Law Schools are the Needles Popping the Education Bubble

Universities, as we now know them, will cease to exist in 15 years. The education bubble will burst. Count it. Put it down in the record books. Circle back with me in a decade and change and call me wrong. I dare you. Not only is everything that we now know about universities about to go lop-sided, but my profession is going to be the blind executioner delivering the ax-blow. Again, try me on this. I double-dog dare you.

The Writing on the Wall

Unless you've been living with your head in the sand, you're probably aware of the dismal numbers being reported from today's law schools regarding employment. The miserable job market for new lawyers even made the cover story on last week's Birmingham Business Journal. The 20% decline in median starting salary, the general decline in overall employment, and the steep decline in employment in jobs that require a law degree is only one side of the story. The rest is much uglier.

What further research will show you is that new graduates across the nation are also failing the bar at significantly higher rates than they ever have before. Multiple states are posting record-low pass rates, like Florida and Arkansas, and some rumors are pointing to similar results in California and Oregon. Alabama just posted its worst pass rate in recent history. The results still aren't official in most states, but get ready, because this year will be a doozy.

Supply Lag

The problem with all of this is the same problem with measuring any strictly regulated industry: lag. From an economic and statistical standpoint, we can't do accurate measurements in the legal industry to gauge supply because there will be at least 3 years before the supply is able to react to changing demand. More realistically, you might not see a responsive change for anywhere from 5 to even 7 years.

Let's give a pertinent example. Let's take your average pre-law college student with some mundane humanities degree like English, Philosophy, History, or Politics. On the cusp of graduating college, there are no real prospects for employment without going to some graduate school for these aspiring humanitarians, and at the top of the midden heap is the ineffable law school opportunity. After all, the market for philosophers is currently in a secular bear rotation.

With no real alternatives, that college student is going to go to law school (assuming they get in), because it's the best alternative. In an ideal scenario, that person graduates, passes the bar a few months later, and is officially allowed to practice law after a little over 3 years.

Most of our current statistical models show that any change in the supply of lawyers really needs to look at only the 3-year law school requirement to respond to changing supply. This delays responding to demands by 3 years, which means that what we're seeing now is only reflective of the market exactly 3 years ago.

However, there's a major flaw in this assumption. That humanities pre-law student suffered from a little path-dependency. S/he didn't have the benefit of switching horses mid-stream and going the lucrative STEM route. However, that Senior's Sophomores would have had a little more clarity (and hopefully a parent with some financial chops) that might steer them away from the law school-only route. Since that Sophomore would have two years left on their tenure, they can switch to another degree, such as Business Management, without having to scrap all of their pre-requisites and still graduate with a worthy job, or at least have prospects after a relatively shorter (and cheaper) graduate M.B.A. program.

With this information, we need to realize that, in order to properly account for changes in supply in the legal market, we need to look back further, maybe back to when aspiring students have the option to switch educational specialties, before we cut off the sample size. Even further, high school students are likely entering college now with full recognition of the cratering on the legal industry. These students probably won't have visions of torts books dancing in their heads, and will likely deviate into some other lucrative educational area and won't bother with pre-law at all.

Ok, I Follow You, But So What?

This is important, because this means that we're just now starting to see the supply of lawyers actually responding to demand after the economic downturn.

I graduated from law school in 2010. In that year, we fully felt the impact of the economic downturn that started in 2008. While employment was bad in 2008, there was still enough excess demand to fill job positions. By 2009, everyone was still hoping that the downturn would be short-lived, so hiring was down, but not dismal. By 2010, hope had burned a lonely and isolated effigy. I, for one, have since told every college kid that would listen to avoid law school like a sweaty Ebola patient. The sentiment is not mine alone.

It's very possible that that information has just now finally leaking through, and the results are starting to show. They aren't good. Bar passage rates are down. Law school admissions are down. Applications are down. LSAT entry scores are down. Employment is down. Salaries are down.

The only thing going up in the legal industry is, not surprisingly, tuition.

Between a Rock and Law School

To blame law schools, or even the American Bar Association that accredits law schools, is really missing the point. They are victims of a system trying to take advantage of them both. Here's a dirty little secret you may not know: universities are profit-seeking institutions. They seek to maximize revenue and minimize expenses. Public, private, for-profit or not, the motives are similar, if not exact. For most "non-profit"schools, the profit motivator is extra money that can be allocated to research, publication, and marketing, three of the biggest factors considered when schools are ranked by independent reports. This, in turn, feeds the revenue side of the coin through higher tuition and more qualified applicants. For-profit schools just happen to be a little more honest on the equation, and rarely have massive endowments to soften the optics.

Law schools, therefore, are brilliant profit-centers for universities. The facilities don't have to be specialized, and no special equipment is required. The faculty, while usually well-paid, still earns less than their private-practice counterparts, plus the expense of allowing law professors to perform research is significantly less expensive than, say, psychology or medicine or theoretical physics. Plus, lawyers make so much money! Loading up heavy debt on someone that could foreseeably pay off that liability with their year-end bonus makes you feel a little better about charging exorbitant prices for access to that cash-flow, right? Right?!

Well, that used to be the calculus, right up until everything went into a tailspin in 2008. All the sudden, there was increasing demand for education because people were out of work. However, there wasn't any money to pay for it because tax revenues were down and most states were tightening their belts, while also slowing allocations towards scholarships and state school funding.

The Needle Point

As I've mentioned before, law schools operate as profit centers for many universities. This is one of the worst secrets kept in academia. Usually, when you see that a college has been promoted to university status, it has been because the institution added some graduate program, usually a law school. The American Bar Association, at least until 2009, was generous with accrediting new law schools to the tune of one or two per year for the last several decades. This allowed universities to add a significant revenue source without exorbitant operating costs.

However, when the legal market went up side down in 2008, law schools were the first to feel the crunch. Applications dropped precipitously over the next five years. But this did not alleviate the pressure from the university for the traditional cash-cow profit-center to keep funneling revenue from the law school to the university. Many law schools have an obligation to pay a high percentage off of top-line gross revenue directly to the university before the law school is even able to cover its own costs. Therefore, if the law school does not have a certain number of applicants who are paying full or almost full tuition, the law school will simply be unable to operate because all of the money is allocated before even professors can be paid.

We are seeing this bearing out in the numbers that we are getting from law schools over the last several years. Law schools have not significantly dropped the size of classes, despite the precipitous drop in law school applications. One would think, fewer applications would result in lower class sizes. In reality, law schools have lowered standards to accept more applicants at the expense of quality. If you don't believe me, look at the miserable bar passage rates over the last several years, and this year especially. The individuals taking the bar exam this year, in 2016, were admitted into law school in 2012, just four short years after the recession began, and two years after the realities of the legal market became apparent. However, many of these students might not have been able to redirect their studies to focus on a non-pre-law major, meaning that future numbers could actually get worse.

Many law schools have been able to hide this by being able to recruit higher-end students that are able to shift their bell curve enough to still brag about their LSAT entrance averages, but this comes at a cost too. Most law schools do not work on a need-based scholarship criteria. In my experience, most scholarships, and especially the largest scholarships, are directed on merit basis. This means that, if you're in the bottom end of the class, but able to pay full tuition, you are probably subsidizing somebody in the top quarter of the class, who is there to bring your average up for statistical and reporting purposes. This is a common practice, if not often openly discussed. It is not necessarily a problem, so long as everyone is still able to participate in the market after graduation.

The Needle Tears a Hole

Like I said, it's not necessarily a problem. That is, except until the bottom half of the class is consistently failing the bar exam and unable to earn enough money to pay off those massive student loans. In Alabama, a plurality of individuals taking the bar have student loan debt in excess of $100,000. On average, they have about $75,000 worth of student loan debt, and the top quartile easily has over $160,000 in student loan debt. This is just for Alabama, a state in which is relatively inexpensive to get a law degree. In other states, this can be significantly higher, especially where students have had to finance significantly more living expenses over the 3 to 7 years that they have been pursuing their education.

Initial reports are showing the national averages for passing the bar in your given state will probably be around 65% to 75%. This means that the poor saps on the bottom end of the law school curve, who were also more likely to be paying full tuition, can't even practice law. There is no opportunity for them to earn the high salary necessary to pay back the debt load. These loans are non-dischargeable in bankruptcy, and currently carry an effective interest-rate of approximately 7.5%, nearly double the rate for home mortgage in 2016. For reference, Alabama defines usury interest as 6%, but that provision is preempted by federal mandate and not applicable in student loans. These individuals will end up paying anywhere between $1600 and $2500 per month in order to meet their ten year pay-off deadline, but practically will not be able to participate in the industry in which they spent significant funds to gain entry into.

This, of course, will result in increased regulatory scrutiny from the American Bar Association and, most likely, even Congress. There's even talk of removing the accreditation from existing law schools simply because their standards have slipped so low.

The Education Bubble

If you've ever had a beer with me, and we started talking about the economy, I've probably mentioned the Education Bubble. Everyone you ask has a different definition of a "bubble." I define a bubble as an area of the market in which prices have sored well beyond the investment opportunity, usually because social pressure or government policy, and often both, have created a moral hazard in which the market participants cannot, or will not, rationally value the return on investment. We saw this in the housing market, and I think we are now seeing it in the education market.

A generation ago, going to college was a value add, but not a requirement. Now, a college degree is hygiene. Your individual major might help, but increasingly, graduate schools are becoming the factor that differentiate potential applicants. This, of course, requires a lot of money, especially if a student needs to finance not only 5+ years of tuition, but also living expenses.

Universities are cashing in on this opportunity to the tune of big revenues. While the traditional revenue model for universities focused primarily on endowments, alumni donations, and tuition, universities have become scrappier in finding alternative revenue schemes. The most common alternative revenue scheme today is on-campus housing, in which a large majority of universities, both private and public, have begun to mandate that students live on-campus for certain number of years, in facilities generously provided at greater than market rates by the university. College meal plans work much the same way: the universities know that their breakage (the number of students that routinely opt out of partaking of university food services) will allow them to make a hefty return on their investment, and the university can force participation as a condition of admission and participation.

The problem with this, obviously, is that it's not contributing to the core college experience: the education you're receiving from the educational institution you're attending. These expenses are not only increasing the cost of attending college, but are often time eclipsing the costs of tuition itself. We will look back at these excessive student life perks as prime evidence of the education bubble in the same way that we are now looking back at sub-prime loans during the housing bubble.

Increasingly, studies are showing that graduates are ill prepared to work in the actual labor force and that graduate and post graduate academia is not preparing and educating the future workforce. A running joke amongst recent graduates is that every "entry level" position requires two to even five years of experience. This is hardly entry level.

If you go to an educational institution to learn how to perform a specific profession, such as the practice of law, and that educational institution does not prepare you to perform that specific profession, then you must value that investment accordingly. The problem is that analysis is based largely on uninformed popular opinion, and hard numbers are often difficult, if not impossible to obtain. This has prompted prominent entrepreneurs, such as Peter Theil, to actively campaign against the college experience as a waste of valuable time and money.

While I don't go as far as Theil, I agree that the risk-return outlook for education has gotten skewed, such that a correction is inevitable.

How It Goes Down: A Prediction

The first part of this article was to give you pretty extensive background on the issue. Now it's time to address where the rubber meets the road. This next part is my prediction.

There will be a correction in the education market. The correction will be large enough to destabilize and alter our current perception of the education industry in such a way as to cause the bubble to pop. After the correction is over, colleges and universities as we know them now will need to significantly change, or, in the alternative, will come under such increasing federal oversight and regulation as to be shadows of their former selves.

Here's how it will play out

Sometime in the next five years, law schools will come under hot scrutiny from the American Bar Association or Congress. Regardless of who wields the ax, the end result will be that a number of law schools, and disproportionately for-profit law schools, will lose accreditation under the ABA.

This will create a conundrum for the multitudes of students that had previously attended or graduated from those schools who are not licensed to practice law. This visible and litigious microcosm of the educational bubble will force legislative change on the way that federally-backed loans are issued and repaid. Specifically, in much the same way that the federal government increased regulation on the housing market after 2008, more education and review will be required prior to a student taking on substantial debt. Additionally, more avenues will open up for deferred payment or even partial or full loan forgiveness in more circumstances.

This will increase the budget squeeze on universities. As a practical matter, they will simply not be able to attract as many students as before because of the increased scrutiny and they will receive relatively fewer dollars for their effort. The blank checks written by the current education finance market will no longer be valid. Further the cost of doing business will increase, forcing universities to reevaluate their existing profit centers, because traditional areas of high revenue, such as law schools, are no longer making as much money as they used to. Many universities are already investing heavily in online education, and this will continue to be a feature moving forward, because the university can benefit from more revenue at marginally low-cost. More than one prominent university will shift from physical learning to online learning as a primary outlet for education within the next 10 years.

Probably the single biggest problem in popping the education bubble is the inability to short the market and force realization of the actual cost-benefit relationship. While many people despise investors that short the market, shorters provide a necessary service, namely putting downward pressure on an overvalued market. Movies like The Big Short highlight how difficult it can be to spot flaws in even highly public markets and structure a shorting position. The education industry is vastly more difficult, because so much of the industry is not transparent and does not have options market exposure to allow shorting. Regardless, someone will figure a way to make money off the collapse of the education industry, and the first domino will fall.

Once the media picks up on the story, numerous students will profess how they felt lied to in an increasingly public forum. This will cause increased scrutiny and oversight and further decrease not only graduate enrollment, but also undergraduate enrollment, as well.

Ultimately, the education bubble will pop, and we will be left with a generation of over-educated unemployables with staggering debt loads. Colleges and universities will respond by providing more directed, career-focused educational tracks, without trying to package the entire "college experience," which will have become pseudonymous will the prior generation's excess. After all, suite-style dormitories and rooftop pools don't prepare you for your job as an engineer or market analyst.

Law schools get hit especially hard during this time, and the legal industry as a whole takes a serious look at itself. Weathered by decades of cheap competition from technology and overseas alternatives, the legal industry reassess admissions criteria and makes a significant change to increase access into the industry, while still holding onto a higher, more specialized and regulated, practicing tier, much in the same vein as the English barrister. Law schools, especially, reassess, providing a two-tiered track for paralegals and for full lawyers, but with more practical application than today's schools. Their class sizes are also significantly smaller, and individual schools work to develop practice specialties to attract out of state applicants.

The Bottom Line

Because of the pressure placed on them by universities, all law schools have increasingly been forced to take less qualified individuals in order to keep class sizes and, vicariously, revenues up. This is creating an entire class of graduates who are both unable to practice law and unable to pay back the mounting load of debt that they have been saddled with. Ultimately, the visibility of this group will force the legislative change that affects the entire education industry, which will pop the current education bubble. Universities will be forced to reconsider and reposition their value proposition in light of increasing governmental scrutiny and public backlash. In the end, universities, and more importantly, the graduate programs attached to them, will focus on narrower, more practical training that prepares individuals for actual job experience.