June 20, 2010
For-Profit Colleges
Default Rates and For-Profit Colleges- Becker
Since a college education is expensive, many students would be unable to receive a higher education unless they got help with the financing. Some students are lucky to receive the needed resources from their parents, but many others in the United States and elsewhere have to borrow in order to attend college. The vast majority of loan programs available to students are highly subsidized by governments, either through direct government loans with generous interest rates and other terms, or through government insurance of loans from private banks combined with restrictions on the interest rates banks can charge students.
Even though student loans cannot be discharged through personal bankruptcy, default rates have been high. The average rate of default in 2007 was high, about 7%, but still much below the over 20% rate in 1990. In addition, many borrowers with lower incomes work out terms that involve slow and usually only partial repayments of the amounts borrowed. As Posner indicates, for-profits have a high default rate of close to 25% on their student loans. There is a clear hierarchy in default rates by type of school: For-profits have the highest default rates, followed by public and non-profit junior colleges, then by graduates of four year colleges, and graduates of medical and law schools, and other high earning professionals have the lowest default rates.
Since student loans are heavily dependent on government financing, governments have a legitimate and important interest in these default rates. Consequently, it is proper for governments to impose limits to colleges on both the fraction of their students who can default, and also on the fraction of students at a school who can receive government loans. However, the present default limits of 25% for profit-making institutions are too generous. Banks would be forced out of business if the default rates on their commercial loans were so high. The maximum allowable default rates should be cut to 15% %, or so. That itself, without any other changes, would give for-profit and other colleges much stronger incentives to police better who they accept as students since they would not want to exceed such more stringent ceiling on default rates.
A lowering of the permitted default rate is a far superior approach to reducing defaults than is the proposed limit on the amount of loans available to students who are expected to have low incomes. For it is hard in most cases to know in advance how much a student borrower will eventually earn. Students entering well-paying fields may turn out to do badly, whereas those entering poorly paying fields might do extremely well. Colleges have a strong incentive to police their default rates in order to remain eligible for student loans, but one can hardly expect government officials to be able to predict with any accuracy the eventual earnings of students applying for loans.
Unfortunately, various proposals to restrict loans to low earning students partly reflect the federal government's desire to bash for-profit colleges. Yet these colleges play a significant role in the portfolio of college choices available to students. For-profit colleges appeal to older and fulltime working students who never received a college education. To be sure, the quality of the courses offered by for-profit colleges are generally are not so high. But many public colleges, such as Loop College in Chicago, or Santa Monica Junior College, also offer courses at the low end of the quality spectrum, and also have high loan default rates. That for-profit colleges can compete against highly subsidized public and private non-profit schools indicates that the for-profits are offering an education valued by certain students that is not available to them at other schools.
In addition, comparison of default rates between for-profit colleges and public colleges is not the right measure of how much government subsidies they receive. All public colleges and most private ones receive large direct subsidies from various governments that enable them to offer much lower tuition levels than are offered by for-private colleges. Many students in public colleges, especially the lower quality ones, also drop out without finishing, and also receive low earnings, after having been generously subsidized by governments. The right comparison between for-profit and public schools might be the increase in earnings of students per dollar of government subsidy, no matter what form these subsidies take. The for-profits may still look worse on this measure than do the public colleges they compete against, but the difference would be much smaller than the differences in default rates.
Some argue that for-profits can only compete by misleading students into believing they will benefit much more from such an education than they will actually benefit. Clearly, some of that does occur. However, even some of the best colleges and universities are quite misleading in their advertising and other attempts to attract students. For example, very few philosophy, French, or English Lit departments warn incoming students that jobs in their fields are scarce, and that most entering students may never get a decent job using their specialized training. To be sure, for-profits tend to be more flagrant in their efforts to attract students, but it is a difference in degree.
So my conclusion is that while stiffer default rules on government subsidized student loans are needed, for-profits should not be discriminated against in these rules since they offer valuable forms of education. Moreover, public colleges receive substantial direct government subsidies that for-profit colleges do not receive. With lower allowable default rates, for-profit (and other colleges) would cut back on the number of students accepted whom they expect to eventually default on their student loans.
The Controversy over For-Profit Colleges—Posner
Conservative economists believe that the basic regulatory mechanism of a capitalist economy should be antitrust law, designed to preserve competition; because as long as a market is competitive, the self-interest of producers and consumers should operate to maximize the value of the market's output. Of course if the activity of the market participants produces external costs or benefits—costs or benefits to nonparticipants, as in the case of pollution, competition will not optimize output. Output will be too large from an overall social standpoint if the externality is a cost, as in the pollution example, and too small if the externality is a benefit, as in the case of education; hence the government's subsidization of education.
A college that is operated for profit might seem a worthy object of subsidization. That was the view of the Bush Administration and led to the relaxation of a number of restrictions on the subsidization of such colleges, and so the number of students enrolled in them soared; it is now almost one million. Under what is known as the "Title IV" program, the government makes loans to college students to finance their education. Students at for-profit colleges are eligible for thesse loans. Title IV loans to such students have increased by 500 percent since 2000 and now amount to $26.5 billion a year, which is more than a quarter of all Title IV loans. A for-profit college may not derive 90 percent or more of its revenue from such loans, and the default rate of its students may not exceed 25 percent for three consecutive years. The for-profit colleges tend to keep just below the 90 percent and 25 percent ceilings, which means that the bulk of their revenue is derived from the federal government and that the rate of default of their students on the federal loans is very high. Defaulting on a student loan is particularly painful to the defaulter, moreover, because the unpaid balance of a federal student loan can't be discharged in bankruptcy. Still, even the government can't squeeze water out of a stone, so many of the defaulted loans are never repaid.
The default rate is so high because the dropout rate from for-profit colleges is so high; it probably exceeds 50 percent on average. (The overall college dropout rate is high too—about a third—but considerably lower than the for-profit college dropout rate.) In 2007, students at for-profit colleges were only 7 percent of all students in higher education (they are now close to 10 percent), yet they were 44 percent of all students who defaulted on their federal loans.
Steven Eisman is a very able hedge fund manager who was one of the few financiers to spot (and profit from) the financial collapse that crested in September 2008. He is one of the heroes depicted in Michael Lewis's fine recent book, The Big Short. Eisman believes that there is an uncanny resemblance between the financial situation of the for-profit colleges and that of the banks before the collapse. See Steven Eisman, "Subprime Goes to College," May 26, 2010, www.marketfolly.com/2010/05/steve-eisman-frontpoint-partners-ira.html. In both cases loans—mortgage loans in the bank case, student loans in the for-profit college case—were made to people who were at high risk of defaulting, and in both cases "rating agencies" (credit-rating agencies in the case of the banks, college accreditation agencies in the case of colleges), were afflicted with a conflict of interest because they were paid by the institutions whose securities (in the case of the banks) or educational programs (in the case of the colleges) they were rating. (For criticism of the accreditation agencies, see Melissa Kornm "New Scrutiny of Groups That Accredit Universities,"* Wall Street Journal*, June 7, 2010, p. A8, http://online.wsj.com/article/SB20001424052748703340904575285014094515910.html.)
Eisman thinks that the federal government is likely to lose $275 billion on its Title IV loans over the next decade. These defaults will not have the macroeconomic consequences of the financial collapse, but they will slow our economic recovery and increase the federal deficit.
The government is concerned. The Department of Education has proposed denying eligibility for federal-financed student loans to students who cannot repay their loans within 10 years by annual payments of no more than 8 percent of their starting salary. See Tamar Lewin, "Facing Cuts in Federal Aid, For-Profit Colleges Are in a Fight," New York* Times*, June 6, 2010, p. A21, www.nytimes.com/2010/06/06/education/06gain.html?scp=1&sq;=Eisman&st;=cse. This would mean, for example, that a student whose first job paid $18,000 a year could borrow no more than $10,000.
The Department of Education has delayed action on the proposal, apparently in response to lobbying by the for-profit colleges. The proposal may eventually be watered down, if not abandoned outright, because no interest group has a big stake in shrinking the industry. If it were adopted, this "gainful employment" rule as it called might reduce student enrollments at such colleges by a third, by driving a number of for-profit colleges out of business. It would also lead to reductions in tuition for students in the surviving for-profit colleges by reducing the amount they could borrow from the government to pay college tuition. Despite their high drop-out rates, these colleges charge high tuition (often higher than public colleges charge) because the students can borrow most of it. The colleges are also very profitable, so most of them will be able to survive with lower tuition—which is a bit of a puzzle, since one expects competition to drive the average price of a product or service down to cost (including an allowance for profit, viewed as the cost of equity capital). It is possible, however, that the industry faces a sharply rising average-cost curve, so that the costs of the efficient firms are lower than the market price. In addition, demand for for-profit college education has been rising rapidly, and when demand for a product rises at a fast rate profits may rise because of delay in expanding supply.
The aggregate cost of the for-profit college industry is great. The $275 billion default cost to the federal government anticipated by Eisman is not a cost in the economic sense, but a transfer; it is money that goes from the government to the students to the colleges and stops at the colleges rather than being repaid by the students. But we cannot be insensitive to large government transfers, because they increase the federal deficit at a time when the national debt is growing at an alarming rate from an already very large base. These transfers are not costs but they give rise to costs.
The (other) costs of the industry, consisting of the opportunity costs of the teachers (and other staff) and the students, the considerable marketing expenses that the colleges incur to build enrolment, and other expenses, are substantial and the question is whether they generate commensurable benefits. Assuming that almost 90 percent of the industry's revenues are the federal student loans and that the industry's total costs are 90 percent of its revenues—the rest being profits in excess of the cost of equity capital—the total annual costs of the industry are equal to the student loans: $26.5 billion.
The benefits conferred by the for-profit college industry would consist in the first instance of any increased income of the graduates of these colleges (or of the drop-outs, assuming they attend for a significant time before dropping out) as a result of their having attended college, but also of the nonpecuniary benefits of their college experience and the benefits to society as a whole of a more educated population; the second and third types of benefit are impossible to measure, however.
It's hard to believe that the dropouts obtain benefits commensurate with the costs, especially when we consider their opportunity costs—they might have been working and earning an income rather than attending college—and the interest and other costs to them of the loans, which remember they can't shuck off by declaring bankruptcy. Among the graduates there are many defaults as well, which suggests that they don't gain a lot from college attendance so far as bolstering their incomes is concerned. So it is quite likely that on balance the costs of the for-profit colleges exceed the benefits, and that costs and benefits would be brought into closer alignment if the new 10 percent-8 percent rule were adopted.
The big puzzle is why (to return to my opening point) the for-profit college market is not self-regulating—why, for example, for-profit colleges don't emerge that set higher entrance standards and as a result can advertise truthfully that their students are less likely to drop out and therefore more likely to derive a net benefit from attending. Stated differently, if the 10 percent-8 percent rule is optimal, why doesn't competition drive the industry to that level without the government's having to intervene? For remember that most for-profit colleges would survive under such a regime, and some surely would thrive—in fact would be able to charge higher tuition than they do now because they would be offering a better product. Does anyone think that Harvard is hurting itself by having very high entrance standards? (The dropout rate at Harvard is 3 percent, and some of the dropouts, like Bill Gates and Mark Zuckerberg, go on to become billionaires.)
The solution of the puzzle may be, as Eisman argues, that the private-college industry, which is at a disadvantage in competing against nonprofit colleges because of the tax advantages, donor income, and direct state and federal support of nonprofit (including public) colleges, has targeted a class of people who cannot gain admission to those colleges because they do not meet their entrance standards. There is evidence that just as in the case of the marketing of mortgage loans during the housing bubble of the early 2000s, the for-profit colleges use aggressive advertising to attract students from low-income families that lack financial sophistication and the ability to evaluate the benefits of attending a for-profit college. These people—who may be the only people who would consider a for-profit college, because no other college would admit them—almost by definition have little information about higher education and are therefore prey to skillful marketing that even if literally truthful may create a misleading impression of the benefits of attendance at a for-profit college. For-profit colleges often pay recruiters by the number of enrollments that a recruiter generates. (The Department of Education is trying to prevent that with a new regulation.) Recruiters have been known to recruit at homeless shelters.
An alternative possibility, however, is that most of the people who attend a for-profit college understand the risk of failure but prefer to gamble on succeeding in obtaining a college degree and using the credential and what they have learned to obtain a much better job as a result—a job that will enable them to repay their loan and derive a net benefit from having borrowed it. (This is likewise a theory of why during the housing boom so many people took out adjustable rate mortgage loans, or home equity loans, that they could not "afford"—they were gambling, many with their eyes open.) College graduates earn substantially higher salaries than less-educated workers, but it is doubtful whether, in the aggregate, graduates of for-profit colleges earn enough more to compensate for the costs and the dropout risk.