Financial Irresponsibility

What to Do Next to Improve Oversight and Protect Taxpayers
Blog Post
Mark Van Scyoc /
Jan. 5, 2018

This post is the third and final in a series about the financial responsibility rules to which institutions of higher education are subject. The first post explored the history of the rule; the second post delved into the Department’s ongoing regulatory efforts; and this final post provides recommendations for Congress and the Department in moving forward.

Too often, high-risk colleges close precipitously, placing a substantial financial burden on taxpayers, not to mention students. Without obtaining collateral or surety from schools upfront, the Department of Education is forced to spend taxpayer money to bear the costs of providing the relief to which borrowers are entitled by law. With the growth of high-profile closures in recent years, some stakeholders have once again turned their attention to this issue, with a host of interesting—if yet unexamined—ideas. However, congressional Republicans largely turned a blind eye towards such concerns in their recent reauthorization draft for the Higher Education Act (HEA), instead signaling their intent to gut longstanding protections and safeguards for students and taxpayers in the wake of the largest institutional closures in our nation’s history. The latest version of the reauthorization bill (see New America’s analysis here, here, and here) would substantially curtail the financial standards institutions must meet to receive taxpayer funds, opening the door to a golden age of waste, fraud and abuse.

On the bright side, the latest draft of the reauthorization bill wouldn’t eliminate the Department’s authority to use financial ratios to adjudicate an institution’s financial wherewithal altogether. But there’s a catch: A school can fail the composite score test and remain in operation, no strings attached. This is because the bill creates new escape valves that institutions can use to prove their finances are intact, even if they fail the test. The bill replaces the manifold list of standards for financial responsibility in current statute with a list from which an institution need only satisfy one to be considered financially responsible. For example, an institution with a high credit rating could be considered financially responsible, even if it fails all the other indicators.

As written, the bill also limits the Department’s authority to obtain surety (such as letters of credit*) from risky institutions up front. For example, failing the financial responsibility composite score alone wouldn’t trigger the letter of credit (LOC) requirement, like it does today. The Secretary could only require an LOC if the institution’s auditor indicated that the institution is not a going concern (accounting jargon meaning that the auditor doesn’t think the institution has the money to operate for more than a year), if the Department can prove that the institution is at risk of precipitous closure, or if it can prove that the institution is at risk of not being able to meet all of its financial obligations.

These criteria seem innocuous enough, but would introduce additional subjectivity into each decision the Department must make, straining staff capacity, adding time to the process, and likely translating into ineffective oversight. How effective have auditors been in flagging an institution’s risk for closure? Based on the very limited data currently available, we don’t know and neither does Congress. How is the Department supposed to prove that an institution is at risk of closure or what is the threshold for an institution being at risk of being unable to meet its financial obligations? Some might say these issues are the province of the composite score model, but this bill suggests otherwise.

The proposed reforms fly in the face of reports from the Department’s Inspector General (IG) and the Government Accountability Office (GAO) that the Department’s financial oversight warrants improvement. The IG found that the Department’s slow response to resolving composite score disputes with Corinthian Colleges precluded early intervention prior to its closure, resulting in millions of taxpayer dollars lost. If this bill were passed, the Department would have even more hoops to jump through before a failing institution’s appeal could be resolved, leading to a domino of Corinthians.

Moreover, the IG and GAO both asserted that the Department’s should consider more, not less, information from institutions in evaluating their financial condition. This bill keeps oversight at a bare minimum, introducing none of watchdogs’ proposed reforms. The IG endorsed the Department’s recent efforts to collect and use additional information from ratings agencies and other external financial reporting tools when selecting which institutions warranted a program review. The IG also endorsed provisions of last year’s borrower defense rule that added extemporaneous reporting of events that can significantly increase the risk of closure, such as big year-to-year swings in federal aid revenue (which indicate enrollment instability, or could even suggest fraudulent or inappropriate behavior, possible precursors to closure), lawsuits initiated against an institution, or violations of the terms of an institution’s loan agreements (if it carries debt). The Trump Administration has put implementation of these reforms on hold, and this bill does nothing to enact them.

*An irrevocable letter of credit (LOC) is a financial instrument issued by a financial institution (most commonly a bank) on behalf of a school, which is generally secured by collateral (generally cash reserves), held by the bank. The bank will pay the LOC funds to the Department when the Department initiates collection for reasons that are listed in the LOC. The LOC mitigates the monetary risk from schools not in compliance with various regulatory standards, yet allows the school(s) to continue Title IV participation, while improving, or eliminating the issue(s) that required the LOC.

Recommendations for Reforms to the Financial Responsibility Score

While the current reauthorization bill is a step in the wrong direction for financial oversight, it’s not too late. Congress could still pursue some common-sense reforms, like the ones below, that strengthen existing safeguards and address the weaknesses of current statute to the benefit of both students and taxpayers. Congress must take a more proactive role in improving oversight of shaky institutions by creating a more dynamic set of tools that allow the Department to respond to a wider range of financial indicators, and allow the Department to respond to problems flagged by those indicators more nimbly. Statutory changes could improve oversight of financially risky schools and reduce burden on institutions and the Department.

1. Congress should appropriate funds for the Department to hire risk management and accounting experts to conduct an in-depth review of the financial composite score to improve its capacity to predict failure.

Instead of focusing on short-term fixes to the composite score in the present rulemaking, which we warned against in our previous post, the Department should create a long-term fix to the composite score that predicts failure early and accurately. The most common criticisms of the composite score’s predictive ability have remained fairly superficial: the score is “old” or “outdated,” so it must be bad; the score hasn’t predicted every single closure (no model will be perfect); the score doesn’t consider liquidity (it does); or changes in accounting standards render the score ineffectual (an exaggeration). Even if there is truth to some of these claims, students and taxpayers deserve a deeper, more thoughtful look at the problem.

If the model did not predict failure in a particular case, we should know why it didn’t and what changes would have produced a different result. To start, the Department should scour the balance sheets of every institution that suffered closure to identify specific trends that portended failure. For example, their analysis might indicate whether the aggregate thresholds for composite score failure should be raised or lowered from the current cutoffs of 1.0 and 1.4, or that weighting the net income ratio more heavily than the primary reserve ratio would have flagged more institutions in dire straits. It may also indicate that alternative ratios would have picked up on failure far earlier than the existing model. Only rigorous analysis will tell. At a minimum, the Department’s data on closure should be improved to allow for easier post-mortem evaluations that help identify the inflection points of failure. And Congress should direct the Department to use that analysis to inform a new rulemaking on the composite score, bringing financial responsibility into the 21st century.

2. Congress should create a board of non-partisan accounting experts who convene following any update to the FASB standards. The board should provide guidance on unresolved accounting disputes between institutions and the Department and evaluate potential changes to financial responsibility standards.

Congress should form a body, similar to the National Advisory Council on Institutional Quality and Integrity (NACIQI), the independent advisory board that makes recommendations on the recognition of accrediting agencies to the Department, to convene experts in the accounting field and determine whether periodic FASB accounting standards updates warrant revisions to the financial responsibility rules, and when. Given the frequency of updates from FASB (which has adopted changes, albeit minor ones, to its accounting standards frequently in recent years) and the cost and time—not to mention the politics—required for negotiated rulemaking, an outside advisory body would provide expertise in a transparent way to inform the Department’s actions. And similar to NACIQI, the advisory board would also submit recommendations to a senior higher education official at the Department for review, who would approve the measure and update the standards through policy manuals published and provided to institutions with each change.

This process would be far more transparent than the present rulemaking, where updates to the accounting standards are being debated in private by the very institutions being regulated. The board would ensure potential changes to financial responsibility rules are carefully circumscribed to cover only basic definitional changes and not policy issues, and would adjudicate only those disputes between institutions and the Department that are specific to accounting principles.

3. Once a revised financial composite score is in place, Congress should require the Inspector General to conduct routine sensitivity analyses of the composite ratio score and allow the Department to adjust failure thresholds outside the negotiated rulemaking process to ensure risky institutions continue to be captured.

As a nonpartisan government watchdog, the Inspector General at the Department is in the best position to provide regular guidance on the predictive value of the composite score, without straying into policy disputes that would undermine effective oversight or the kinds of accounting terminology issues that would be best addressed by other experts. For instance, if a lot of institutions receiving a zone score around 1.1 were failing, the IG may recommend adjusting the cut-off for failure so that more schools in this zone were flagged as failures. Real-time updates to the ratio thresholds would ensure that the composite score continues to operate as an early warning sign of failure, even as the higher education sector continues to change. The IG would be responsible for ensuring that the Department maintains rigorous and comprehensive data on institutional failure, which would be used for improving the predictive quality of the composite score and guaranteeing the Department is fulfilling its financial oversight duties effectively.

4. Require periodic reporting of significant financial events to the Department.

According to the 2017 Inspector General report about financial oversight, the Department has done a poor job of tracking significant events that occur in the period between an institution’s annual submission of its audited financial statements, even when those events pose a grave and immediate danger to the institution’s financial health. The 2016 borrower defense rule created a mechanism through its financial responsibility framework to measure risk on an ongoing basis, and was lauded by the IG as a first step to improving oversight of embattled institutions. The Department should give serious consideration to which of those elements it would like to maintain in regulations--starting with the few it proposed to maintain in its draft--so it identifies and takes action against high-risk institutions automatically and protects taxpayers from the costs of closed school discharges and other liabilities. Moreover, to further cement this work and require the Department to update its practices, Congress should dictate in law that the agency consider these elements, much as it currently does in directing the Department to take factors such as fluctuations in federal aid revenue, default rates, or dropout rates into account when selecting institutions for program reviews.

5. Establish financial protection requirements for non-financial issues in statute outside of the financial responsibility framework to account for other sources of closure.

The financial responsibility composite score is explicitly designed to capture financial reasons driving a risk of closure. But as the GAO pointed out in a recent report, many closures are driven by other issues—such as accreditation concerns or state authorization issues. Corinthian Colleges and ITT Tech--two of the biggest closures in recent memory--were driven in large part by open state and federal investigations that left them vulnerable to huge liabilities. We shouldn't expect the composite score to catch issues it wasn't necessarily designed to detect. Congress should establish statutory links between these “non-financial” risk factors and existing surety requirements by mandating that the Department obtain an LOC of at least 10 percent of annual federal student aid funds from institutions facing high-risk, non-financial issues. It makes no sense to require funds up front from institutions with low financial composite scores but not from those at risk of losing accreditation or state authorization, which may face an equal, if not greater, chance of closure.

A Better Financial Aid System

The upcoming reauthorization of the Higher Education Act is a once-in-a-decade opportunity to shore up oversight of the federal student aid programs. Congress should build upon past oversight efforts and expand the Department of Education’s toolbox in dealing with institutions that burden taxpayers and harm students. Digging into institutions’ finances using financial ratios is an important part of that oversight--and efforts to refine these oversight heuristics must be improved on an ongoing basis. But the composite score also needs to be supported by other oversight mechanisms such as periodic reporting of significant events--financial and non-financial--to ensure every institution receiving government funds has a clean bill of health. Or, if the prognosis looks grim, unhealthy institutions must provide the surety necessary to reduce the impact of closure. Together, the Department and its partners--states and accreditors--can protect students and safeguard taxpayer dollars as Congress intended.