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.

Comments

[Peter Cribbett]

Off topic I know but I have wondered why those 'managing' the oil leak in the Gulf of Mexico don't seem to have put the market to work. Clearly, the oil companies, the government and the commentariat are flummoxed about what to do to stop the oil flow while the relief well is drilled, which still may take several months. Why not tap the ingenuity of the rest of the planet by offering a prize of US$100 million to whomever comes up with a workable solution that manages to stop the flow? The 'prize' could be paid by BP or the government and it would take but a few hours to set up a website to accept submissions. Given the accumulating damage and damage costs already in the billions, $100 million, which would likely provide sufficient incentive to get thinkers thinking, would be a very small price to pay. I notice a website has been set up asking for suggestions but offering nothing in return. With a prize, if they get no workable suggestions the effort would have cost them close to nothing.

[Jimbino]

I have both taught and recruited for private tech schools (like DeVri, but not) who attracted mostly high-school grads who were not "college material." While the electronics teaching was excellent, of course, the recruiting and other matters left something to be desired.

Having already worked and networked as an engineer in the high-tech industry of Austin, as a teacher at the school I was, with little effort and at no cost to my students, able to place them after graduation in good technician jobs in Austin just by calling around.

I was so successful that I was finally fired for my efforts for reasons of "competing against the school placement office." To add insult to injury, the gummint denied me unemployment compensation "for cause."

As a recruiter for a different private tech school, my job was to sell the applicant and his parents on the great career prospects offered by the school. As when I had sold Fuller Brushes from door-to-door as a youth, many times I had doubts as to the ability of the family to afford the steep tuition fees as well as of the applicant to benefit from the 2-year experience.

But since the government was footing the bill, almost without question, it would have been stupid of me to waste my time qualifying the family as to finances or the applicant as to ability to gain from the tuition.

Good teachers can't teach and a recruiter can't be forthright. The only answer to this conundrum, as usual, is to get the gummint the hell out of education.

[NEH]

Once again we are all confronted with the paradox of ideals (everyone should have access to higher education) and the reality (not everyone is college material and not all degrees and majors are valued the same financially). The question becomes, What do we want from "education"; educated individuals or mere technicians in demand by industry and business? The latter can probably pay off their loans. The former, good luck. Meanwhile, the money continues to drain. And as the lament goes, "I need a full time, paying job, with benefits". I've got financial obligations I've got to meet! The answer, "Go talk to the Chinese or Indians, we're all just out of work here due to our outsourcing and offshoring". Payback of loans educational or otherwise? That requires full time employment.

[Jim]

Wow!!! I agree once again with NEH. The basic politically driven philosophy that everyone should have a college education and everyone should own a home has once agian led to a disaster for both areas. We all know about the housing bust and now we will find out about the college bust not only in the for profit sector but in the traditional sector as well. Culturally desirable and "needed" by all and promoted as necessary by politicians, the cost has been and will continue to rise faster than inflation. So not only has the quality of college gone down, the value has gone down (everyone needs a master's degree) and the politicians will stand ready to jump in to fund ore and more of this "activity". I suggest a dirct analogy to health care. Look out, professors.

[Robert Johnson]

I think you have it exactly right: there is a mismatch between the goals of society and the incentives that potential students face. As a low income prospective student I have a motivation to, as you say, gamble on higher income against a possibility of the consequences that come with default. I gamble or not according to my guesses about my individual chance of success, and the costs I'll face (what do I have to lose?) if I don't succeed. In choosing between the near certainty of a future of very low income, and the possibility of a much higher life-long income, I may consider the penalties that come with default to be low. This probably explains why more students are taking that gamble than the larger society would prefer.

[Kate McCann]

If anyone who either worked for or attended a for-profit college in Chicago's south suburbs is reading this and is willing to be quoted in a newspaper article, please call me as soon as possible. I am writing a story about the proposed rule changes on recruiting practices, and want to speak with someone who has first-hand knowledge of for-profit schools, the tuition rates and what to expect after graduation.

Thanks,
Kate McCann
Education Reporter
The SouthtownStar
P:(708) 633-5960
[email protected]

[Dennis Tuchler]

Why not make the schools with a high rate of student defaults guarantee all subsequent loans until the default rate falls below a particular level. That makes the school like a lender who eats the default, and therefore much more careful about whom to admit.

[Prototyping]

I just don't think the government can afford to spend any more money on anything right now.

[Sam]

So, you recognize the positive externalities associated with subsidizing education, but conclude that we should cut out low-income and largely minority applicants (which would be the effect of the “gainful employment” rule). We have a $90bn Title IV program. The question is distribution. Right now 25% of that goes to for-profit institutions that are statistically equivalent in graduation rates and defaults as community colleges and traditional Black colleges and universities.

My question is: If you believe in subsidizing post-secondary education, who should get the subsidies? Right now the Government collects 122% of the total amount of student loans it makes… is this a subsidy at all? And why do you characterize low-income and minorities who are attempting to gain and education and better themselves as “gambling”?

[Miguel Villarreal]

Sam - even if your statistic about default rates being the same at community colleges and for-profits is true - the fact that for-profits cost 3-4 times as much as community colleges do mean that the impact of for-profit defaults on the government as a lender is accordingly 3-4 times worse on a per-student basis.

[Sam]

Miguel - I was under the impression that tuition costs between 2-year college degrees was roughly equivalent. A quick check on my local commmunity college v. a local Devry confirms this. Do you have other information that I can look at?

[Transor Z]

Harvard might not be the best example right now, Your Honor. Recall that the IRS is currently auditing Harvard and a few dozen other higher ed institutions with an eye on their tax exempt status:

http://www.thecrimson.com/article/2009/4/23/hmc-tax-concerns-aided-federal-inquiries/

http://www.boston.com/business/articles/2010/01/12/irs_auditing_harvard_in_review_of_nonprofits/

[S]

Posner says it best when he realizes no big interest group has a stake in shrinking the industry. I can easily imagine a 2025 where the University of Phoenix has 100 times as many campuses as it does today.

The interesting part of this unfortunate situation is that we get to see the kind of growth a sector can exhibit with the right government subsidy. What if we were able to apply the same government subsidy to primary education, i.e. loans for k-12 for profit education. Assuming that consumers of these loans would be allocating their debt to the primary schools most capable of getting their children into good secondary schools we might see an improvement in primary education.

[Miguel Villarreal]

Sam, according to the Senate's report via the NYT:

the average tuition at for-profit colleges is $14,000 a year, compared with $2,500 at a community college and $7,000 in-state tuition at a public four-year college, the report found.

[Chuck Matthews, SPHR]

I am one of the market influencers. As a HR exec, I have always had a problem with the motives of educational institutions that depend upon profit to survive.

[coach sale]

Those who truly treasure the past will not bemoan the passing of the good old days, because days enshrined in memory are never lost.

[Sam]

All educational institutions depend on profit to survive, regardless of their tax status. I just spoke with a friend working for the financial aid department at a private college in Washington and he is routinely frustrated by their admissions people accepting students he knows won't be able to pay their debt. It's a competitive market - again, regardless of tax status.

Miguel, it would be good to see a net cost to the taxpayer. In-state public universities and community colleges receive subsidies above and beyond the Title IV program - something for-profit institutions don't receive.

[Jack]

I worked for a non-profit company focused on subsidized housing. We made a lot of money, we just spent a lot too. Non-profit universities seem to operate under the same principles, but we shouldn't confuse their motives with true do-gooders. For-profits are run for shareholder benefit and subject to market forces. Private universities have similar constituencies and must balance the same issues.

[David Hoopes]

Well, one thing is for sure. Any college education is really expensive. I work in the Cal State system. Our college as been squeezing out costs for 5 years. This school is running on fumes. But, it's still costs more per year than most people can afford (by costs I mean the costs to operate the school not what we charge students).

[Michael Young]

"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)."

Here's my hypothesis to explain this: the consumer-students using these colleges don't value price in the way you would expect; hence, they won't respond to price differences the way you would expect. To the extent that consumers aren't motivated by price, then, to that extent, it's not surprising that you would not see price competition; if offering a cut rate won't get consumers in the door, then why offer a cut rate?

What you *do* see (at least in tv commercials) is competition in the "it's easy!" category-- the offered programs becoming shorter and shorter, and promises of easy and convenient classes abound. Demand is apparently driven by offering less product. (As some wag once said, "Education is the only product where you *don't* want to get your money's worth.")

In other words, the market is broken because of irrational consumers who don't demand a real education and to some extent don't care about the costs.

[sesli chat]

I think you have it exactly right: there is a mismatch between the goals of society and the incentives that potential students face. As a low income prospective student I have a motivation to, as you say, gamble on higher income against a possibility of the consequences that come with default. I gamble or not according to my guesses about my individual chance of success, and the costs I'll face (what do I have to lose?) if I don't succeed. In choosing between the near certainty of a future of very low income, and the possibility of a much higher life-long income, I may consider the penalties that come with default to be low. This probably explains why more students are taking that gamble than the larger society would prefer.

[nfl jerseys]

ore: Creative Commons License: Over the 1980s, the U.S. Department of Transportation decided that somewhere in the Constitution that the power to use taxpayers' money to serve the public with two dummies Vince and Larry,http://www.epayebuy.com/walter-payton-chicago-bears-nfl-navy-jersey-team-logo-p-198.html
to the Americans to convince fund had seat belts while in their cars. The campaign slogan: You can learn a lot from a dummy. Well, yes, you can learn a lot from a plastic mannequin, or a member of Congress.

[Pandora Bracelet]

As a low income prospective student I have a motivation to, as you say, gamble on higher income against a possibility of the consequences that come with default. I gamble or not according to my guesses about my individual chance of success, and the costs I'll face (what do I have to lose?) if I don't succeed. In choosing between the near certainty of a future of very low income, and the possibility of a much higher life-long income, I may consider the penalties that come with default to be low.

[Van Gogh]

interesting what you got goin on here. could you share a few pointers maybe? im sturggling to get my blog even off the ground. you have my email if you don't want to post it here for everyone to see

[oil paintings]

Well said, such a person should be a good sentence, or the future will be more rampant.will be happy to be proved wrong with this I have to admit to a raised eyebrow with this as well.