By Daniel Golden and John Hechinger – May 27, 2010
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Steven Eisman, a hedge-fund manager whose bet against the housing market was chronicled in a best- selling book, said he has found the next “big short”: higher education stocks.
The stocks of companies operating for-profit colleges could fall much as 50 percent if the U.S. tightens student-loan rules, said Eisman, manager of the financial-services fund at FrontPoint Partners, a hedge-fund unit of New York-based Morgan Stanley.
An Obama administration proposal to limit student debt would slash earnings of Apollo Group Inc., ITT Educational Services Inc. and Corinthian Colleges Inc. by forcing them to reduce tuition and slow enrollment growth, Eisman said yesterday at a New York investment conference. Without new regulation, students at for-profit colleges will default on $275 billion of loans in the next decade, he said.
Eisman is shorting, or betting against, shares of higher- education companies because of the parallels he sees to the housing market, where prices began to fall in 2006 as loan defaults by homeowners with poor or limited credit history began to climb, he said. Like the lenders to these subprime borrowers, for-profit colleges boomed by saddling low-income people with debts they can’t repay, he said.
“Until recently, I thought that there would never again be an opportunity to be involved with an industry as socially destructive and morally bankrupt as the subprime mortgage industry” said Eisman, 47, one of the sellers featured in “The Big Short: Inside the Doomsday Machine” (Norton, 2010), Michael Lewis’s book about investors who anticipated the housing bust. “I was wrong. The for-profit education industry has proven equal to the task.”
A comparison between higher education companies and the subprime mortgage industry is “absolute nonsense,” Harris Miller, president of Washington-based Career College Association, which represents more than 1,400 for-profit colleges, said in an interview. Mortgage brokers had no stake in the ultimate success of their borrowers since they sold the loans to investors, while colleges will succeed only if their students graduate and find jobs, Miller said.
Eisman didn’t name the companies whose stock he has sold short, or say over what period he expects them to lose value. In a short sale of stock, an investor seeks to profit by selling borrowed shares, with the expectation of replacing them later at a cheaper price. Bets against subprime mortgages helped FrontPoint double the size of its fund to $1.5 billion by the end of 2007, Lewis wrote in his book.
“Default rates are already starting to skyrocket,” Eisman said at the Ira Sohn Investment Research Conference, in New York. “It’s just like subprime, which grew at any cost and kept weakening its underwriting standards to grow.”
Just as bond-rating firms gave high grades to securities backed by risky mortgages, so the accrediting associations responsible for monitoring educational quality of for-profit colleges don’t provide thorough and independent scrutiny, said Eisman. Because accreditation is a peer-review system, in many instances representatives of for-profit colleges sit on the board of the body that certifies them, he said.
Peer review is a rigorous process that ensures quality in medicine, as well as education, Anthony Bieda, director of external affairs for the Washington-based Accrediting Council for Independent Colleges & Schools, which oversees many for- profit schools, said in an interview.
“We believe that for every bad actor or marginal institution that holds a grant of accreditation, three or four or 10 do a stellar job,” Bieda said.
One difference between the higher education and mortgage industries is that, while investors betting against subprime lenders only had to wait for credit quality to deteriorate, for- profit colleges don’t suffer the consequences of lowered underwriting standards, Eisman said.
The U.S. government is on the hook when former students don’t pay their loans. Federal aid for students at U.S. for- profit colleges rose to $26.5 billion in 2009 from $4.6 billion in 2000, according to the Education Department.
Without new regulation, it will reach $89 billion in 2020 as more low-income students attend for-profit colleges, which peg tuitions to the maximum federal grants and loans available, Eisman said. More than half of students at most for-profit colleges drop out within a year, he said.
Preliminary versions of the Obama administration proposal would require for-profit colleges to show that graduates earn enough money to pay off student loans. If for-profit colleges can’t meet the standard, they could lose federal financial aid, which typically makes up three-quarters of their revenue.
The proposed rules, which are expected to be released this month for public comment, may disqualify for-profits from receiving federal financial aid if their graduates must spend more than 8 percent of their starting salaries on repaying student loans. Had this rule, known as “gainful employment,” been in effect in 2009, earnings of higher-education companies would have been lower, Eisman said. Assuming the companies would have cut tuition and kept costs the same, Apollo Group would have earned $1.32 a share instead of the $4.22 a share it reported excluding certain costs for the fiscal year ended Aug. 31, he said.
Sara Jones, an Apollo spokeswoman, declined to comment on Eisman’s analysis. The company is “closely monitoring” the gainful employment legislation and analyzing its impact, Jones said.
“The majority of students served by our educational institutions are employed, and many report salary increases well above national averages while enrolled,” she said in an e- mailed statement.
ITT Educational Services Inc., based in Carmel, Indiana, would have lost 22 cents a share rather than reporting a profit of $7.91 a share, Eisman said. Washington Post Co., which operates Kaplan Higher Education, would have lost $33.25 a share, instead of earning $9.78 a share. Pittsburgh-based Education Management Corp., which is 38 percent owned by Goldman Sachs Group Inc. and earned 87 cents a share in the year ended June 30, would have lost $5.50 a share, Eisman said. In the year ended June 2009, Corinthian Colleges earned 81 cents per share in 2009 from continuing operations, though would have posted a loss of 76 cents, he said.
The companies have the flexibility to cut costs by about 10 percent, which would offset a portion of the effect on earnings from the revenue declines, said Eisman. Hal Jones, chief financial officer of Washington Post, declined to comment. Representatives of ITT, Education Management and Corinthian couldn’t be reached.
In an April 28 speech, U.S. Deputy Undersecretary of Education Robert Shireman drew parallels between the higher- education and subprime-mortgage industries. Eisman has met with federal education officials and members of Congress to discuss for-profit colleges, according to people close to him. Justin Hamilton, a spokesman for the U.S. Department of Education, declined to comment.
While Shireman is stepping down next month, it would be “absurd” to think that his departure signals that the Education Department is backing down from the gainful-employment rule, Eisman said.
“We just loaded up one generation of Americans with mortgage debt they can’t afford to pay back,” Eisman said. “Are we going to load up a new generation with student loan debt they can never afford to pay back?”