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 Can the Income Based Repayment Plan Save
ESI from A Tidal Wave of Student Loan
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from A Tidal Wave of Student Loan Defaults? We Now?
 A Pair Trade with Some Sparkle - Long Signet
In our original post on ITT Educational Services, Inc., we argued that the Jewelers/Short Blue Nile
company’s business model was structurally broken because it was no longer  Recent Correction in ARP Shares Brings the FCF
Yield Back to 20%+
clear that students earned a positive return on their educational
 What To Do About Smith and Wesson (SWHC)
investment. After more than a decade of increasing tuition at an annual rate Now
twice that of inflation, the affordability equation for a student pursuing an
associate’s or bachelor’s degree at the ITT Technical Institute has become
problematic.  As a reminder, the average cost of an associate’s degree for a Popular Posts
student enrolling at ITT Tech this year is approximately $45,000 and the  Revisiting Our Mean Reversion Pair Trade from
average starting salary for the 75% of graduates placed in their field of study in the Energy Pit - Long Natural Gas/Short Crude
2008 was $33,370. Historically, organizations such as the Project on Student Oil: We Still Like It
Debt and FinAid have recommended that students do not take on more student  Causality in the Natural Gas Pit - How the UNG
Works in Theory (And Why it Doesn't)
debt than their expected starting salary upon graduation. Anything beyond that  A Pair Trade with Some Sparkle - Long Signet
level typically places undue financial strain on the student and makes them Jewelers/Short Blue Nile
more likely to default. Based on our proprietary analysis in our original post on  Housing is the Business Cycle, So Where are
ESI, we argued that student debt burdens for the company’s graduates were We Now?
now approaching levels similar to that for mortgage debt during the peak of the  How Are We Doing?
housing bubble. Stated another way, graduates from ESI’s associate’s degree
programs in 2008 will allocate approximately 20% of their GROSS income to
servicing student loans. Clearly this is unsustainable. In our view, this is a Join Our Email List
secular issue - tuition has increased beyond the student’s ability to consistently
pay.  The current economic downturn will only exacerbate this trend. You may manage your subscription options from
your profile.

There is some good news, the Income Based Repayment (IBR) plan could
substantially reduce student debt burdens nationally and for ESI grads in Subscriber Count
particular.  However, it is not a panacea and we still think ESI is more likely than 98
not to see a higher level of regulatory scrutiny over the coming years as cohort
default rates for their students surge.
Archives
Income Based Repayment Lowers Payments in the Short Term, but Will  July 2009
Not Make a Huge Difference for ESI’s grads  June 2009
 May 2009
 April 2009
 The Income Based Repayment (IBR) Plan was introduced as part of the
College Cost Reduction and Access Act of 2007 and became available July 1st
of this year. IBR is a new repayment plan for the major types of federal student Market Quotes and Current Investment
loans.  Under the plan, the monthly payment is capped at an amount that is Ideas
intended to be affordable based on the income and family size of the borrower.
Stafford, Grad PLUS, and Consolidation Loans made under the Direct Loan or
Federal Family Education Loan Program (FFEL) are all eligible for repayment
under IBR. The amount of repayment under IBR is determined based on a
formula that evaluates a student’s/graduate’s discretionary income, where
discretionary income is the difference between adjusted gross income and the
federal poverty line (approximately $16,000). Payments are limited to 15% of
monthly discretionary income. Here are a few other key provisions of
Income Based Repayment:

 The maximum repayment period is extended to 25 years and the

difference between the original interest payments owed and interest

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payments made under IBR are capitalized and added to the principal of
the loan
 Students must be current on student loans in order to apply for IBR  
 Plus loans and private loans are not eligible for IBR

How significant are the reductions in student loan payments? For many
students this could be a “game changer”.  However, looking at the profile for the
typical ESI graduate, the reductions appear to be helpful, but not as much as
one would think. It is important to remember that the maximum federal loan
limit for an independent student only covers approximately half the cost of
obtaining an associate’s degree at ITT Tech.   Assuming every student  that 
graduates from ITT Tech obtains the maximum federal loan limit of $21,000 for
the first two years of an undergraduate degree program we estimate the
monthly debt servicing cost to be approximately $240. According to the
Department of Education’s own calculations, independent students that are not
married would pay $172-$234 in monthly debt servicing costs if their adjusted
gross income is between $30-$35,000.  The savings become more material if 
the student is married or has children. Overall, IBR does not appear to be a
game changer for the vast majority of ESI students who are typically single and
between the ages of 22-30.  The Institute for College Access and Success has 
estimated that as many as one million students will take advantage of IBR. It
will help dampen the coming surge in cohort default rates, but for ESI in
particular it does not appear like it will have a dramatic effect.

Revisiting ESI’s Revenue Sources

 Over the past two-years, ESI’s revenue sources have shifted substantially as

private lenders have backed away from the student loan market. At the start of
the decade, ESI only generated 5% of its revenues from private student loans.
However, private loans increased to as much as 34% of revenues in 2006 as
the company’s tuition price increases widened the gap between the overall cost
of education at ITT Tech and federal student loan limits. Sallie Mae was the
single largest provider of private loans to ESI’s students from 2002-2007.  In
February 2008, Sallie Mae elected to terminate its private loan relationship with
ESI due to rising delinquency and defaults. As a result, private loans for ESI
plummeted to only 8% of total revenues in 2008 and the company’s internal
financing program increased to 10% of total revenues. The chart below outlines
ESI’s revenues sources by category so far this decade (click on chart for full
image view):

Source: Company reports

 Outside of using their own balance sheet, ESI has been a direct beneficiary of

higher federal student loan limits and expansion of the size of the maximum Pell
Grant.   As the chart below demonstrates, from 2007 to 2008 the percentage of
revenues coming from FFEL loan programs increased from 51% to 59%, while

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the average amount of funding per student increased from $9,183 to $11,439
annually.

Source: Company reports

The average Pell Grant per student was $2,501 in 2008, up substantially from
$1,805 in 2005. Although its impact will be modest relative to the overall
student debt burden, we expect ESI’s students to benefit from increased Pell
Grant limits and overall funding in the next year.

Source: Company reports

ESI has been pursuing other private lending relationships to help bridge the gap
between the cost of its programs and federal loan limits. Recently the Eli Lilly
Credit Union expanded its relationship with ESI and its students. We do not
have details on the size of their program with ESI, nor whether or not these
loans are recourse to the company. We still find it remarkable that ESI
management commented at in investor presentation that they planned to
increase tuition over the next several years at rates commensurate to the past
few years. That begs two questions: 1) How will the company fund those tuition
price increases (more from its balance sheet)? and 2) How will students be able
to service that debt upon graduation when starting salaries are likely to remain
in the $30-$35,000 range?

A Review of Recent Sallie Mae Data Suggests “The Horse Has Left the
Barn” For Defaults in FY08 and FY09 - Will ESI Take Any Charges for
Recourse Loans Under the Sallie Mae Program

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 As we have mentioned in the past, the “cohort default rate” used by the
Department of Education to measure educational outcomes is a poor barometer
of real-time trends in how students are keeping up with loan payments. As a
reminder, under the Higher Education Act a postsecondary institution can lose
eligibility to participate in certain Title IV loan programs if the rate at which
students default on their federal student loans exceed certain percentages. The
rates are calculated per institution and are based on the number of students that
default (not the dollar amount). An institution whose cohort default rate exceeds
25% for three consecutive years loses eligibility to participate in the vast
majority of Title IV programs.

The methodology used to calculate the cohort default rate dramatically

understates credit risk for a particular group of student loans. The data is
calculated based on a fiscal year that begins October 1st and ends September
30thand is structured to capture student defaults within a 24-month period.
Students that enter repayment after October 1st are captured in that particular
years cohort. For example a student that enters repayment on October 10,
2006 and defaulted in June of 2008 would have been captured in the cohort
default  data for FY07 (the most recent data set available). However, a student
entering repayment on October 10, 2006 and that defaulted in December 2008
was not captured in the cohort default rate for FY07. In fact, that student under
the current metholdogy is not captured in the cohort default data at all. Any
student that defaults 24-months after the initial repayment period will not be
captured in the cohort default data. In order to address the inadequacies of the
cohort default data, the time period was recently expanded to three years, which
will begin with the FY09 cohort. Unfortunately preliminary cohort default data for
FY09 will not be released until early in calendar 2012. We think the cohort
default data for FY08 will be terrible and that for FY09 even worse. How can an
investor get real time data on what cohort default rates might look like? Let’s
take a look at data from Sallie Mae’s “non-traditional” loan portfolio.

Sallie Mae is the largest servicer of student loans in the US. In the late 1990’s
in an effort to boost profitablity, the company introduced a private loan program.
As part of this initiative, in the early part of this decade Sallie Mae expanded
their private loan program to what they called “non-traditional schools”,
which was primarily made up of for-profit postsecondary education providers.
ESI, Career Education Corp. and Corinthian Colleges, Inc. all had significant
relationships with Sallie Mae. ESI has never disclosed exactly how much of its
revenues were attributed to private loans offered to its students through Sallie
Mae, but it is important to note that private loans were 30% of revenues for ESI
up until Sallie Mae terminated the program in February 2008. Overall Sallie
Mae’s non-traditional loan portfolio was approximately $5.1 billion as of 3/31/09.

Default rates and delinquencies have sky-rocketed in the past 6-months, as one
might expect given the economic environment and the high cost of completing
some of the degree programs offered by ESI and Career Education Corp.
According to Sallie Mae, the number of charge-offs in the portfolio has
increased from 10.0% as of 9/30/08 (remember the last measurement date of
the FY07 cohort default data) to 14.5% as of 3/31/08. Perhaps even more
unsettling is that the percentage of loans that were more than 90 days
delinquent has increased from 11.9% as of 9/30/08 to 19.1% as of 3/31/08.
Stated another way, approximately 34% of loans Sallie Mae made to non-
traditional schools are delinquent or in default!

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Source: Sallie Mae

It is important to note that defaults and delinquencies are not a perfect proxy for
what cohort default rates might look like for companies like ESI. First, defaults
and delinquencies captured in the Sallie Mae data could go back to loans
originated beyond the scope of the cohort default calculation (i.e. prior to
September 30, 2007). We know there are loans in that portfolio that are 3-5
years old that could now be in delinquency or default. Second, the interest rates
charged on many of these loans were higher than the typical loan under Title IV.
Finally, there could be substantial variances in the quality of the schools in Sallie
Mae’s “non-traditional” loan portfolio.

That being said, the data from Sallie Mae suggests that cohort default rates are
poised to surge. In the past, this has resulted in significant regulatory scrutiny
and often changes to the operating landscape.

One thing which we have not heard much discussion about is ESI’s potential
liability from loans originated by Sallie Mae to its students in 2007. Here is
what ESI stated in its 2006 10-K stemming from its relationships with private
lenders:

“In 2006, we also indirectly derived approximately 34% of our revenue

from unaffiliated private student loan programs. We have no financial
responsibility with respect to any loans made to students or their
parents under the unaffiliated private loan programs, except for an
immaterial amount of loans with respect to which our obligations are
fully reserved.”

Here is what the company stated in its 2007 10-K related to its relationship with
Sallie Mae:

“Inaddition, we are financially responsible for certain

loans made to students or their parents under an
unaffiliated private education loan program.  This
program was terminated effective February 22, 2008 [Sallie
Mae].  We do not believe that our financial responsibility

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with respect to those loans will have a material adverse affect

on our financial condition, results of operations or cash
flows.”

ESI has never disclosed exactly what the trigger might be for potential
liability with respect to its relationship with Sallie Mae. Based on the
changes in the company’s disclosure, it would seem ESI’s only liability
relates to originations made in 2007. Assuming that loans made by Sallie
Mae accounted for 20% of ESI’s revenues in 2007, that would imply the
total loan portfolio for that year amounted to $170 million. We think
investors should pay close attention to the performance of Sallie Mae’s
non-traditional loan portfolio going forward to gauge whether or not ESI
will take any charges related to defaults.

Department of Education Clearly Is Focused On Affordability

There is no discernible difference between educational outcome for students

attending the ITT Technical Institute and other career oriented schools as
measured by placement rates and average starting salaries. However, ESI has
some of the highest operating margins in the for-profit education sector. Even if
you wanted to give the company credit for more cost efficient marketing and
educational delivery, we think that higher tuition costs are the biggest single
factor in ESI’s superior operating margins. The administration has made it clear
they are focused on access and affordability. During a period of rising default
rates, we think it is highly likely that ESI will become subject to greater
regulatory scrutiny due to the high cost of its programs and elevated operating
margins.  We continue to believe the only remedy is for the company to restore
the affordability of its programs such that “the more you learn, the more you
earn” student covenant is re-established.  We estimate that restoring
affordability of ESI’s programs could negatively impact EPS by $2.50-$3.00,
perhaps more.

As always, please act accordingly…

Related Posts:
 U.S. News and World Report Article Highlights Debt Burden of Students
Attending For-Profit Colleges
 Whatever Happened to "the More You Learn, the More You Earn"? The
Structural Problems with ESI's Business Model
 Some Quick Thoughts on the Credit Suisse For-profit Education Sector
Downgrade and ESI's Upcoming Earnings Release
 Survey Shows the Elasticity of Demand Is Starting to Creep Into the
Higher Education Sector - The Acceptance Rates at Some SUNY
Schools Are Lower than Some in the Ivy League
 The Bulls Are Going to Like the Headline Numbers for ESI's 1Q09, but
Some of the Balance Sheet and Cash Flow Details Deserve Attention

This entry was written by PAA Research, posted on July 5, 2009 at 1:30 pm,
and filed under For-profit Education, Short Ideas and tagged Career Education
Corp., CECO, COCO, Corinthian Colleges, ESI, For-profit Education, Income
Based Repayment, ITT Educational Services. Edit

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