An American Tragedy Brewing

http://www.dailywealth.com/1775/An-American-Tragedy-Brewing

An American Tragedy Brewing
By Porter Stansberry
Friday, July 1, 2011

For the past two days, we've been talking about what I call "New American Socialism."

As I explained, in New American Socialism, the power of the system produces private profits. It began when Nixon took us off the gold standard. Without the tie to gold, the amount of economic mischief our government could engineer became practically limitless.

Today, I'll show you an example of how New American Socialism works and how thoroughly corrupted the system has become, and I'll begin to set up our challenge as investors today...

While you're reading today's essay, I want you to think about whether you're willing to make a profit on a business that couldn't survive without government protection... whose products aren't saleable in a real market.

In other words: How mercenary are you?

To answer that question, we're going to take a look at a tragedy that's brewing right now...

For many decades, the government has supported higher education in America. Does the government give money to actual students based on their achievement? Yes... but that's a small part of the program. Most of the government money spent comes via access to student loans – so-called Title IV funding.

A host of rules apply to these loans, but knowing just a few of them is instructive. The most important rule relates to a college's total revenue mix. To access Title IV funding, a college cannot receive more than 90% of its revenue from government-related sources. The government is allowing the market to determine whether or not a college is useful and legitimate by requiring it to earn only 10% of its revenues from private sources. (Does this sound smart to you? It's tantamount to requiring only a tiny down payment to buy a house. It's dangerous because the student – and the college – doesn't have much skin in the game.)

There's another important rule. Colleges can lose access to government-backed funds if loans made to previous students experience default rates in excess of 25% for three consecutive years. (Naturally, the rule has a key loophole, which I'll discuss in a moment.)

These two key rules, which leave the government on the hook for 90% of the risk of the student loans, led to the creation and massive growth of the for-profit education industry.

Clever entrepreneurs realized a traditional college education wasn't practical for many students who lacked either the cognitive ability to succeed at a traditional college or the desire to acquire a liberal arts education. What many students wanted, could master, and could afford were essentially trade schools that taught skills in demand from local employers. For-profit education grew up competing with poorly funded community colleges. And they had a major advantage: huge marketing budgets.

Let me show you what this means in terms of how these for-profit schools spend the Title IV money they receive.

Apollo is the largest company in the for-profit education space. In 2009, Apollo grew its total revenues by $833 million. Yes, you read that correctly – $833 million in revenue growth during a severe recession. Its Title IV funding rose by $1.1 billion. That is, the amount of government-related loans and grants it received increased by more than its total revenue growth. The company became even more dependent on the government.

Where did the money go? Not toward education. In 2009, Apollo increased its spending on faculty and other instructional costs by $99 million. That is, out of every $1 it got extra from the government, it spent roughly $0.09 on actual education.

Instead, a lot of money went to shareholders. Since 2008, Apollo has spent more than $1 billion buying back its own stock. But most of the money went to its executives. Apollo currently spends almost $1.5 billion annually on compensation for its administrators and salesmen.

In one way, you can argue for-profit education executives have earned their paychecks. Enrollment is booming, with the public showing a clear preference for the curriculum offered by the for-profit schools. Since 1986, enrollment in the sector has grown sixfold. The U.S. now has 2,800 for-profit institutions of higher learning. About 10% of all college students are now enrolled in for-profit schools.

And you can make a good case these firms are providing a valuable service at a reasonable price. Supporters of the industry note that average revenue per student is the lowest at for-profit colleges: $11,130, while public universities average $18,922 per student and private not-for-profit colleges received $37,869 per student.

So are these students (and our society) getting a bargain? Does foisting 90% of the risk on government lead to positive outcomes? No, not really. Instead, much like Fannie Mae did to housing, these government guarantees create huge incentives for selling college to students who can't afford it. It also makes college more expensive and less affordable.

The most recent examination of student-loan repayment shows for-profit education students have much higher default rates. In 2008, the national default rate on student loans was 7%. The default rate for private not-for-profit schools (the most expensive) was 4%. The default rate for public not-for-profit school loans was 6%. The default rate for private for-profit schools was 11.6%. U.S. Secretary of Education Arne Duncan said of the numbers:

The data tells us that students attending for-profit schools are the most likely to default... Far too many for-profit schools are saddling students with debt that they cannot afford in exchange for degrees and certificates they cannot use.

When you look at the default figures in aggregate, the problem jumps out at you. Students at for-profit schools represent 26% of the borrower population. They make up 43% of all defaults.

When I saw that number, the first thing that occurred to me was... "Wait a minute... I thought schools get kicked out of the program if default rates reach 25% for three consecutive years? How can for-profit schools represent so much of the default rate when they make up so few of the students borrowing?"

The answer is – borrowers who default after the first two years of repayment aren't counted.

What?!

That's right. To count as a default, you have to stop repaying your student loans in the first two years after graduation. The repayments required during this time are extremely low – much like the teaser rate on a subprime mortgage. The real extent of the problem can't be understood until you see the actual default rate on all loans. After all, the real default rate isn't the percentage of students who default in the first two years. It's the percentage of borrowers who never repay their debts. What is the real number? Well, we don't know. The Department of Education won't make that data public.

What we do know is the companies themselves write off between 50% and 60% of the private loans they make to their students.

The companies use these private loans to make sure they stay within the 90% rule that governs access to the government's backing. That's tantamount to the many second mortgages that were made on the side to homebuyers, so they could afford their down payments. And not surprisingly, when folks buy a home using 100% borrowed money or when they get a college degree using 100% borrowed money, they frequently won't (or can't) pay the loan back.

I have no objection to a private lender who decides to lend to poor credit risks – even for things like an expensive home or degree. But let that lender bear the risk. Don't pass those risks to me via government protection.

Obviously, with 50% to 60% of these loans defaulting, the only real profit in the system comes from the government's protection. And the scary part is the amount of government money flooding into these schools is soaring.

Historically, little government money was available to these schools – only $2 billion to $4 billion a year. But then... with the right kind of legal corruption... the floodgates opened.

Sally Stroup was the head lobbyist for Apollo. In 2002, she became the assistant secretary of the Department of Education under President Bush. Guess what happened next?

Stroup gutted the rules that governed which students these schools could recruit. Government funding for for-profit college education is now more than $20 billion a year. And at current growth rates, within 10 years, 40% of all government-backed college funding will go to for-profit education.

Call it socialism. Call it New American Socialism. Call it compassionate conservatism. It doesn't matter what you call it, the rules of the game are clear: The government takes all of the risk while investors and executives keep all of the profits.

This brings me back to the challenge I outlined above. After reading today's essay, would you buy shares of Apollo? They're cheap, trading at about 3.5 times cash earnings, and the U.S. Treasury has essentially guaranteed its future revenues.

That's certainly attractive. But knowing what you now know about the for-profit education business, do you want to own this company?

I can't say what the right answer is for you. But I know my answer. I'll share it with you tomorrow.

Regards,

Porter Stansberry


Further Reading:

"Whose wealth and power increases with inflation? Whose stature in society grows alongside the government?" Porter asks. "Who profits from increased spending on wars, prisons, and social programs that are doomed to fail? And most of all... who profits from an explosion in debt?"

Get the answers in Part I and Part II of his series here: New American Socialism and here: Why a Full-Scale Economic Collapse Is Inevitable.