At long last the details on the Department of Education’s proposal for its “gainful employment” were released. You can read an excellent summary of the proposal as well as responses from Senator Harkin, Harris Miller (NYSEMKT:CCA), and other interested partieshere. The proposal came inline with recent market conjecture, with one notable exception. The Department of Education added a “repayment rate” safe harbor to the provision. The table below summarizes the Department of Education’s proposal. For the purposes of this table, TI = Total Income and DI = Discretionary Income.
After analyzing the proposal, we think many investors are left with two primary questions:
- What does “restricted” mean for compliance purposes?
- What are repayment rates on federal student loans over a four year period?
Admittedly, when we first read through the Dept. of Ed’s proposal on gainful employment we were surprised. It appeared that the “repayment rate” would create a far reaching safe harbor, which could effectively render the entire proposal as moot except for the most extreme “bad actors” in the space. However, upon further analysis we think the provision will actually impact a greater percentage of schools that you might think at first glance. The repayment rate provision stipulates:
“….former students who entered federal loan repayment in the four most recent fiscal years, at least 45 percent would have to be paying down principal on their student loan debt. Forbearances and deferments (other than for program completers who qualify for public service loan forgiveness) would be considered nonpayments.”
The key element here is the four year measurement time period and the inclusion of student loans that are in deferment or forbearance in BOTH the numerator and denominator for the calculation of repayment. Currently, loans in deferment and forbearance are not included in the numerator for the calculation of the cohort default rate, but are included in the denominator. Based on data from Sallie Mae and other FFELP student loan servicers, a high percentage of students that seek out forbearance (economic hardship forbearance is calculated as student debt payments that exceed 20% of gross income) and deferment eventually default. Importantly, students that pursue deferment and forbearance options within the 2-year time frame in which cohort default rates are calculated and then default later are never captured in the government’s data. As we have stated before, it’s hard to imagine a regulatory metric which is a worse barometer of actual credit outcomes and more favorable to schools than the 2-year cohort default rate.Repayment Rates Could Be Stunningly Low
The notion of “repayment rate” appears to be an attempt on the part of the Department of Education to get closer to lifetime default rates. To put this in perspective, as of 7/1/09, the Department of Education was budgeting for a 47% lifetime student loan default rate for students attending 2-year proprietary (for-profit) schools compared to a reported 2-year cohort default rate of 11.0%. In our view, this discrepancy between the regulatory construct and the reality of the student loan default crisis is a primary reason why Arne Duncan has been so vigilant in his pursuit of stricter oversight of the for-profit education sector. The question now for investors is: how will the four year measurement period and inclusion of loans in forbearance and deferment as “not in repayment” impact the “repayment rate calculation?
The calculation should be relatively simple, for a school:
Repayment rate = 4-year cohort default rate + % of students in deferment and forbearance
First, let’s take a crack at what 4-year cohort default rates might look like. The table below summarizes the conclusions of a GAO report on the factors impacting cohort default rates. For FY04, the average cohort default rate for proprietary schools increased by 170.9% when the measure was expanded from a 2-year to 4-year calculation. Stated another way, if you’re trying to determine the cohort default rate for an individual institution on a 4-year basis your best bet is to multiply the 2-year rate times 2.7x.
Next, let’s evaluate the percentage of students that could be in deferment or forbearance. As part of this analysis as we have relied on data from two separate sources:
- Student Lending Analytics Blog – In October of 2009, Student Lending Analytics Blog issued a report discussing the conclusions from a recent Freedom of Information Act (FOIA) request surrounding the number of students in deferment and forbearance. According to the FOIA request, 1.1 million students for the FY07 cohort, or 33% of the entire cohort were in either forbearance or deferment. Certainly one would expect the number of students pursuing deferment and forbearance options in an economic downturn to increase, but this is an astonishingly large number to us. You can read more here.
- Fitch Ratings – On 6/1/09, Fitch Ratings issued a press release in which it outlined its estimates for the percentage of students that were in deferment and forbearance through the first quarter of 2009. According to Fitch, the rate of deferment increased to 16.4% and the rate of forbearance to 11.8%. You can read more here.
We’re going to stick with the data from Student Lending Analytics Blog since it is based on actual data to try to get to a reasonable calculation of the FY07 repayment rate. The simple math would be:
2-year cohort default rate
X 2.709 (the 2-4 year multiplier)
+ 33%, the percentage of students in deferment and forbearance on average
= repayment rate on a 4-year basis
Looking at the formula above, you probably will quickly conclude that the “repayment rate” at many institutions is likely stunningly low. In the table below we summarize our estimates for the number of OPE-ID institutions owned by each publicly traded for-profit postsecondary education company that have repayment rates of less than 45% and 35% using our methodology. Please keep in mind that these are ESTIMATES using national level data. School by school data can vary significantly. Here are our key conclusions:
- Repayment rates generally are woefully low. Based on our methodology, we estimate the average repayment rate for the sector on a four year basis is around 45-50%.
- Any school whose 2-year cohort default rate exceeds 12% could have difficulty meeting the 35% repayment rate provision, assuming national level data is indicative of trends at that specific school.
- The “repayment rate” safe harbor provides little relief from the other provisions of gainful employment for COCO, ESI, LINC, and WPO. The repayment rate metric still has negative implications for CECO and EDMC.
Please do not hesitate to contact us if you want more detail on a school by school basis or more information on the methodology we have used. The conclusions from our estimates indicate that those schools whose students face unwieldy debt burdens and poor returns on education investment will have difficulty complying with this proposal.Time to Fade This Rally?
Our analysis demonstrates that the “repayment rate” safe-harbor might not be much of a safe harbor at all. Additionally, we think a broader discussion about repayment rates in the for-profit education sector might lead to more intense scrutiny from Congress. This metric, which initially appears to prevent the sector from facing more strict oversight could actually lead to that very outcome. The gainful employment proposal has done little to change our short thesis on COCO, ESI, and WPO. Enrollment trends are starting to weaken, operating margins have peaked, and it now appears operators in the space will face far more rigorous regulatory compliance standards. We would use strength this morning to add to or initiate short positions in COCO, ESI, and WPO.
As always, please act accordingly…