This Government Rule Should Make You Irate

As a former teacher, I've been following the for-profit industry intensely as it has self-destructed over the past year. To say that I'm not a fan of the industry would be a vast understatement.

And yet, last month I went looking to see if there was a diamond in the minefield of for-profit education. Before yesterday, there were three key rules -- as laid out by the Department of Education -- which investors needed to consider before putting their hard-earned cash toward the sector:

  1. New student enrollment numbers.
  2. Adherence to federal funding guidelines.
  3. Student loan default rates.

As of today, we can add a fourth metric to our list: gainful employment rules, which were released yesterday by the Department of Education. The new rules go into effect in July 2012.

A boost for the industry
By far the most contentious piece of legislation, the gainful employment rules are a far cry from what they were before the for-profit education industry sent their lobbyists to Washington. This almost immediately created a boost for investors in the sector, as stock prices sky-rocketed upon market opening today.

The following chart shows percent increases for education stocks on today's market opening.

School

Close on June 1, 2011

Open on June 2, 2011

Change

Corinthian (Nasdaq: COCO  ) $3.99 $5.44 36.34%
ITT (NYSE: ESI  ) $70.73 $89.12 26.00%
Education Management $20.30 $25.42 25.22%
Strayer $121.87 $147.88 21.34%
Career Education $22.87 $27.02 18.15%
Lincoln (Nasdaq: LINC  ) $14.59 $17.06 16.93%
Grand Canyon (Nasdaq: LOPE  ) $12.82 $14.79 15.37%
DeVry $53.99 $61.75 14.37%
Capella (Nasdaq: CPLA  ) $47.98 $54.02 12.59%
Apollo Group (Nasdaq: APOL  ) $42.19 $46.90 11.16%
Bridgepoint (NYSE: BPI  ) $23.68 $26.30 11.06%
Washington Post (Kaplan) $405.96 $445.99 9.86%
Universal Technical Institute $17.40 $19.09 9.71%
American Public $43.50 $46.72 7.40%

Source: Google Finance.

Shame on the Department of Education
There are three provisions of the gainful employment rule. To avoid punishment, a school need only pass one of these three rules. To lose federal funding, a school would need to fail all three tests for three years in a four-year span.

Below, I've provided a chart of the rules, along with what I consider to be major flaws in the rules.

Provision

Rule

What's wrong with it?

1 At least 35% of former students must be actively paying down their loans. With such a low threshold, schools could have almost two-thirds of their students not paying off their loans and they would pass.
2 Graduates cannot be spending 30% or more of their discretionary income on loan payments To be honest, I'm baffled at how the Department of Education will go about collecting information for this. How will "discretionary income" be determined? It seems to me there's lots of room for distortion in this provision.
3 Graduates cannot spend more than 12% of their income on loan payments I actually think this rule makes sense and -- using tax forms -- can be easily followed.

Even though I think one of the provisions makes sense, the fact that two don't is a huge flaw. Again, a school need only pass one of these criteria to pass the gainful-employment test.

Foolish takeaway
I'm disappointed that the Department of Education didn't take stronger action with this rule. Knowing this, I think the student loan default rate is the most important metric for investors to keep their eye on. It is really able to measure whether an education at these schools creates enough earnings potential for students to justify its cost. It's also less susceptible to manipulation by the schools.

With student enrollments declining and more and more traditional universities offering online courses, I'm still a bear on the industry in general. What do you think of today's news? Sound off in the comments section below, and don't forget to add these companies to your watchlist.

Fool contributor Brian Stoffel does not own shares in any of the companies mentioned, nor does he hold a short position in any of the companies. The Motley Fool owns shares of Bridgepoint Education and American Public Education. Motley Fool newsletter services have recommended buying shares of Universal Technical Institute. Motley Fool newsletter services have recommended creating a call spread position in Bridgepoint Education.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (15) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 02, 2011, at 4:34 PM, p2i wrote:

    So you didn't see the hand writing on the wall and didn't cover your short? Too bad for you. Obama wants to be re-elected.

    Provision flaws?

    >>>At least 35% of former students must be actively paying down their loans.<<<

    This provision takes into consideration all other legal reasons for nonpayment, not just defaulted loans.

    >>>Graduates cannot be spending 30% or more of their discretionary income on loan payments<<<

    You can't see how this could be determined? Simple. Discretionary income is the taxable income after tax deductions (IRS). Traditional mortgage gauges use 28% of gross income or 36% of gross income with all other credit payments to determine qualifications. You must think that education loans should be harder to get than one for purchasing a home.

  • Report this Comment On June 02, 2011, at 4:55 PM, Melaschasm wrote:

    Why are non profit schools completely exempt from these requirements?

    Shouldn't all schools be held to this minimal standard if they want to continue getting federal financing?

  • Report this Comment On June 02, 2011, at 6:18 PM, TMFCheesehead wrote:

    @melaschasm-

    All institutes of higher education that receive federal Title IV funds are subject to the laws. For-profit schools are the ones that regularly push up against the limits though, so the attention goes disproportionally towards them.

    Brian Stoffel

  • Report this Comment On June 02, 2011, at 9:34 PM, jimmy4040 wrote:

    Brian:

    Wow, I have been a lone voice in the wilderness on this. Glad to have some company. This is the same as sub-prime, nothing more.

  • Report this Comment On June 02, 2011, at 11:53 PM, mattgoff123 wrote:

    Why are these rules not also applied to non-profits colleges and in the same manner? Don't non-profit schools also have many students who graduate with large amounts of debt they can't pay back due to poor job prospects?

    Regarding the gainful employment issue, whether a school is for-profit or non-profit, how does it have any control over the job market?

    Why should schools be held financially accountable for job markets they do not control?

    Do we really want the goverment defining "disposable" income for us? Isn't this intrusive?

    Why should the government be making a distinction between a non-profit or for-profit school if they are both accredited? Isn't this discriminatory?

  • Report this Comment On June 03, 2011, at 11:30 AM, jimmy4040 wrote:

    "Why should the government be making a distinction between a non-profit or for-profit school if they are both accredited? Isn't this discriminatory?"

    Very few non-profit colleges lose up to 70% of their students after two years, as is common at many for profit colleges. Also very few get 90% of their income from student loans, as is also the for profit model. For profit colleges are responsible for almost half of all student loan defaults nationwide.

    Need any more reasons?

  • Report this Comment On June 03, 2011, at 12:52 PM, brewersfan81 wrote:

    @jimmy4040-

    The part that confuses me is the partisanship on this. Typically, Republicans like industries to be unregulated. From that view point, I can see why they don't want heavy restrictions.

    On the other hand, they tend to oppose wasteful spending. With all of the government money being wasted when students default on their loans, I'd think they'd want some tighter policies.

    I guess that explains why I'm not an elected official!

    Brian Stoffel

  • Report this Comment On June 03, 2011, at 12:53 PM, TMFCheesehead wrote:

    Woops,

    Should have posted under my TMF username. Sorry,

    Brian Stoffel

  • Report this Comment On June 03, 2011, at 1:57 PM, jimmy4040 wrote:

    This one skews oddly that's for sure. For instance the normally solidly Dem Washington Post has been relatively silent on this, because Kaplan contributed 62% of their total revenues in 2010. No expose' for them!

    Grassley is leading the charge against, despite they're being headquartered in his home state. As I tell my children, whenver you see things that don't make any sense in life, look to see who is getting paid. Sub-prime was another industry that cut across the usual party lines, because the money was thrown all around by the industry.

  • Report this Comment On June 03, 2011, at 3:04 PM, benb0508 wrote:

    Higher education wether for profit or not is costing familes and this country a fortune. This education generally leads to better paying jobs, never guaretees a job. I think we need to look at the overall cost of all these education choices and take action to control the costs. Student Loan burden is nothing to ignore as more and more students are being forced to take on more as costs go up at rates far exceeding inflation. What are we getting for this? certainly not a better education. Why single out for profits particularly regading student loans. Is it possible that college costs are the next bubble as we have made student loan money almost unlimited and colleges have just jacked up the price to consume it?

  • Report this Comment On June 03, 2011, at 4:25 PM, jimmy4040 wrote:

    "Why single out for profits particularly regading student loans"

    Because they comprise about 12-15% of total student loans, and 43-45% of defaults. That figure is WITH the for -profits disguising their default rate by failing to report a lot of loans as delinquent. The real figure is probably well over 50%

  • Report this Comment On June 07, 2011, at 11:14 AM, CFADude11 wrote:

    Well, Jimmy, I hope that you shorted BPI because I like to know who I can thank for my +40% return in the stock (other than Andy Louis Charles that is).

    Do yourself a favor and read just a snippet of this interview with an actual value investor and you'll realize your mistake is the same as saying every oil company has to be as bad as BP because they're all oil companies.

    Good luck...

    http://www.santangelsreview.com/2011/05/31/interview-with-ir...

  • Report this Comment On June 09, 2011, at 10:32 AM, FelixHoenikker wrote:

    Why not just make student loans dischargable by bankruptcy just like mortgages?

    Schools with high default and discharge rates would be frozen out by the banksters without any new rules.

  • Report this Comment On June 11, 2011, at 6:34 PM, Orthonormal wrote:

    CFADude11, did you just equate short term success on the stock market with having the moral high ground?

  • Report this Comment On June 20, 2011, at 12:37 PM, epmeehan wrote:

    Brian,

    Your understanding of the for-profit sector is very limited. Did you know that taxpayers contribute $8,000 per year for each student in community colleges directly to the community college.

    Graduation rates at community colleges are about 27% when measured over a three year period. So the average community college student is in school say 4 - 5 years on average. The subsidy per student paid to the college, is about $32,000 - $40,000 then. I think the cost structure of the non-profit system is the challenge that needs to be dealt with.

    There are good and bad for-profits and non-profits, the new regulations are irrational and work against low income at risk students......

    The 90/10 rule is just another form of redlining - another irrational rule as well.

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