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The Bubble in For-Profit Schooling

Mises Daily: Monday, April 19, 2010 by

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In the midst of economic depression, the for-profit trade-school industry is booming. Enrollment has grown 20% annually over the past two years, and some experts predict that revenue may increase as much as eightfold over the next decade. Entrepreneurs and economists alike would usually commend such a herculean performance and credit the basic laws of supply and demand at work; however, this growth has not been earned by free-market means such as innovation, efficiency, and accurate forecasting.

Instead, the giants of for-profit education have grown fat on a steady diet of government credit by cleverly maneuvering their way through a vast field of regulatory landmines to take advantage of federal-aid programs aimed at helping those they ultimately hurt — students. As expected, many have ignorantly aimed their weaponry at the profit motive, instead of unleashing their fury on the root cause: government interference in the market.

For-profit trade schools have long been marred by controversy stemming from questionable business practices and accusations of sub-par education. For example, only 16% of University of Phoenix students without prior college experience graduate within six years, compared to nearly 50% at traditional schools; moreover, Corinthian Colleges Inc., which owns Everest College, agreed to pay $6.5 million in 2007 to settle a lawsuit that claimed they engaged in false advertising by overstating starting-salary information. Unimpressive outcomes and multimillion dollar lawsuits have become synonymous with the for-profit trade school industry.

Under market conditions, such dismal performance would unquestionably have a substantive impact on a company's bottom line; after all, if an airline agreed to bring its passengers to Maui but instead brought them to Midland, a rational observer would expect the business to founder soon after. In essence, this is precisely what for-profit trade schools are doing — promising paradise in the form of high-paying jobs and delivering destitution in the form of unimpressive career prospects and heavy government-sponsored debt burdens. In fact, the average debt for students graduating from proprietary schools in 2008 was an astounding $33,050 — a substandard return on investment, considering many struggle to achieve hourly wages above $12 in the workforce.

Unlike the fate of our incompetent airliner, however, trade schools continue to fill their seats. In 2009, the publicly traded giant Career Education Corporation (CEC), which owns Le Cordon Bleu and American Intercontinental University, reported revenue of $1.84 billion, a 10.6% increase over 2008. Similarly, Apollo Group, which owns University of Phoenix, has seen enrollment nearly double since 2004. Federal loans and grants accounted for 80% and 86% of their revenues, respectively while this figure jumps to 88% industrywide. To understand how unsatisfactory student outcomes can be accompanied by increased profits, one need not look further than the effects of federal financial aid (FFA) on the industry's pricing system.

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"In essence, FFA allows for-profit schools to increase their prices significantly above what they would be in a true market."

In a free market, the ability to satisfy an obligation is a basic consideration of almost any transaction; with a reputation for not satisfactorily settling his debts, one is hard-pressed to find a willing creditor. However, creditors might be keen on accepting a high degree of risk in exchange for a larger return; this risk is directly reflected in the form of higher relative interest rates. In essence, a market has natural mechanisms for punishing credit abusers, mechanisms that decrease the likelihood that these individuals will be the beneficiaries of credit in future transactions. Unfortunately, much to the dismay of the American taxpayer, such mechanisms are not intrinsic in FFA, where everyone enjoys equal status regardless of their ability to satisfy debt-related obligations. Only in rare instances, such as prior default on student loans, will government restrict access to this ubiquitous program. While some may champion FFA by arguing the merits of readily accessible education, they fail to heed the lessons taught to us by Henry Hazlitt in his masterpiece Economics in One Lesson. In particular, advocates conveniently overlook the unintended consequences of systematically extending credit to undeserving debtors: higher prices and default.

When government offers virtually unfettered access to student loans, it artificially increases the threshold of what students can afford. Many would presume this to be a highly desirable outcome and precisely the reason FFA exists. However, this reasoning fails to account for the causal relationship between FFA and prices: tuition rates are not only based on factors such as the costs of delivering education, the industry's competitive landscape, and the economy as a whole, but also on demand, which encompasses the ability of students to pay for the education they consume. In essence, FFA allows for-profit schools to increase their prices significantly above what they would be in a true market. If FFA were eliminated or significantly scaled back, schools would be forced to decrease their prices to the point of market efficiency or face a catastrophic decrease in enrollment industrywide. Only then would students receive a market-based return on investment in their education.

Moreover, it's commonsensical that systematically extending credit to high-risk borrowers has dire consequences for creditors and debtors alike. Unqualified borrowing, in addition to paltry completion rates and low admission standards, has caused for-profit education to become a breeding ground for student-loan default. A US Government Accountability Office analysis of the 2004 federal student loans cohort default rate has shown that 23.3% of proprietary students default on loans within four years. In a private transaction, this would generally be of little or no consequence to the average citizen; however, because these losses are socialized, one can reasonably conclude that the financial success of for-profit schools is being bankrolled by American taxpayers.

Many schools have begun offering their own institutional loans to stay in compliance with federal regulations such as the "90/10" rule, which stipulates that no less than 10% of a school's revenue must come from nongovernmental sources; failure to adhere to this guideline could result in FFA funds being frozen, a cataclysmic result for any of the major trade schools. To prevent the well from drying up, CEC planned on giving approximately $50 million in institutional loans in 2009, which helped them maintain a sufficient gap between public and private student funding. Interestingly, some schools are setting aside as much as 50% of these reserves as losses, clearly indicating that they have relatively little faith in the ability of their students to honor debt obligations. One cannot help but wonder how taxpayers can reasonably expect to collect their dues when for-profit schools can't collect such debts themselves. There is something terribly awry with this system.

Conclusion

 

Government interference in the marketplace has allowed for-profit schools to realize immense profits at the expense of American taxpayers. By offering virtually unfettered access to FFA, these institutions are able to increase prices significantly beyond true market value to students who pose a high risk for default. Privatized profits and socialized losses are the result of such a system.

Profits, per se, are not to be demonized; rather, the role of government-backed loans in private transactions must be called into question. For-profit schools can play a significant role in educating a traditionally underserved market; however, for their thousands of students to be the beneficiaries of such education, the market must be freed of governmental involvement.