the 2-year focused ones like COCO, ITT, DV, and CECO, service a generally low income, minimally educated demographic. In fact, up until this year a quarter of Corinthian's enrollment was "Ability To Benefit" students, a program set up by the government to allow students with no high school diploma or equivalent to attend higher education. It is of little surprise that ATB students graduated at low rates, defaulted on loans frequently, and were hard to place in jobs (Corinthian is dropping them for 2011). Most programs at these 2-year schools are vocational, and targeted at either older students or younger students that do not possess the desire, SAT test scores, or GPA to be accepted into public universities.

Could it be that the relatively low repayment rates at many of these institutions were due more to the demographic they served as opposed to the supposedly poor quality of education they delivered? I wanted to test the hypothesis.

Is There A Demographic Pattern?

One way to test the demographic theory on the DoE's data is to look at some 4-year public schools (the ones not ruined by capitalism). Data about average student incomes at public schools is obviously difficult to come by, but reputation is a good place to start. MagicDiligence operates from Baltimore, and I started there with a few inner-city and rural colleges that, by reputation, service low income demographics:

Coppin State University 23% ($11,958)
Morgan State University 23% ($14,765)
University of Maryland, Eastern Shore 31% ($12,433)

Hmmm... all 3 schools have similarly low debt repayment rates. We're off to a good start, but this is clearly not enough data. Let's stretch the example out some. Athletic conferences are built around schools with similar demographic populations, so let's look at the rest of the Mid-Eastern Athletic Conference (MEAC):

Bethune-Cookman 15% ($12,890)
South Carolina State 17% ($15,583)
Savannah State 20% ($12,511)
Delaware State 21% ($15,316)
North Carolina Central 22% ($20,367)
Norfolk State 24% ($13,325)
North Carolina A&T 27% ($12,036)
Howard 32% ($31,789)
Florida A&M 32% ($18,804)
Hampton 42% ($17,377)

Well, this is interesting! The entire conference of schools have repayment rates below 45%, and only Hampton even clears the DoE's 35% restricted threshold. 7 schools have lower repayment rates than Corinthian, the worst of the for-profits (1 is the same). And several are sticking the federal government with more than double the debt of the 2-year schools (challenging another myth that for-profits are way more expensive than public schools).

So, the MEAC should be shut down by the DoE and shorted by Steve Einsman. But is this an anomaly? What if we look at another conference of low income demographic public universities? Let's take the Southwest Athletic Conference (SWAC):

Mississippi Valley State 8% ($19,143)
Grambling State 12% ($17,111)
Jackson State University 12% ($20,433)
Alabama State 14% ($15,102)
Arkansas Pine Bluff 14% ($13,559)
Alcorn State 15% ($15,398)
Southern 18% ($19,621)
Prairie View A&M 20% ($20,833)
Alabama A&M 21% ($18,186)
Texas Southern 23% ($17,931)

That's even worse than the MEAC! The entire conference, 10 publicly funded schools, with repayment rates well below Corinthian's (drastically below ITT and DeVry), and with more than double the repayment obligations.

Clearly, Debbie Frankle Cochrane is dead wrong when she asserts that only for-profit schools have students that cannot repay their debt. But do we really believe that all of these schools are "churn and burn" institutions, uninterested in the outcomes for students? I think it is unlikely that is the case.

Summation

While I realize that this is by no means an exhaustive analysis, I think it is more then enough to show that demographics matter to repayment rates - and they matter a lot. The "best and brightest", with well-to-do families that pay a significant portion of their bills, should not be the standard for which a student who went to work out of high school to support their family is.

Furthermore, the "gainful employment" rule seems to do a very poor job at weeding out the bad apples in for-profit education - the ones that are not truly providing valuable instruction. In fact, for these low income students, the trade-based for-profit schools are a much better value than the 4-year publicly subsidized schools. They are providing jobs that allow higher repayment rates and leave students with much lower debt burdens, according to the DoE's own data!

A better plan would be to simply do what has been done - limit federal aid based on cohort default rates. This system has been fairly successful, penalizing a school when cohort defaults exceed 25% for three consecutive years (or 40% for one year). Even lowering these rates by a few percentage points would help the bad apples to shape up. If the DoE is really serious about pushing "gainful employment", for which no positive outcome studies exist, a better idea is to include consolidation loans that are current. It is unfair to penalize any school (private or public) for loans that are current, regardless of the repayment schedule.

I fear that, if passed, all this rule will succeed in is limiting educational opportunities for low income students looking to better their position in life. We need a better way to weed out what schools are providing value vs. those that are not.

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Disclosure: Steve owns no stocks referenced here.

Joel Greenblatt and MagicFormulaInvesting.com are not associated in any way with this website. Neither Mr. Greenblatt or MagicFormulaInvesting.com endorse this website's investment opinions, strategy, or products. Investment recommendations on this website are not chosen by Mr. Greenblatt, nor are they based on Mr. Greenblatt's proprietary investment model, and are not chosen by MagicFormulaInvesting.com. Magic Formula® is a registered trademark of MagicFormulaInvesting.com, which has no connection to this website. The information on this website is for informational purposes only and solely represents the views and opinions of the author. No warranty is provided or implied as to the accuracy, completeness, or timeliness of this information. This information may not be construed as investment advice of any kind, nor can it be relied upon as the basis for stock trades. Alexander Online Properties LLC, the proprietor of this website, is not responsible in any way for losses or damages resulting from the use of this information. Alexander Online Properties LLC is not a registered investment advisor. All logos are trademarked properties of their respective companies.

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Comments

Posted by ghenricks975 on 2010-10-14 12:57:22

Hi Steve,

So are you buying more of APOL?! I'm considering it although its already 6+% of our four MFI portolios and we're now 21% underwater on it. Hmmm. I read your smart analysis in August of the for profit educational industry and I was surprised at the level of non-payment in public institutions. APOL is doing much better than many of them, and I believe that APOL may benefit ultimately from increasing regs in making them a better company. I just worry that the DoE is going to come down too hard on the industry.

Posted by Steve on 2010-10-14 13:12:47

I'll be putting a full analysis on APOL up in the members section today!

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