How Many Lenders Does it Take?

According to recent reports, some lenders are pulling out of the Federal Family Education Loan (FFEL program due to malfunctioning credit markets - and, some loan industry officials say, due to cuts in federal subsidies. The authors of these reports appear to believe that fewer lenders is bad news. But is it necessarily bad to have fewer lenders participate in the FFEL program and better to have more? Are there too many now or too few?

These questions expose FFEL’s fundamental policy flaw. An auction system, like the one Congress enacted for PLUS loans set to begin in 2009, provides the remedy.

FFEL Can’t Get it Right

The FFEL program's fundamental policy flaw is that it is not designed to ensure that an optimal number of lenders (or any lenders at all) participate in the program at a reasonable price for taxpayers. The result is a continuous debate about how much lenders should be subsidized to ensure that "enough" lenders participate in the program.

More lenders in the program ensures a well capitalized program and greater competition for school and student business, fostering better customer service. On the other hand, more lenders in the FFEL program requires higher subsidies and costs taxpayers more money, making fewer dollars available for say, student grants or other priorities. Unfortunately, Congress, the media and student loan lobbyists never confront these tradeoffs head on. A framework is therefore needed that forces policymakers to be explicit about the tradeoffs. The PLUS auction provides that framework.

Sloppy Guesswork, Waste and Lobbying

First, let’s reiterate the goal of the FFEL program. Since its inception in the 1960s, the program has aimed to ensure that all college students have access to affordable loans for any school they wish to attend. Prior to FFEL's creation, private lenders were not willing to provide loans to all borrowers at all schools. So, the federal government wrote generous terms for all borrowers into law and then subsidized lenders to make the loans.

Unfortunately since the FFEL program's inception, Congress has not known how much banks need to be subsidized in order to issue loans and provide quality customer service. And Congress isn’t sure how many, or even which lenders it should subsidize. In response to this lack of information, Congress guesses a subsidy rate, writes it into law, and then provides the same subsidy to any and all lenders willing to make loans. There’s no guarantee, however, that lenders will make loans, since the subsidy is an incentive, not a contractual obligation.

These factors - that loans are made voluntarily and that Congress doesn’t know how much subsidy is needed or how many lenders are needed - lead to influence peddling, waste and risk. Congress errs on the side of over-subsidizing lenders because it is afraid of the risk that someone, somewhere might not get a loan if the subsidy is too low. Student loan companies take advantage of this fear and send representatives to Capitol Hill to make the case for big subsidies. And when a few lenders leave the loan program, the loan companies make no haste in whipping up fears that the entire program is on the verge of collapse. And they are extremely effective in getting the press to do their bidding.

The Auction: Making Tradeoffs

The PLUS loan auction pilot puts an end to this dynamic. It establishes a contract between the government and lenders to provide loans, and it sets the price paid to the lender through competition. It also ensures that the subsidy is high enough to compensate lenders, because the lenders themselves submit the subsidy bids. Additionally, the auction establishes a set number of lenders to make loans. Two lenders in each state will have the right to make all PLUS loans every two years. Lenders win this right by bidding on the interest rate subsidy. The lower the bid, the more likely a lender is to win the right to make the loans.

Now, it is fair to argue that two lenders per state is an arbitrary number and not optimal. But a benefit that the auction system has over the current FFEL structure is that it forces Congress to recognize and act upon the explicit tradeoffs in federal student loan policy. One side of the tradeoff is capitalization and customer service. A greater number of lenders will ensure that there is ample competition for loan business, thereby fostering quality customer service. More lenders will also ensure that there are enough lenders to raise, disburse and service the capital needed for all students at thousands of schools all around the country.

The other side of the tradeoff is cost. If two lenders are deemed insufficient to promote adequate service and capitalization, then Congress can allow more lenders to share the right to make PLUS loans. But more lenders will increase the government’s cost, because the subsidy rate would have to be high enough to allow the third, fourth or tenth least costly providers to make loans. Additionally, lenders would demand higher subsidies in their bids, as they would share the right to make the loans with more lenders and receive less loan volume.

An Improved Loan Program

The debate about subsidies, customer service and lenders leaving the program goes on and on, because the FFEL structure doesn’t allow policy makers to efficiently make tradeoffs among the competing goals of the program. The PLUS loan auction pilot offers a simple and straightforward way for policymakers to understand and act on these tradeoffs. It should help define more clearly what a better student loan program would look like for borrowers, taxpayers and even lenders.