On Monday or Tuesday of next week, the Department of Education will release final cohort default data for FY07. Before we get into company specific discussions, we wanted to review how the default rate data is calculated and provide you with an outline of the timing of future release dates for cohort default rate data.
How Cohort Default Rates Are Calculated and Their Implications
Under the Higher Education Act a postsecondary institution can lose eligibility to participate in certain Title IV programs, if the rate at which their students default on their federal student loans exceed certain percentages. The rates are calculated per institution and 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.
How the Cohort Default Rate Is Calculated
It is critically important to understand the methodology used to calculate the cohort default rate, which in general has been proven to understate 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 30th. The cohort is based on the number of students that enter the repayment period in a particular fiscal year. The repayment period typically begins 6-months after a student graduates or withdraws from a postsecondary institution. Student loan defaults are then calculated through the following fiscal year to determine the numerator in the cohort default rate calculation.
For example, if a student began repayment in October 2006 and defaulted on their student loan in August 2008, they would be captured in the cohort default data for 2007. However, if that student were to default two months later, in October 2008 they would not be captured in the cohort default rate. In short, any student that defaults 24-months after the initial repayment period WILL NOT be captured in the cohort default data. In addition, a lender can not make a claim for a defaulted loan with a guaranty agency until it is more than 270 days delinquent. A loan is not considered in default until a claim has been PAID by a guaranty agency. For example, a student that graduates in October 2006, enters repayment in March 2007, makes payments on his student for 12-months and then never makes another loan payment will actually never be captured in the cohort default rate data (as of the end of the measurement period, 9/30/08 his loan was only 180 days delinquent). The cohort default rate is not a good indicator of overall student loan outcomes, in fact during a period of rising unemployment it will likely massively understate the level of defaults associated with a particular cohort.
Changes Made During the Reauthorization of the Higher Education Act in 2008 (the Higher Education Opportunity Act)
Starting with the 2009 cohort, the maximum default rate to determine institutional eligibility to receive Title IV funds will be increased to 30%. However, as a trade off, the amount of time used to measure defaults will be extended from two years to three years. This will likely result in SUBSTANTIALLY higher cohort default rates for all industry participants.
Until three consecutive years (FY2012) of cohort default rates (CDRs) are calculated using the three-year default period, CDRswill continue to be calculated and penalties assessed using the two-year default period. Here are a few other changes beginning with FY2012 (which begins 10/01/11), the new law:
- Allows schools with a CDR of less than 15% (currently less than 10%) to qualify for multiple delivery and delayed delivery exemptions
- Requires any institution whose CDR is equal to or above 30% to establish a default prevention task force and prepare a plan to submit to ED for review
The Cohort Default Rate Data Timeline
Historically, schools have received preliminary cohort default rate data in early February and final data around September 15th. After next week’s release, the next major data point for the for-profit postsecondary education sector will come in early February when the preliminary data for FY08 is released to the schools. It is important to note that only the final data is available for public dissemination on the Department of Education website. Here is a link to a site managed by the Dept. of Ed. where cohort default data on any given school can be found. Not all companies disclose preliminary cohort default data. ESI, in their 10-K provides aggregate preliminary cohort default data (not on a school by school basis). COCO, provides school by school detail on preliminary cohort default data in its annual 10-K filing (which is typically released 1-month before final data is released). Given the likelihood that cohort default rates are poised to surge, we think investors will increasingly demand that companies release the results of preliminary cohort default rate data. The table below outlines the timing of the release of key data points related to cohort default rates. We view the “Student Delinquent as of” line as the most important. The FY07 cohort default rate for example will only show us data for students that were delinquent as of January 2008, in other words, on another planet.
Source: Department of Education,
Four Stocks to Focus on In Conjuction With the Release of Final FY07 Cohort Default Data
We have discussed our views on the pending spike in cohort default rates in the past. You can find our thoughts on ESI and COCO in particular here and here. The most recent private loan performance data from Sallie Mae suggests that cohort default rates could surge in the next few years. You can find more detail here. Overall, we expect the final FY07 cohort default rate to be materially worse than that for FY06, but it won’t be until the release of preliminary and final data for the FY08 cohort that investors will get an initial understanding of how the economic downturn will impact default rates. FY09 (students that are delinquent as of 1/3/10) will be worse than FY08 and at this rate it appears that FY10 could be as bad as FY09.
We have argued that cohort default rates were poised to increase irrespective of the economic environment due to the unneccessary financial burden incurred by students due to tuition policies that have eroded (if not eliminated) returns on educational investment. Based on the data we have reviewed from ESI and COCO it appears reasonable to assume that some schools could witness a 3-7% increase in their cohort default rate from FY06 to FY07. We think the increase from FY07 to FY08 will likely be much larger and the change from FY08 to FY09 even more. In general, we think any school that had a cohort default rate equal to, or in excess of 15.0% in FY06 could be at a material risk of exceeding the 25% default rate threshold as early as FY08. If unemployment levels remain high, it does not seem unreasonalbe that many schools could have cohort default rates in excess of 25% for FY08, FY09, and FY10, which would put them at risk of losing access to Title IV funds. Although stocks such as STRA or CPLA could be impacted by the release of final cohort default rate data (if the data showed a sudden increase, for example), we do not think those companies will be at any risk of violating the 25% standard. Here are a few companies we are focused on:
Washington Post Company (WPO)
- Total Number of OPE-ID schools – 27
- Total Number of OPE-ID schools above 15% in FY06 – 11
Washington Post is often overlooked among investors in the for-profit education sector. Kaplan, which is owned by WPO, is one of the largest providers of postsecondary education in the country with more than 100,000 students enrolled. Kaplan is now the driving force of WPO, accounting for 52% of revenues and effectively all of the company’s operating profits. Within Kaplan, the Higher Education division accounts for 54% of revenues and more than 80% of operating profits. Stated another way, WPO is Kaplan Higher Education. Kaplan Higher Education supports the operating difficulties at WPO’s newspaper, magazine, cable and television divisions.
When we reviewed the FY06 default rate data for Kaplan we were a bit stunned. Their student loan performance is the worst among the publicly traded for-profit postsecondary education players. It seems highly possible that as many of 25-40% of their schools could have cohort default rates in excess of 25% for the FY08-FY10 period. We know that Donald Graham has taken a “hands-off” approach with Kaplan over the past decade when the division was run by Jonathan Grayer. We are not sure how involved Mr. Graham might be now that Andy Rosen is in charge of Kaplan. Unless the company materially alters its enrollment practice it appears that WPO’s primary earnings driver could face major regulatory headwinds in the next few years.
Corinthian Colleges, Inc. (COCO)
- Number of OPE-ID schools – 40
- Total Number of OPE-ID schools above 15% in FY06 – 11
As we mentioned earlier, COCO has already released preliminary cohort default rate data for FY07, so we do not expect any major surprises. We have discussed COCO in detail, which you can find here.
ITT Educational Services, Inc. (ESI)
- Number of OPE-ID schools – 29
- Total Number of OPE-ID schools above 15% in FY06 – 0
ESI has already disclosed aggregate preliminary cohort default rate data in its 2008 10-K. Overall the range of cohort default rates increased from 5.5-12.9% in FY06 to 9.7% to 15.3% in FY07. We think public attention to cohort default rate data will increase in conjunction with the release of FY07 data. Companies with relatively high default rates and high tuition rates are likely to receive the most scrutiny. ESI falls into that category.
Lincoln Educational Services Corporation (LINC)
- Number of OPE-ID schools – 16
- Total Number of OPE-ID schools above 15% in FY06 – 2
LINC is a leading provider of automotive tech, allied health, business and IT diploma and associate’s degree programs. Historically the company has targeted students from lower socio-economic backgrounds. We think LINC could witness some of the largest increases in cohort default rates over the next few years based on the type of student the company enrolls and its tuition price points.
As always, please act accordingly…
