Hedge Funds Turn Against Education Stocks - TheStreet

NEW YORK (TheStreet) -- Steve Eisman ranks as one of the most notable hedge fund managers of recent years. As the credit crisis unfolded, his FrontPoint Partners took a bold step, shorting subprime mortgage bonds, a move that produced enormous returns. The exploit was chronicled by Michael Lewis in his bestselling book The Big Short: Inside the Doomsday Machine (Norton, 2010).

Now Eisman is the manager of FrontPoint Financial Services Fund, a hedge fund owned by

Morgan Stanley

(MS) - Get Report

. He is once again drawing attention, warning investors about the dangers of for-profit education stocks, including companies such as

Apollo Group



ITT Educational Services

(ESI) - Get Report

. In recent years, the education businesses have prospered by enrolling students who seek to improve their career prospects.

Eisman says the education industry can only expand because students can cover their tuition with federal loans. But low-income students will never be able to repay their debts, he says. If loan defaults rise, the schools could suffer badly. The resulting mess could be as destructive as the subprime mortgage debacle.

Eisman says the amount of federal dollars flowing annually to for-profit schools has increased from around $2 billion in 2000 to more than $20 billion now. If present trends continue, defaults could total $275 billion over the next 10 years. Eisman says the government will have to clamp down in response to defaults. That will hurt leading for-profit companies, including

Corinthian Colleges



Education Management



Washington Post


, which operates the Kaplan education group.

Eisman spoke about his views last month at the Ira Sohn Conference, an annual charity event attended by 1,000 hedge fund managers and financial services executives. If you are tempted to follow Eisman's lead, keep in mind that two other hedge fund managers have also spoken about education companies at an Ira Sohn event.

At the conference in May 2009, Jim Chanos of Kynikos Associates, made the case against for-profit educators. Chanos said enrollment in the five largest for-profit companies had climbed from 379,000 in 2004 to 630,000 in 2008. That growth enabled the companies to record hefty profit margins and trade at a big premium to the overall market. But if the growth slowed, the companies could tank.

Another speaker at the 2009 Ira Sohn event was Steve Mandel of

Lone Pine Capital

. Mandel presented the bullish case, recommending

Strayer Education

(STRA) - Get Report

. He said the company would grow steadily for the next 10 years.

How have the Ira Sohn predictions fared? So far, the record is mixed. The industry remains soundly profitable, and Strayer Education climbed 33% in the year after Mandel recommended it. But if you shorted Apollo and Corinthian, you would have made money.

Eisman is well aware of the earlier predictions. But he says the stocks are likely to fall sharply soon because of new government regulations covering the employment of graduates. Under the legislation that created student loans in the 1960s, for-profit schools must prove that their graduates land suitable jobs.

The Bush administration loosened employment rules, Eisman says. That made it possible for schools to expand, even if many of their graduates did not get jobs. Now the Obama administration wants to tighten the rules. Under a proposal, graduates of for-profit schools would be expected to spend only 8% of their starting salaries on loan repayments. If students needed to spend a higher percentage of their pay, the schools would fail the test. Schools could be forced to lower tuitions or turn away applicants who could no longer qualify for federal loans.

In recent months, the Department of Education has introduced a variety of proposals on employment. Whenever tough rules look more likely to be approved, education stocks sink. But when industry lobbyists seem to be succeeding in watering down the rules, the stocks recover. Last week Education Secretary Arne Duncan said new rules will be coming out shortly.

Eisman says if the new rules are not passed, the for-profit education industry will implode eventually. Like homeowners who received mortgages that they couldn't afford, students are taking on more debt than they can handle. Defaults will rise -- until the government halts the debt binge.

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Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.