For-profit schools are a bad deal for both investors and taxpayers

December 29, 2014, 12:02 PM UTC

In Imperial China, convicted criminals were subjected to a particularly unpleasant form of execution called lingchi, which involved slicing a condemned man’s flesh multiple times until he was dead. This horrific form of old Asian justice gave rise to a commonly used Western phrase: death by a thousand cuts.

Publicly traded for-profit colleges, a group that includes ITT (ESI) and Corinthian (COCO), are suffering a form of lingchi these days. If their critics are right, they deserve it. Once darlings of Wall Street, they have underperformed this year as they have endured repeated slashings by the media, academics, consumer advocates, and federal and state law-enforcement agencies who say that they are cheating both students and taxpayers. At the end of the third quarter, their shares were down 20% compared with the S&P 500 index, which was up 7% for the year.

Studies show that students who have attended such schools have higher unemployment rates, lower earnings, and greater student debt loads and default rates than do students at comparable public and nonprofit private schools. Studies have also found that many for-profit schools spend more on marketing, multimillion-dollar compensation packages, and shareholder payouts than they do on actually educating their students. Government investigations have uncovered multiple instances of misleading recruitment tactics. Because enrollment numbers drive profits, the game is to attract as many new students as possible. One school, for example, was inflating its job-placement stats by paying employers to hire their graduates temporarily and counting as a “placement” jobs that lasted only one day.

Parents and students should be concerned, but so should taxpayers, since the schools’ revenues are financed almost exclusively by federal grants and loan guarantees. Indeed, while for-profit schools account for only about 12% of all U.S. college students, they account for 32% of federally backed loan borrowers and a whopping 44% of student-loan defaults. In the 1990s, Congress tried to place limits on their ability to milk Uncle Sam by requiring that they derive at least 10% of their revenues from sources other than federal student aid. However, these schools have found ways around this by, say, targeting veterans using GI benefits to pay for their education. (Because of a loophole, the GI Bill doesn’t count as federal student aid.)

Defenders of for-profits protest that they are providing opportunities to disadvantaged students that would not otherwise be available. To be sure, these schools target low-income and minority students, but what kind ofopportunity” are they providing by loading these kids up with debt they can never escape—student debt is not dischargeable in bankruptcy—to pay for an educational experience that does little to improve their job prospects?

The Education Department recently finalized rules tightening federal student-aid eligibility for for-profits and other schools that offer vocational degrees. But the rules do not attack the core problem, which is misaligned economic incentives. Like any crony capitalist, they privatize profits and socialize losses, making money by gaming the government instead of providing a service the market values. We need to close loopholes in the 10% test and require the schools to cover 20% of a defaulting student’s loan out of their own pockets. This would give the schools stronger incentives to make sure their students graduate and find jobs.

The Chinese administered lingchi when they believed there was no possibility of redemption for the victim. But for-profit colleges and their investors can be saved. They need to fundamentally change their business model from one based on taxpayer subsidies and cynical exploitation of students’ dreams to one based on providing valuable degrees that are responsive to the labor market. By doing that, they would help both students and our economy and perhaps justify their taxpayer support. 

Fortune contributor Sheila Bair is former chair of the FDIC.

This story is from the January 2015 issue of Fortune.

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