This report was originally published on 12/14/09.

The Department of Education released unofficial 3-year cohort default rate data this morning.  You can find the DOE’s press release here, which also contains a link to an excel file with school by school 3-year cohort default rate data.  Overall, the data was more or less inline with our expectations.  The addition of an extra year to the measurement period resulted in an average increase in the cohort default rate of 90-100% for most schools, which is similar to the FY04 student loan default data presented in a recent GAO reporton the for-profit postsecondary education sector.

As we anticipated, the data released this morning suggests that COCO (17.42 ↓0.40%), LINC, and WPO(451.55 ↓0.43%) could have particular difficulty navigating an environment in which the 3-year cohort default rate becomes a primary regulatory tool for maintaining access to federal financial aid programs.  As a reminder, as part of the Higher Education Opportunity Act of 2008 the calculation of the cohort default rate was expanded from 2-years to 3-years.  In conjunction with expanding the measurement period, the threshold for the maximum default rate allowed for three consecutive years was increased from 25% to 30%.  The one-year cohort default rate threshold of 40% remains in place.  Compliance with the 3-year cohort default rate will begin in FY12, for borrowers who entered repayment in FY09. Sanctions based on a three year calculation won’t begin until FY14 (borrowers entering repayment in FY11).  Here are the highlights of the 3-year cohort default rate data for COCO and WPO:

• For COCO, the number of schools whose 3-year cohort default rate exceeded 30% increased from 5 (out of 40) in FY05 to more than 20 (out of 40) in FY07. The company had five schools whose 3-year cohort default rate exceeded 30% for three consecutive years and one school (the Everest Institute in San Antonio, TX) whose cohort default rate eclipsed 40% for FY07.  The company’s total 3-year cohort default rate was 29.8% in FY07, up from 23.3% in FY05.
• For WPO, the number of schools whose 3-year cohort default rate exceeded 30% increased from 1 in FY05 to 17 (out of 34) in FY07. The company had three schools whose 3-year cohort default rate exceed 40% in FY07 (Texas Careers, Texas School of Business, and TESST College – Baltimore).  We view the default rate trends at the company’s flagship Kaplan University (50,000+ students) as particularly alarming given the rate of growth experienced at that institution over the past few years. On a three-year basis, the cohort default rate increased from 12.8% in FY05 to 23.2% in FY07.  The default rate is particularly high for a school accredited by the Higher Learning Commission (regional accreditation).  We think this could result in greater scrutiny of Kaplan University’s regulatory compliance going forward.

Getting Closer to Reflecting Lifetime Student Loan Default Rates – Is the Government’s Estimate of 40% Defaults for 2-Year Proprietary Schools High Enough?

We have received a number of questions about the data released today and what it actually reflects. First and foremost, we think the data underscores how ineffective a tool the 2-year cohort default rate mechanic was as a barometer of student outcomes.  The 2-year cohort default rate only captured payments on student loans that remained current for at most 460 days and also could be easily manipulated through forbearance and deferment (student loans in forbearance or deferment are not included in the 2-year cohort default rate calculation).  Anecdotally we know that a number of schools encouraged students to pursue deferment and forbearance options to minimize default rates.  Student loan guarantors such as Sallie Mae have dramatically reduced deferment and forbearance options over the pas 12-18 to get a better handle on defaults, rather than “kick the can down the road”.

We think the 3-year cohort default data brings us one step closer to understanding lifetime student  loan default rates  on a school by school basis.   As the GAO report and other presentations from student loan guarantors have illuminated in the past, the 2-year cohort default rate is an incredibly poor proxy for lifetime default rates.  The three-year cohort default rate is a better proxy, but still not a great one.  There is increasing public support for the disclosure of lifetime default rates on a school by school basis.  The  Dept. of Education does provide lifetime default ratesby institutional category.  In the table below, we outline lifetime student loan default rates for the FY02-FY06 cohorts.  In the upper portion of the table you can see that the lifetime student loan default rate for the FY02 cohort was 11.5% as of 9/30/08, compared to a 2-year cohort default rate of 5.2%. The government typically updates this data annually in December, so we should have more insight into lifetime student loan default rates by the end of the year.

Source: Department of Education

From the table above, it is easy to see that default rates for students attending proprietary schools are multiples of the national average.  We would argue (and many of the operators in the space would as well) that a comparison of student loan default rates to those witnessed at 2-year private and public institutions would be more appropriate. In this case, it appears default rates at proprietary schools are typically 4-5% higher than those at 2-year non-profit institutions.  The lifetime student loan default rates experienced thus far for the FY02-FY06 cohorts do not appear to be particularly noteworthy.  However, we thought it might be interesting to evaluate how the government budgets for student loan defaults by school category.

In the table below we have outlined the government’s estimates for student loan defaults over a 20-year period by instiutional category.  The expectations for defaults for students attending 2-year proprietary schools (for-profit) should stand out.  In general, the government expects approximately 40% of students attending 2-year for-profit institutions to default.  Although the government has not issued details on lifetime student loan defaults, we can only assume that the budgeted amount reflected below is indicative of historical loan loss experience.

Source: Department of Education

The federal financial aid program will exceed $80 billion this year.  According to U.S. Department of Education data, students attending for-profit institutions represented 5.8% of total postsecondary enrollments at the end of FY05.  We estimate proprietary schools have gained 1.5-2.0% of market share annually over the past 4-5 years.  This would imply that their market share today could represent 12-15% on an enrollment basis.  Students attending for-profit institutions borrow considerably more than students enrolled at traditional schools.  Based on the market share gains achieved over the past 4-5 years and higher borrowing amounts, we think it is reasonable to assume that 20-25% of federal financial aid is now allocated to students attending for-profit institutions.

The use of the 2-year cohort default rate metric obfuscated the actual student loan default data for operators in the space.  The introduction of 3-year cohort default data pulls back the curtain just a little bit.  We think a discussion about losses associated with loans made to students attending for-profit postsecondary institutions could become a public policy debate in the near future.  Assuming for-profit institutions account for 20% of Title IV disbursements, we estimate aggregate losses on those loans could approach $5-$6 billion.  We think increased public awareness of the magnitude of ACTUAL defaults could spark greater regulatory scrutiny of the space.  At first glance, it appears the  government has budgeted conservatively for defaults for students attending for-profit institutions.  However in light of the reserve policies established by COCO and ESIon their internal loan progams (55%-57% and 40-45%, respectively), we wonder if the government has been conservative enough.

Will the “Back-End” Oriented Approach to Default Management Work?

Stocks in the for-profit education sector rallied today in response to the unofficial 3-year cohort default data, in a trading move we would characterize as “not as bad as feared”.  The group has been oversold and ripe for a “relief rally”.  However, we don’t think today’s stock price action should be construed as a pronouncement that the “coast is clear”.  We think the operational challenges that COCO and WPO in particular face over the next several years to achieve compliance with 3-year cohort default rate regulatory standards are considerable.

COCO issued an 8-K today in response to the release of the unofficial three year cohort default rate.  The company stated the following:

“Numerous published studies have indicated that the factors which most influence CDRs are employment status, income, ethnicity of the borrower, and educational attainment of the borrower’s parents. The Company’s career-oriented programs, most of which can be completed in one year or less, serve non-traditional, economically disadvantaged students seeking entry level occupations. Students in this category generally default at higher rates than traditional students, and the current economic downturn is exacerbating this trend.“

Similar to other publicly traded for-profit education companies, COCO has issued the familiar refrain: “it’s not our fault that our students default at higher rates”.  There is no question companies like COCO and WPO, among others target a difficult student demographic, but it appears companies in the space continue to deny their direct involvement in high default levels. It seems that the most obvious way to reduce student loan defaults would be to increase admissions standards, reduce tuition, and improve educational quality/outcomes.  Instead of addressing student loan issues on the “front-end”, COCO has indicated that it will continue to focus on the “back-end” through more stringent default management:

“As disclosed previously, the Company has recently implemented a multi-faceted cohort default management program and expects to remain in compliance with the two-year default rules currently in effect. Our default management program includes: a new contact management system to assist in reaching students who are no longer in school; an internal department focused primarily on early stage delinquencies; an expanded program of entrance and exit counseling and financial literacy training for current students; and the use of an outside firm to help reach and inform borrowers about alternatives to default, including income-based repayment, forbearance and deferral. The Company believes the income-based repayment option, which went into effect in July 2009, after the periods reflected in the unofficial trial rates, will be an especially effective tool to reduce default rates going forward.”

In our view, it is particularly difficult to improve the collection rate from the student demographic COCO targets. We think it is inevitable that COCO and WPO will eventually have to alter their admission policies and potentially reduce tuition in order to achieve consistent compliance with the 3-year cohort default rate regulatory standards.

As always, please act accordingly….