Is the Bloom Off the Rose?

For-profit colleges have been innovators, but excesses by some of them have put the sector's success at risk, write Terry Connelly and Dan Angel.

September 30, 2011

Rapidly deteriorating share prices; rampant short selling; abrupt quarterly declines in new customers, revenue and profits; proliferating federal and state investigations; multiple lawsuits; critical Congressional hearings and reports; executive resignations and replacements; proposals for significant new industry regulations; and endless talk of loan defaults.

No, this article is not about the mortgage finance industry or the Wall Street investment banking collapse -- although it could be. All these circumstances today surround an industry that for many people might conjure images of ivory towers rather than the steel and glass canyons of lower Manhattan: for-profit higher education.

Over the past three decades, for-profit colleges have designed and implemented a business model that propelled enrollment growth at six times the rate of other American universities. This outcome has occurred just as our economy demands that the U.S. produce significantly more workers with college credentials than we are now, and do so faster. To their credit, the for-profits have made a contribution to addressing our nation’s “graduation gridlock” by catering to the growing mass of working adult students, while traditional universities have made only modest efforts to accommodate them.

Even as public and private nonprofit colleges and universities have been cutting budgets, staff, faculty, classes, programs, and student resources -- and still losing money -- the for-profit sector has continued to grow enrollments and profits until very recently. It did so by focusing on education as a business, structuring educational offerings to focus on students as customers.

But when some forgot this principle and in fact exploited their students (as well as the American taxpayer), they began a process of killing their “golden goose." Today’s for-profit colleges have become captives, as well as beneficiaries, of the Wall Street money machines that created them. Many now find that their equity shareholders are turning their backs on them just when they need them the most -- a modern “live by the sword, die by the sword” parable. What has gone wrong for an industry that until recently was flourishing? Is the bloom indeed off the for-profit rose?

How They Got Here

The for-profits started with a clean slate in designing postsecondary degree programs without the baggage of academic systems or government structures that traditionally elevated academic policy (and faculty control) over business model considerations keyed to generating shareholder returns. They first created their own national accreditation bodies to vet their new educational models and thereby earn eligibility for federal education aid dollars, but then moved on to win approval by the 1990s for their nontraditional pedagogy by regional bodies that typically served as accreditors for traditional nonprofit private and state universities.

Despite their departures from traditional academic norms, the for-profits could thus show that they were accredited in exactly the same way as traditional colleges, which helped them win credibility with potential employers of their graduates. As a result, the sector grew enrollment tremendously over the past two decades among students eligible for federal financial aid. In turn, these students’ federally subsidized tuition dollars funded the robust, sophisticated marketing campaigns that have sustained the for-profits’ drive for even further enrollment increases to respond to their shareholders’ expectations for continued top- and bottom-line growth.

Meanwhile, stubborn and foolish resistance among traditional higher education institutions to online learning models also gave the for-profit sector a golden opportunity to capture a significant “first-mover advantage." The for-profits pushed hard to remove major regulatory barriers to the expansion of postsecondary education via the Internet. They won a huge victory in 2006 when Congress eliminated the prohibition against providing federal education aid to programs delivered more than 50 percent online. While the change applied to all colleges, the for-profits’ positive approach to Internet learning, contrasted with traditional institutions’ foot-dragging, generated big increases in online enrollment in the for-profit sector even into the teeth of the Great Recession of 2007-9.

This surge was further abetted by another federal rule change that expanded the limit on the amount of tuition funding that an eligible higher education institution could receive from federal resources to 90 percent. This deregulatory change significantly increased the U.S. taxpayers’ subsidy of higher education, for-profit style. Soon thereafter, The Financial Times showed how for-profits’ operating margins were surpassing those of even the government-funded defense industry. One example noted was the two-year-old Bridgepoint Education, which reported an 85 percent increase in quarter-over-quarter revenues after the tuition limit was lifted, with a 32 percent operating margin after spending $44 million on marketing but only $39 million on education and student support.

A related driver of nonprofit online growth was the federal decision to exempt military educational assistance programs from the 90 percent limit on federal tuition sourcing. A U.S. Senate report this month showed that 37 percent of the $4.4 billion in federal military education aid dollars in fiscal 2011 went to the for-profit sector.

For-profits deserve commendation for being enthusiastic “first responders” to the special learning needs and circumstances of active duty soldiers and veterans On the other hand, a New York Times front-page article last year asserted that some for-profit military education programs “have come at substantial taxpayer expense while often delivering dubious benefits to students” -- setting them up to default on untenable debts they cannot cover even with the jobs that their degrees will qualify them for.

The for-profit sector’s increasing profit margins are leveraged on a mountain of educational debt that mortgages an unsustainable proportion of for-profit students’ future income. Ninety-six percent of all for-profit students use loans to pay for school, compared with 64 percent at public and 72 percent at private colleges. According to the College Board, for-profit graduates with bachelor’s degrees carry an average indebtedness of $33,000 -- $13,000 more than public college graduates and $5,000 more than those finishing private colleges. The top recipients of federal student aid are all for-profit universities.

For-profit college students, however, are not profiting to the same extent. They are far more prone to default on their borrowings than students at other institutions of higher learning (perhaps because they are also less likely to finish their degrees). With 10 percent of higher education enrollment, they attract 25 percent of all federal aid dollars (including Pell grants, but also account for 25 percent of loan defaults and 44 percent of loan defaulters.

Loan defaults are truly a tragedy of the first order for students, especially for those who don’t manage to complete their degree. Those who default on student loans may have their wages and tax refunds garnisheed by the government, lose their credit standing, and be denied mortgages, car loans, credits cards, and even rental apartments and jobs. But defaults are also a tragedy for the U.S. taxpayer over the longer term.

Not surprisingly, high default rates among students at for-profit colleges have captured the attention of a Congress and executive branch focused on the federal deficit, since the taxpayer, not the institution, is on the hook for loans not repaid.

Regulators seized on the statutory requirement that colleges must achieve learning outcomes that enable graduates to find “gainful employment” sufficient to pay off their loans as a possible leverage point for disciplining for-profit marketing practices and pedagogical effectiveness. Officials cited anecdotal evidence that “boiler room" recruitment tactics and lax academic standards at some institutions have led to a waste of taxpayer money on student loans with dubious likelihood of repayment

With their federal tuition aid lifeline under attack, the for-profits used their ample resources to fight back, not with educational “3 Rs," but with what could be called a “3 Ls” strategy: $8 million in lobbying; litigation against proposed new federal rules; and phantom “loans” to students, direct from the institution but written off after they bring aggregate tuition funding under the 90 percent limit.

The final rules enforcing the “gainful employment” mandate adopted by the U.S. Department of Education in June 2011 turned out to be more lenient than the original draft,. For a college program to be disqualified from federal education aid, more than 65 percent of its students would have to be delinquent in repaying their loans, and its graduates would also show loan debts that comprise more than 30 percent of their discretionary income, or more than 12 percent of their total earnings -- in each case, for three out of four years running. Thus no programs can be disqualified from receiving federal student aid until at least 2015.

Moving Forward

A perhaps more imaginative regulatory approach toward driving for-profit institutions toward a “best practice" model in recruitment and student retention practices would be to focus on the percentage of federally funded tuition that they spend on marketing as opposed to educating. The government surely has a legitimate interest in assuring that the bulk of its subsidies to the higher education sector are put to work in teaching and student support.

Just as the Affordable Care Act of 2010 has mandated a limit of 15 percent administrative expense for health insurance entities under certain federally subsidized coverage programs, Washington could look to setting a similar 15 percent limit on the amount of the 90 percent of government-funded tuition revenue maximum that for-profits (or any college, for that matter) can spend on advertising, call centers and other marketing activities. A sliding scale could be established with higher percentage limits applying for start-up institutions , and as dependence on federal subsidies decreases below 90 percent.

Such an approach would also level the playing field for nonprofit institutions (including community colleges and our own Golden Gate University) that appreciate the value of online platforms and also seek to serve the “working adult” and online markets the for-profits have captured, but without having to divert a massive share of tuition dollars to fund competitive marketing campaigns.

Because Golden Gate is routinely mistaken for a for-profit institution, given its focus on the same underserved higher education market, we have every interest in supporting whatever regulatory framework would clean up the excesses that have damaged the reputation of the for-profit sector.

The for-profits have up to now succeeded in keeping immense profits generated by their business model for themselves and their shareholders, while transferring the related student loan default risks to the U.S. taxpayer. If the subprime mortgage financial crisis taught us anything, it should be at least that this kind of separation of risk from reward is a particularly dangerous brand of economic alchemy.

Indeed, there is an eerie resemblance between practices at some for-profit schools and the subprime mortgage industry, not just in their common history of customer loan defaults, but also in their sophisticated telephone sales centers and aggressive marketing programs, which eat up almost as many federally subsidized tuition dollars as classroom and online instruction.

Some investment commentators have come to view the for-profit college industry as a clone of the subprime mortgage disaster zone. David Einhorn, a leading hedge fund guru, who correctly predicted Lehman Brothers’ financial collapse, specifically advised investors to “short” for-profit college stocks because of such similarities. This view paints with too broad a brush, but a reform agenda is nonetheless timely and essential.

For-profit lobbying and promotional organizations have insinuated that the U.S, Department of Education is actually allied with, and even doing the bidding of, the Wall Street analysts and short-sellers who have been highly critical of the shadier aspects of some of the sector’s business models. But even in a time rife with conspiracy theories, it smacks of desperation to suggest that the Obama administration is in cahoots with Wall Street speculators.

For-profit college managements should rein in their lobbyist and remember the names in the last business sector that tried to blame its regulatory and financial difficulties on the short-sellers: Lehman Brothers, Bear Stearns and Merrill Lynch, et al. That’s a whole bouquet of roses that clearly lost their bloom!

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