June 27, 2010

Student Loan Market Created a Tuition Bubble Rivaling the Housing Bubble

When Banks and Government Subsidize Markets the Average American Gets an Education in Debt Serfdom; For Profit Schools Dominate the Pell Grant Market

Finance My Money
June 8, 2010

Recently a handful of articles have discussed the rise of subprime debt in higher education. Broadly speaking a college educated American has lower unemployment, higher earnings, and a better potential for financial success.

Like the housing market, the emotional notion that everyone should own a home allowed the predatory banking industry with government support to funnel out mortgages to people with no ability to pay it back. The consequences are still rippling throughout the current economy.

Today the higher education market is seeing all the traits of a bubble and certain parts of the industry dominate the toxic loan market. Many of the for profit schools are more adept at tapping into Federal funds and marketing and pump out degrees with learning outcomes a step above a paper mill. They have no student learning outcomes attached to their funding source so they have no federal mandate to report how successful their students are in getting careers after graduation.

If we look at the rise of education costs and housing from 1993 to the present, we can see an exact trend with housing:

Source: Census

It should come as no surprise that over this timeframe, the cost of college and housing have risen at nearly the same pace. Why? Part of this comes from the massive amount of debt used to finance these markets.

With housing for the large part of the last decade people were able to purchase homes with nothing down. Qualifications for loans were diluted so anyone with the mere desire to buy did. A fleet of commission hungry brokers and companies made sure they gave loans to everyone even if they had no ability to repay it back.

When you disconnect success from the lender to the borrower you will find that predatory lending will take place. The student loan market has been the major reason why college costs have inflated at bubble like trends:

Source: New York Times

Over the last 30 years the cost of college has soared by approximately 500 percent. This has outpaced medical care costs and the median family income by a sizeable portion. The outrage should be directed at Wall Street and the government for inflating the market.

You will hear these people argue that costs are rising because operational costs demand prices to go up but this is simply nonsense. Even studies that look at increases in federal grants and loans show that institutions will basically raise their tuition to meet the change in financial aid:

“(Chronicle) The finding tends to support what is known as the “Bennett hypothesis” — the notion, first popularized in the 1980s by the U.S. secretary of education at the time, William J. Bennett, that colleges and universities tend to absorb most federal student aid by increasing their tuition revenue.

The new paper, by Larry D. Singell Jr. and Joe A. Stone, both professors of economics at Oregon, employs a much larger data set than most previous tests of the Bennett hypothesis. Mr. Singell and Mr. Stone examined data from 1,554 four-year colleges and universities from 1988 to 1996. They drew on institutional data collected by the National Science Foundation and by the U.S. Department of Education.

Mr. Singell and Mr. Stone found that public colleges’ tuition for in-state students did not rise in tandem with Pell Grant levels. But private colleges’ tuition, and public colleges’ out-of-state tuition, increased by roughly $800 for every $1,000 increase in Pell recipients’ average grants.

Much of that additional tuition burden, the scholars suggest, is borne by students whose family income is relatively high. The Pell Grant program generally succeeds at expanding lower-income students’ access to college and at allowing lower-income students to attend more expensive institutions than they otherwise would, according to the paper.”

So the market simply adapts to suck up this added easy money like a debt hungry vacuum. You can see how flawed this policy is with the Pell Grant program. The Pell Grant like most programs started off with good intentions. It was designed to help low income families finance the cost of college. A National Postsecondary Study found that in 2000 families making less than $41,000 accounted for 90 percent of Pell Grant recipients. Now this in itself isn’t a problem if students come out with solid educational outcomes. But what is happening is a perverse scamming of the system by the for profit machine of education. This is the true subprime market of education.

They argue that everyone should have an opportunity to have an education no matter the cost (sounds familiar to the everyone should own a home argument). Of course these so-called equal opportunists don’t work for free and charge massively higher rates than local public state schools (you can see the massive profits of these for profits as they trade on the stock exchanges). And here is where you see the problem arise. For profit schools cover 6 percent of students but eat up 20 percent of the Federal Pell Grant money. University of Phoenix is number one here pulling in $656 million in revenues from Pell Grants. This is taxpayer money going to an institution that does not have to show educational learning or career placement outcomes. How many of their graduates are working in the field that they studied for? What is their career placement data?

Of course these for profit institutions are fighting tooth and nail to stop any legislation that will tie funding to educational outcomes because it will expose them for the subprime education market that they are exploiting.

Then on the other side you have massive amounts of loans subsidized by the government for other students. Story after story is now coming out about students coming out with $50,000, $75,000, and over $100,000 in student loan debt from private schools and students are unable to find jobs. The tired argument is that a student signed on the dotted line and got an education. But that doesn’t address the bigger issue of college tuition inflation. Of course the hand of Wall Street is deeply involved here as well:

Recognize a few names? You should. These are the same players in the toxic mortgage lending market that received trillions in taxpayer bailouts for their horrible loans in real estate. Of course they don’t care about originating standards or putting undue stress here because they know the government is on the hook here as well. So now, what we see is this inflation bleeding over into the public school system:

Source: OC Register

Here is an interesting chart. The University of California is one of the biggest public higher education systems in the world with a solid reputation. Back in 1990 the cost to attend the UC was under $2,000 per year. At that time, the median household income was making $33,000 in California. So the cost was 6% of total median annual household income. Today, the median household income is $57,000 and the cost is over $10,000 per year. It now eats up 17% of the annual household gross income. In other words, the increase in tuition is far outstripping any gains in family income. Clearly people are finding other ways to pay and school are finding other ways to make money.

So why is this all happening? Because the government is operating under the advice of the banking system. Wherever Wall Street has had its hand in the last few decades bubbles just seem to spring up, (i.e., housing, higher education, tech boom etc) because it enslaves the population to debt while not actually paying attention to longer-term fundamentals. The reason college costs keep going up is because people can get government backed grants and loans without any outcome showing the ability to payback. Institutions simply raise fees to match this added funding.

Just look at the housing market once the easy money is pulled back. Prices fall. This will happen in higher education as well if we stop spending money needlessly. Why not use that money to add classes at local community colleges?

And those that currently capitalize are the for profit schools that market heavily to poor populations, enroll students, saddle them with debt, and have no need to show their long-term outcomes. This is subprime part two and the American people will be on the hook again while the predatory leeches get away with another bailout.

When will people see that anything the banking industry touches turns into a method for bleeding it dry?

For-profit College Enrollment Soared 418 Percent; as Much as 80 Percent of Their Total Revenue Comes from Federal Student Loans

The Lookout
May 26, 2011

The number of bachelors degrees given out by for-profit colleges skyrocketed by 418 percent since 2000, according to data from the National Center for Education Statistics.

Of the 4.4 million students who enrolled in college between 2000 and 2009, 27 percent of them enrolled in private for-profit institutions. The decade before that, only 7 percent of new undergrads enrolled in for-profit schools. The industry's success is partly due to its unorthodox focus on advertising and recruitment.

For-profit schools such as the University of Phoenix and ITT Technical Institute have drawn criticism from education wonks and lawmakers for aggressive recruitment tactics targeting low-income students. Detractors note that many for-profit schools hire recruiters working on commission to tap into people's "pain" and feelings of inadequacy.

Many for-profit colleges get as much as 80 percent of their total revenue from their students' federal loans--and a good deal of that money goes right back into the schools' advertising campaigns.

While for-profit students only account for about 12 percent of all college students, they take up a quarter of all federal grants and represent 43 percent of all defaults, according to data from the federal Department of Education. The industry is currently fighting a bevy of new restrictions from the Department of Education, and argues that its default rate is high simply because its schools serve more low-income students. Officials at for-profit universities also point out that many community colleges--which typically cater to a lower-income student population--are overcrowded, and that for-profits provide an alternative.

But the Department of Education study calls into question whether for-profit schools are worth their relatively high price. For-profit schools are more expensive than public schools, yet spend far less per student than those institutions on average. From 2000 to 2009, for-profits devoted 24 percent of their total expenses to instruction, while nonprofit public schools spent 28 percent and nonprofit private schools spent 33 percent on instruction.

Overall, for-profit institutions spend less money per full-time student, as you can see in the chart below:

Yet for full-time students, four-year for-profit schools charge more in tuition and fees than public schools:

A larger share of for-profit undergrads take out loans to pay for school, compared to their peers at other schools. More than 80 percent of students at for-profit four-year colleges have a student loan, compared to 49 percent of all undergraduates. And many of those students won't have a degree to show for their debt. Over six years, only 22 percent of students at for-profit institutions graduate with a degree, compared to 65 percent at private non-profits and 55 percent at public schools, according to the study. (Two-year for-profit programs out-performed two-year public schools in graduation rates, however.)

How a Tiny Bank Made Millions in Bad Student Loans

Money Blog

A little bank on the Kansas prairie made hundreds of millions of dollars in bad loans over the last few years and big profits for itself while playing a key role in pushing the nation’s student loan system to the brink of a crisis. Operating in a converted grocery store, the tiny Bank of Horton came to rival Citicorp as a student lender admittedly exploiting a federal program for needy students. Horton has issued nearly $1 billion in loans over the past five years even as its loan default rate grew to 40 percent, according to interviews and documents obtained by Newsday.

Despite that rate of default, almost four times the national average, the bank made big money from loans made to trade school students. There were virtually no risks to the bank, but there were consequences for the federal government, which picks up the tab for almost all defaulted loans.

Located in a region of rolling prairie that produce corn, sorghum and soybeans, the bank dominates the town of 2,000 where the only other big building is the Bureau of Indian Affairs, where residents flock to the Kickapoo Indian reservation to buy cheap gas and no liquor is sold by the glass.

At its peak, the Bank of Horton processed about 2,000 loans a day from as far away as Long Island and Florida, employees said, and sold them quickly for a fast profit. The bank used high-rate certificates of deposits to lure money so it could make the loans. It hired local women to handle the paperwork and paid wages so low that many were eligible for welfare.

All along the way, federal regulations allowed the bank to operate and even prosper without the kind of control that could ensure that the system would not be exploited. Even when a regional Department of Education auditor found the bank did almost all of its business in student loans — contrary to federal regulations — the bank got his bosses back in Washington to bend the rules.

While officials in the General Accounting Office have long warned of student loan problems, it was only in May that the Bank of Horton was reined in –the Federal Deposit Insurance Corp. told the bank to change its practices. Horton, which posted losses this year after a tide of defaults nationwide dried up the resale market for its loans, has even had to lay off a couple of dozen workers.

Most of Horton’s loans were insured by the Higher Education Assistance Foundation, which last month told the Department of Education that it does not have enough funds to cover its obligations for more than $1 billion in bad loans, triggering a scramble to bail it out.

The troubles of HEAF, which was the largest loan guarantor, shook the financial markets and the student loan industry last month. Never before had a guarantor said it couldn’t meet its obligations to holders of the loans.

Federal education officials say another half dozen of the more than 50 guaranteeing agencies are in a fiscal danger zone. And if they follow HEAF’s pattern, students could find it much harder get loans for school.

While the Bank of Horton is not the only cause of the troubles in the student loan business, it provides an unusual look at how lenders have contributed to the growing student loan debacle, a small-scale version of the savings-and-loan crisis. The cost of defaults to taxpayers has been rising and this year will exceed $2 billion.

“The Bank of Horton is a spectacular example of the whole student-loan problem — it made a lot of risky loans,” said Gary Beanblossom, an analyst in the Education Department’s student loan division. “I always associated Horton with HEAF.”

Horton officials see themselves as simply carrying out a government mandate. In their view, Washington said to make educational financing available to everyone, absorbed much of the risk and the bank merely obliged.

“If you see a niche in a government program run out of Washington, D.C., and you exploit that niche in an honest way, you’re doing what Congress intended you to do,” said Craig MacPherson, a director of Horton. “The fact that the Bank of Horton exploited that niche is partly to Horton’s credit.”

Horton’s chairman, majority shareholder and, until last month, its president, Vance B. Norris, said the bank served as a key-player in an effort to educate the underprivileged.

“Everyone can’t go to Harvard,” Norris said, noting that “three kids out of five can pay back the loans” made by Horton. The other two represent what he called “the social tradeoff.”

“If the public doesn’t want to bear the cost (of the loan program) they’ll pay the costs with more people on the welfare rolls,” Norris said.

Student loans are intended to help people who wouldn’t ordinarily be considered good credit risks by offering guarantees, subsidies and various payments to lenders and insurers. Banks make the loans, which are administered and insured by middlemen agencies such as HEAF. The government subsidizes the interest and makes interest payments while the students are in college. Everything works well as long as students make their loan payments, which start soon after graduation... But if the student defaults, the federal government is ultimately liable.

In recent hearings before a Senate subcommittee, Education Secretary Lauro Cavazos said the loan problem is due to poor oversight by agencies that accredit trade schools.

“We’re going to have to work a lot harder to see that this problem doesn’t happen again,” Cavazos said.

Trade schools operated for profit, where students learn to cut hair, tend bar or fix appliances, have long drawn the scrutiny of government regulators because of high default rates and questionable recruiting practices. In 1987, the last year for which figures were available, the Education Department said the default rate at for-profit trade schools was 33 percent, while it was only 7 percent for public four-year colleges. Sherwood Johnson, director of student financial aid at SUNY-Stony Brook, said that even after they finish and get jobs, trade school students often cannot afford to repay the loans.

HEAF Chairman Richard Hawk acknowledges that the risky trade school loans in which HEAF specialized were the cause of his company’s problems. While declining to discuss details of HEAF’s relationship with Horton Hawk said,

“I’m not trying to suggest that the Bank of Horton or any other lender to vocational schools was not a problem. It was. But if you only have one, it wouldn’t be a problem.”

While neither HEAF nor Horton will divulge the extent of their business dealings, bank officials said that HEAF used to be the guarantor for all their loans, at least until the late 1980s, when the relationship began to sour. Based on the bank’s default rate on its almost $1 billion in loans issued, Horton’s bad loans could have totaled up to $400 million, much of which would have ended up with HEAF.

Trade school loans were a new line of business for the Bank of Horton, which was founded in 1887 and specialized for much of its history in the agriculture loans that fueled the commerce of northeast Kansas.

The Norris family had long owned the bank when Vance Norris took control in 1977. But it wasn’t until 1985 that the bank began going after student loans in a big way. It was then that his wife’s brother, Tony Pizzuti, a former insurance salesman from Philadelphia who became a high-ranking bank official, said he noticed the profits possible in student loans. The bank started a huge growth spurt that saw its assets go from $20 million in 1987 to $275 million at the end of last year.

The student loan business quickly made Horton one of the most profitable banks in the country in its rate of return. At its height, the bank was showing almost 50 percent return on equity. By March 1989, the return for that quarter had dropped to 23.81 percent, which still put it near the top. In a testament to its success, the bank’s headquarters has an impressive interior complete with dark wood paneling, brass rails, and hunting prints.

It was all made possible by mastering the details of the Great Society program begun under President Lyndon Johnson in 1965.

Because the program was too cumbersome to run from Washington, Congress authorized middlemen, such as HEAF, to administer the program and guarantee the loans to the banks.

Students contact the financial aid office at their school, which certifies that they are enrolled, not in default on a previous student loan and have income below a certain level. The school will provide a list of lenders it does business with, and Horton aggressively marketed itself to the trade schools across the country.

The bank issues the loan with backing from one of the guarantor agencies. Included in the loan are an insurance fee that goes to the guaranteeing agencies and helps make up costs in case of default.

The government generally makes the interest payments until the student graduates. Then the bank, or an outfit to which the bank has sold the loan, tries to collect from the graduate. If prescribed collection efforts fall, the holder of the loan turns to the guarantor for reimbursement, and the guarantor duns the Department of Education.

On most loans, known as Stafford loans, the government provides a guarantee and subsidizes the difference between the 8 or 10 percent the student pays and the market rate. Others, known as supplemental loans for students, or SLS, are guaranteed, but not subsidized.

Almost all the 50-plus guarantee agencies are state-sponsored and operate within those boundaries. But HEAF, one of a few private guarantee firms, went nationwide, depending on high volume to generate money. So did Horton. HEAF used to have a large business in New York and after dropping out briefly a couple of years ago, had started a comeback in the state. Most lending in New York is now guaranteed by the state’s Higher Education Service Corp.

The Bank of Horton’s move into student loans coincided with the growth of HEAF, headquartered two hours away in Overland Park, Kan. The relationship between the two became close because HEAF is the designated guarantee agency in which means it had to accept loans made by Horton.

In the early 1980s, HEAF was revolutionizing the student loan business by reducing the turnaround time on loan approvals from two months to two weeks. HEAF eventually would become the nation’s largest guarantor, concentrating its business in high-risk trade school loans. In June, 1988, such loans accounted for 59 percent of its business, according to Hawk.

Horton also used quick turnaround time to market its loans. Promoting itself at everything from trade school conventions to the Kansas state Fair, Horton became a leading lender to for-profit trade schools as far away as New York, including the now-closed Ultissima Beauty School that operated on Long Island and in New York City.

In 1988 alone, the Bank of Horton originated a phenomenal $398 million in all categories of guaranteed student loans, second only to Citibank with $571 million, according to the DOE’s Beanblossom. Last year, after the balloon had started to deflate, Horton slipped to fourth place, with $263 million, behind Citibank and Bank of America and in a virtual tie with Chase Manhattan.

Horton’s default rate was staggering, however; it led the nation in 1987-89 with $66.8 million in defaults in the one category of student loans — supplemental loans for students –studied by the General Accounting Office.

The only risk for lenders involves collection procedures. The Department of Education can refuse to cover a bad loan if the lender doesn’t follow a series of steps to try to collect on loans that go bad. Because of high defaults on trade school loans, the steps can cost the lender time and money. Horton sidestepped this risk by selling the loans as soon as it made them.

“Many banks did not want to get involved with trade schools,” said John J. Conard, a former HEAP official who left four years ago. “But the Bank of Horton didn’t really care if it was a trade school. They would take all comers. They didn’t too much care if the loans went into default or not.”

Horton chairman Norris said that it isn’t his job to pass judgment on the creditworthiness of borrowers. He said the Department of Education makes the lending choices by deciding which schools can participate in the student loan program.

Horton made big profits by selling the loans. If Horton lent $2,500 to a would-be truck driver, it quickly sold the loan to the Student Loan Marketing Association (Sallie Mae) or some other buyer for a 1 percent fee. Despite high default rates, there was little risk to the buyer because the federal government guaranteed them.

The $25 fee doesn’t sound like much until one considers how many loans Horton made. Then the numbers become staggering. At its peak, Horton made as many as 2,000 loans a day. High-cost money garnered from high-interest deposits — a practice frowned on by the FDIC — was used as the pool of capital from which to make the loans.

To improve his bank’s processing time, Norris hired hundreds of people, almost all of them women, for only pennies above minimum wage. Twenty-two people worked at the bank in 1985; that figure had grown to 260 by last December.

But Horton made so many student loans that it found itself in conflict with a law limiting banks to having no more than half of their business in student loans.

“We had been aware of the 50 percent rule,” Norris said last week. “It became more and more disturbing.”

The Department of Education had done nothing about Horton’s gross imbalance until its inspector general’s office started to look into the situation in early 1988. The auditors found, not surprisingly, that Horton was in violation of the 50 percent rule.

In search of relief, Norris turned to his congressman, Democrat Jim Slattery. Slattery helped Horton secure a hearing at DOE, Slattery and Norris said. Election records show Slattery got contributions of $500 each from Norris and Pizzuti, though the congressman dismissed any connection.

The result was a special agreement dated March 24, 1988, and signed by Dewey Newman, then deputy assistant secretary, that helped Bank of Horton get around the 50 percent rule.

“It got a clean bill of health from the DOE inspector general when I was helping them,” Slattery said.

A report signed by Rodney Small, then director of the DOE’s inspector general regional office in Kansas City, Mo., stated that the Bank of Horton was in full compliance with laws and DOE’s rules and regulations.

Reached at his home in Kansas City, Kan., Small, who has since retired, said, “the program people back in Washington” gave the bank “some sort of waiver or special dispensation” on the 50 percent rule.

Another government auditor familiar with the Horton situation but who didn’t want his name used said it was unusual for DOE to make such an agreement and he had never “come across anything like that.”

Rodger Murphy, a DOE spokesman, noting the waiver took place before the current administration took over, said the department had no further information on it.

Practically all the upper-level officials at the Department of Education who were there then have left by now. So has Saul Moskowitz, former chief counsel for the loan program, identified by Norris and Small as a key person in resolving the dispute.

Moskowitz downplayed the agreement, saying the law allowed leeway in interpretation of the 50 percent rule.

The agreement allowed the Bank of Horton to buy up servicing contracts on home mortgages, but not the mortgages themselves, and to count the full value of the mortgages as assets to offset its student-loan portfolio. Loan servicing is the handling of mortgage paperwork for a fee.

Moskowitz left DOE to become a partner in the Washington law firm of Clohan and Dean, which represents the Consumer Banker Association, a trade and lobbying group for banks in the student-loan business. Newman, who approved the agreement, has also left DOE but could not be located for comment.

Meanwhile, HEAF was having its own problems. As more and more loans go bad, HEAF has to repay the banks and get reimbursed by the federal government. But because of federal rules that penalize agencies with high default rates, it lately has been getting only 80 cents on the dollar. HEAF has had to drain its own reserves for several years to make up the difference. Despite insurance charged students and fees paid by the government, HEAF posted a deficit of $44 million last fiscal year and is losing a similar amount this year.

The relationship between HEAF and Horton began to sour as well...

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