Colleges and universities that are designed to make a profit could soon be a thing of the past as federal regulators have begun zeroing in on the industry's habit of exploiting students. The last example of this is ITT Educational Services (NYSE: ESI), which recently filed for bankruptcy after losing access to federally backed student loans.

In this episode of Industry Focus: Financials, The Motley Fool's Gaby Lapera and John Maxfield discuss the latest developments in the for-profit education space.

A full transcript follows the video.

This podcast was recorded on Sep. 26, 2016.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the Financials edition, taped today on Monday, September 26th, 2016. My name is Gaby Lapera, and joining me on Skype is John Maxfield, one of our top analysts at The Motley Fool. Hey, John!

John Maxfield: Hey, Gaby! How you doing?

Lapera: Pretty good! I just wanted to remind listeners that this is the last show that wasn't pre-taped before I leave. So if anything huge happens in the month of October, I'm sorry, we'll cover it in November. Today's show -- John and I were talking about student loan debt the other day, and a Bloomberg article came out this morning that dovetailed neatly with what we wanted to talk about. I don't know if people know, but student loan debt has reached just gargantuan levels in the United States. It's around $1.4 trillion right now. Unlike most other debt, it can't be discharged in bankruptcy, which is crazy if you think about it.

Maxfield: Yeah. And the other thing to keep in mind is that, when you think about all the things that are going on in the country right now from an economic perspective, this is reflected in the student loan issue. In fact, one could argue that that's what caused the whole student loan issue. Let me put some of this in perspective. Since the financial crisis, unemployment rates shot up, which sent people back to school. But the big issue is that state spending went way down -- they were cutting back the budget -- and federal spending went way up. That's where this huge student loan crisis has come from.

Lapera: Yeah, it's crazy. If you look at some of the figures, student loan debt has exceeded automobile loan debt, credit card debt. That's a lot of debt that's been saddled on young people who are just starting out. And sometimes, it doesn't really pan out. What you were saying about debt rising -- the average debt at graduation of 2015 was between $30,000-35,000. It was about $10,000 in the mid-'90s. That's a wild increase.

Maxfield: It's crazy. And what's even crazier is that most of that debt is backed by the federal government -- thereby, the federal taxpayers. To the same point, between 2008 and 2013, federal Pell Grants, which are those income-dependent grants that help underprivileged students -- or, what's the appropriate word... they're need-based grants -- have increased by 72% over the period of 2008 to 2013.

Lapera: Yeah. And just to give listeners some context, about 44% of Federal aids -- not just Pell Grants, but everything -- 44% of those end up in default, which is astounding. You might be sitting there thinking, "So, why are John and Gaby talking about this on my Financials podcast?" It's because there's a story that we've been ignoring in favor of the Wells Fargo story, which is the ITT Tech story. 

Any listeners who are from the East Coast -- I'm not sure if this happened in other parts of the country -- will be familiar with ITT Tech. They ran late-night college ads. Austin, I don't know if you remember this? He's nodding his head yes. They have the exact same format. It's "Man who was sad because he cannot catch a break in life, images of his children sad at the dinner table. Then he goes to ITT Tech! Montage of people at school. Then he gets a job in IT! Montage of people in a corporate environment. Now his family is happy. Pictures of him and his happy kids." That's how it always went. But recently, ITT Tech shut down.

Maxfield: Or went bankrupt. They did it voluntarily. They basically lost their ability to get federal student loans guaranteed, which cut off a huge honey pot for the school. Let me bring up one more point. On the spectrum of schools, these for-profit schools like IT&T, and those educations...

Lapera: It's ITT.

Maxfield: Isn't that what I said?

Lapera: You said IT&T, which is like AT&T.

Maxfield: A nice little mantra; I'm sure AT&T will appreciate that. So, there's $1.4 trillion of outstanding student debt, a ton of it going to these for-profit schools. You cited that 44% statistic earlier. Think about this -- almost half of outstanding student loans in this country are either not being repaid as planned, or are behind in their payments. So the thought process is, in the financial crisis, the issue was, we had all these subprime mortgages that weren't being repaid. Now the conversation is, the same thing is going on in the student loan market. Since the financial crisis, student loans, to your point, have now exceeded auto debt, and now are second only to mortgages in the United States. That's the second-largest source of debt, and we're having these huge potential default issues in that pool of loans. Then you trace it back, as we will in this conversation, to ITT. You think, wow, there's some similar malfeasance going on in that market as there was in the mortgage market.

Lapera: Definitely. And this opens up a topic that I think we should talk about, which is the difference between for-profit and non-profit universities. Non-profit universities are going to be your state schools and your private schools. What differentiates them from for-profit universities is that non-profit schools have other sources of funding, like from the state and federal government, that doesn't involve just scholarships to students, but actual money that just goes to the school to keep the lights on, as well as endowments, especially for private colleges, and then, student tuition. And even for them, tuition rates have been going up, because since the financial crisis, the federal and state governments have not been able to contribute as much to the financing of the schools. 

But for-profit universities do not have that. They are there to make money. Their ultimate authority are their shareholders, because they are private companies. And their only way of making money is via tuition, whether they get that from federal student aid -- ITT Tech got about 83% of the revenue from federal student aid. That's not unusual for for-profit universities. It hovers around 80% for a lot of them. Or they also get money through private loans that they originate, with huge interest rates on them.

The problem with for-profit universities is that, frequently, they don't have the students' best interests at heart, whereas non-profit universities can have more leeway in making sure that students actually get a good education, because in theory, they're not there just for the money.

Maxfield: And, you know what an interesting coincidence is, Gaby, you mentioned that, we've been talking the last couple weeks about Wells Fargo. It's a very similar situation here, isn't it? What would cause a for-profit university to maybe be more exploitative toward their constituents, i.e. their students, than a public university or a private university that isn't for profit? And the issue is, you have an additional set of stakeholders that the people who run these universities have to keep in mind. At a public university, your primary stakeholders are the students. At a for-profit university, your primary stakeholders are your shareholders.

That's important. The shareholders are the most important, and the reason they're the most important in terms of the executives of these companies is because these executives owe fiduciary duties to their shareholders. But they don't owe that same legal duty to their students, theoretically. So they're always going to pick the shareholders over the students. So what happens when you're picking your shareholders over your students? It means you're going exclusively for profit, as opposed to quality of education. And what we have seen in this whole ITT Tech debacle is that, basically, these companies are just going out there trying to maximize revenue in whatever way possible, whether that's jamming people full of loans that they can't afford that they under no circumstance can get, or reducing costs, and they reduce cost by reducing the quality of the education that they're providing. So, at the same time that they're maximizing revenue, they're cutting expenses. And that's great for shareholders -- at least, it was. Now it's obviously horrible for shareholders because they went to zero. But for students, it's an absolute nightmare.

Lapera: ITT Tech is in a lot of trouble. As we mentioned earlier in the show, they shut down about 130 campuses. And they weren't the only ones that got shut down. Their accrediting council also got shut down, which we'll get to in a second. But let's get into why they ended up getting shut down. A lot of it goes to what we were talking about earlier, with them receiving so much federal aid, and the federal government feeling that students were not getting a good value for the money they were paying for their education.

Maxfield: Yeah. It's not only that they would give them a bad product, but they would use these techniques to rope people into the college, to rope people into these student loans. For example, the Consumer Financial Protection Bureau filed a lawsuit about two years ago. At the foundation of that lawsuit was an allegation that was that what ITT would do is -- let's say you want to buy a car, or get a new credit card. And you get that interest-only period, or you don't have to pay interest, or whatever it is. You get those introductory periods where the terms look really good.

ITT would do the same thing. They would give an interest-free one-year loan to get people into the college. But then, when that loan was up, then ITT -- and this was part of ITT's entire plan, according to the Consumer Financial Protection Bureau -- then once the loan was up, the people would be stuck with all this money that they had to repay. So then what ITT would do, they would have their Student Financial people -- the people that help students get student loans -- roll those temporary "free" loans into these really expensive private loans, where the origination cost could be as much as 10% of the actual loan.

Lapera: That's a lot of money! 

Maxfield: Here's what's interesting, Gaby. When I was reading through this, and we were talking about this, when you come away from looking at this, you're like, these companies are loan originators, to a certain extent. And then they have this product that they throw in with it.

Lapera: Yeah. One of the problems with ITT Tech and for-profit universities, in general, is that they frequently preyed on people who didn't have a lot of other resources. So maybe they didn't know a lot about how their loan terms actually worked. They targeted frequently on veterans, who got money from the GI Bill, who maybe were the first generation to go to college and didn't know that the things that were happening were not normal, really, for a non-profit university. But they were for-profit universities. I think a lot of people don't see that distinction, and they don't realize what's going on. And I think that one of the things that ITT Tech promised --  that was the worst thing, maybe, that they did -- was they told people they had 100% job placement rate. And that simply was not true. It was very frequently less than 100%, often less than 60%, which is the bare minimum required of them.

Maxfield: Yeah. And that 100% statistic comes from one of ITT's specific campuses, and it was talking about placement in its computer science program. So, they're out marketing, basically. To the point you were making about the commercials earlier -- they're basically saying to people, "If you come to this ITT campus, and you get a computer science degree, you have a 100% chance of getting a job." If you're in a tight spot, like a lot of people were in the financial crisis, and you have a family -- again, to your point about the commercials -- how can you turn that kind of opportunity down? But as the facts come out, it's closer to 50%. This is just a scam in the for-profit education context. That's what this is really all about.

Lapera: And one of the things that people are saying about this job placement rates is, they'll help you get a job, but it's not necessarily in what you studied. That's the thing. So you get an IT degree from them. They'll offer you a job selling insurance. It doesn't really 100% add up. Not only did the federal government have a problem with this, but their accreditation council also had a problem with this. They found that only 20%-49% of any of the job placement they did had anything to do with the degrees they offered.

Maxfield: Yeah. It's a horrible situation. And even when you were within a program, a lot of those programs didn't have accreditation. You referenced the accreditation process. The nursing program at some of the campuses -- you had nursing students go to these programs -- it was horrible, a horrible situation. Students were led to believe that either the school was in the process of getting accreditation, or already had it, when in fact, neither was true. So you would get out after spending all this money on a nursing degree, and either you couldn't get those credits transferred over to an actual nursing program, because there was no actual accreditation, or you couldn't get a job with it because you didn't come from an accredited program.

Lapera: So, just to be clear, the school can have an accreditation, but particular programs also have to have a sub-accreditation, so employers know the program is good. This also happened with a lot of their criminal justice degrees, as well. It's just really disappointing. So on top of bad job placement, sketchy accreditation, there are many anecdotal reports -- I haven't seen any official commentary on this yet -- that ITT Tech's coursework is very shoddy, that the coursework was produced for people at a fifth-grade level, or it was horribly out of date. That is really sad. That is a failing of education on an unspeakable level.

Maxfield: Yeah. Again, it goes back to that, in some context like education, maybe, that profit motive does not provide the best outcome.

Lapera: Yeah, absolutely not.

Maxfield: And let me bring up another point, Gaby, because I was thinking about this earlier. What they have found when they have talked to these students, they get all these loans and find out that their job prospects are much less promising than ITT or these other for-profit colleges have led them to believe. They've found that, in order to service their student loans, people are avoiding medical treatment, they are delaying marriage, they are putting off home buying. So this isn't just a problem with ITT. This is a problem that has fundamental economic significance to the wider economy, if all these things are going on, and consumer spending is struggling in our economy, just moving along really slowly. Then certainly, this could be a contributing factor.

Lapera: Absolutely. If you have gone to ITT Tech and you are having problems, you can contact the Department of Education; they have resources for you. If you are considering a for-profit university, one of the things you should maybe consider instead is your local community college. It's frequently four times less expensive to go to your local community college than it is to go to a for-profit university. And not only that, but they're accredited by the state. So frequently, you can take credits that you got at your community college and transfer them into a four-year degree that you can get at state public universities. A lot of states have programs with that. And you'll get a much better bang for your buck. 

That's actually something else I wanted to talk about -- the accreditation. ITT Tech was accredited by the Accrediting Council of Independent Colleges and Schools, which is ACICS, which I'm going to try to call it, but it's a little bit of a tongue twister. ACICS actually raised a lot of red flags about ITT Tech, but the Department of Education shut them down, too, because ACICS is responsible for accrediting a lot of these for-profit universities, like University of Phoenix and DeVry, which are pretty commonly well-known names. Those universities have run into a lot of trouble in the last couple years. The University of Phoenix lost 50,000 students last year, and DeVry has been sued by the Federal Trade Commission for telling students -- exactly the same thing that happened at ITT Tech -- that they could help them get jobs that they could not help them get. Last year, I don't know if you've heard of Corinthian Colleges, but they closed most of their schools down, because the Department of Education gave them a $30 million fine, again, for overstating job rates for graduates. I think Corinthian is actually now out of business.

Maxfield: It's coming in this wave where companies need to be more focused on consumers. What we have found in the wake of the financial crisis is that the government is actually serious about consumer-protection reforms. We've seen that in banking, we talked about that with Wells Fargo, and what's now going on in the for-profit education space. I think one takeaway for investors who are invested in these companies -- a lot of these are actually publicly traded companies -- is that there is serious risk now when you're looking at companies where there isn't a close alignment of interest between the various types of stakeholders and the investors and the customers of whatever these companies are. Where there's a lack of alignment there, with the federal government looking at consumer protection right now so intently, there's always the potential now that you could have this backlash like we're seeing with banking in for-profit educations. It's just a good thing for investors to add to the points that they look at when they're considering a company.

Lapera: Yeah. Think about these for-profit schools having the underwriting discipline of banks giving out mortgages pre-financial crisis. And think about whether or not you would invest in that bank. If you would not, then you should not invest in these colleges.

Maxfield: That's exactly right. I think it's great that you bring up that, because it's all about discipline. That's what the credit underwriting process is. It's the same thing in the for-profit education realm, and the same thing in all other realms. Companies that do the right thing, typically they are not taking the path of least resistance. Think about whatever it is. AppleMicrosoft -- these companies all forged very difficult paths. When you see these companies taking shortcuts, and giving one of the constituents, namely their customers, the short end of the stick, that needs to be a red flag for investors.

Lapera: Yeah. Let me give you some quick facts here. On federal loans, in general, an estimated 42% default. I think I said 44% earlier, but I meant 42%. Of that 42%, about 44% of the people who are defaulting attend for-profit universities, which is nuts when you realize that only 11% of the people in higher education are at for-profit universities. So 11% of the people who have federal student aid are accounting for almost half of the loan defaults that occur, which is insane.

Maxfield: That's crazy.

Lapera: Yeah. And that, I think, should make both students and investors think twice about buying into this company. And that's what they are -- they're companies. They are colleges, but they are primarily companies. Which, I think, brings us to the end of our show. In summation: investors, think twice. Students, think twice.

Maxfield: If it sounds too good to be true, it probably is.

Lapera: Absolutely. On the bright side, we will no longer have to watch ITT Tech commercials on the East Coast. Thank you federal government. (laughs). Anyone else have anything to add? Austin? John?

Maxfield: I think that about covers it, from my side.

Lapera: Fantastic. As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell anything based solely on what you hear. Contact us at industryfocus@fool.com, or by tweeting us @MFIndustryFocus. Thanks again to Austin Morgan, who has suffered with me through the online for-profit ads. I'm sure I'm going to have a lot more of them after having researched this story. Everyone, have a great week!

Gaby Lapera has no position in any stocks mentioned. John Maxfield owns shares of Wells Fargo. The Motley Fool owns shares of and recommends Apple and Wells Fargo. The Motley Fool owns shares of Microsoft and has the following options: long January 2018 $90 calls on Apple, short January 2018 $95 calls on Apple, and short October 2016 $50 calls on Wells Fargo. 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.