Investors can make bad decisions, and businesses sometimes fail due to unforeseeable market conditions. But Thomas Jefferson School of Law’s impending default on $133 million in tax-exempt bonds was predictable, perhaps even inevitable. The American Bar Association accredited the private law school in San Diego in 1996, but U.S. News & World Report never rated it; the magazine cuts off its ranking at 145 of the 203 ABA-accredited schools. Undaunted, Thomas Jefferson moved into a lavish new building in January 2011, just a few years after the Great Recession devastated demand for legal services and created a glut of law school graduates seeking employment. Law schools generally, and bottom-tier schools such as Thomas Jefferson in particular, have been in free fall ever since. From 2007 to 2013, Thomas Jefferson raised its acceptance rate from 45 percent to 81 percent—essentially open admissions—but enrollment still declined.
Steadily declining job prospects have cut into law school applications, resulting in lower enrollments and depressed tuition revenue. Many expenses associated with running a law school—such as faculty payroll, rent, and debt service on the physical plant— are fixed. Even sharp tuition increases cannot make up the revenue loss from slashed enrollments. Public law schools can subsist on legislative largesse, but private law schools—especially stand-alone schools without an endowment cushion to ease restricted cash flow—face financial crisis.
It doesn’t help when the school is the target of a class action lawsuit by graduates claiming they were defrauded into attending based on misleading job-placement statistics. Thomas Jefferson faced those charges in May 2011, just months after moving into its fancy eight-story digs in San Diego’s trendy downtown East Village. A 2008 Thomas Jefferson graduate who borrowed more than $150,000 to attend alleged that the school had misrepresented its post-graduation employment. The school said that its employment rates were between 80 and 90 percent, when in fact those statistics included part-time and non-legal jobs. The actual placement rate for Thomas Jefferson graduates in full-time legal positions within nine months of graduation is closer to 25 percent. Combine toxic publicity with high tuition, the highest average student-loan debt in the nation, poor academic ratings, an abysmal job market, and the lowest bar-exam pass rate among California’s 21 accredited law schools, and it’s no wonder that applications plummeted and enrollment plunged.
Notwithstanding some faculty and staff layoffs (even as the new dean gets paid more than $500,000 a year), Standard & Poors recently downgraded Thomas Jefferson’s credit rating from an already poor BB+ to an even lower B+ with a negative outlook—junk-bond status. S&P’s commentary in December 2013 was prescient: “We believe the law school’s large amount of debt and very high debt service, which resulted from the construction of a new facility that the school put into service during 2011, are credit weaknesses. In our opinion, there is also enrollment risk given the declining number of law students nationally and recent weakness in headcount that will likely compress operating margins, particularly since the school has no track record of fundraising.”
Fortunately for Thomas Jefferson, the bonds that it has defaulted on were issued by Merrill Lynch in August 2008, before the downgrade made the school’s credit unworthy. As S&P predicted, Thomas Jefferson has not been able to make payments to its bondholders since June of this year and is now technically in default. The bondholders are currently “negotiating” with the school to “restructure” the debt, but the diminishing viability of Thomas Jefferson’s business model makes a happy outcome unlikely. When the bondholders’ forbearance agreement with Thomas Jefferson ends in October, the law school may have to suspend operations if it cannot resume debt repayments.
If Thomas Jefferson goes bust, disappointed investors may ask their financial managers how a marginal school in a challenging (and overcrowded) industry got approved for $133 million in bonds. As it is, Wall Street underwriters have plenty of explaining to do. A partial explanation is that the bonds were issued as tax-exempt debt obligations, making them more attractive to investors than taxable bonds with comparable risk and yield. How is a privately owned law school able to issue tax-exempt bonds? The tax-exemption comes thanks to the California Statewide Communities Development Authority (CSCDA), a “joint powers authority” under California law that exists to help with “the timely financing of community-based public benefit projects.” The bonds are issued in the name of a government entity, even though a private investment bank has underwritten them. The CSCDA claims to be a mere bystander in the Thomas Jefferson debacle. But its own guidelines state that in order for a nonprofit applicant such as Thomas Jefferson to gain approval for financing construction of new facilities, it “must demonstrate that the community will receive a public benefit as a result of the financing.” The benefit of a luxurious new building for California’s worst-performing law school remains unclear.
A more fundamental question: Who would lend more than $180,000 to a marginally qualified student to attend a mediocre school with, at best, a one-in-four chance of landing a full-time legal job? The lucky few who do find a job will barely earn enough to repay their student loans. Student loans comprise virtually 100 percent of the school’s revenue stream. No bank would underwrite such loans so indiscriminately—only the federal government would be so foolish. The well-intentioned federal Stafford and Graduate PLUS programs allow students to borrow large (and in many cases imprudent) sums of money directly from the federal government to finance a legal education that may never lead to remunerative employment. While such programs are designed to “help” students, they often mire them in heavy debt and enable unscrupulous schools to charge exorbitant tuition for worthless degrees. Many students would be better off if they had never attended law school and incurred such huge amounts of non-dischargeable debt.
One important lesson in the Thomas Jefferson School of Law train wreck is that, if permitted to do so, market forces can provide needed discipline to prevent economically unsound transactions. Government programs such as profligate lending for higher education create a moral hazard. Will we ever learn?