The Real Credit Crunch Culprit (Hint: It's Not Lender Subsidy Cuts)

In trying to raise panic over the student loan crunch, much of the student loan industry has had a not so hidden agenda: to get Congress to revisit lender subsidy cuts it made last fall.

Beware of Propaganda

The goal of reversing subsidy cuts became especially clear last week when Higher Education Washington Inc. (HEWI), a publication owned and operated by a top student loan industry lobbyist, published an article claiming there were "increasing signs that at least some in Congress will attempt to revisit the College Cost Reduction Act -- specifically, the elimination of $18 billion in subsidies to private lenders."

The article's proof for this claim: statements in favor of restoring the subsidies made by Rep. Howard "Buck" McKeon (R-CA) and Sen. Ben Nelson (D-NE). There's just one problem. McKeon and Nelson, both strong supporters of the loan industry, have never wavered in their opposition to recently enacted lender subsidy cuts.

In fact, Nelson, who has strong ties to the Nebraska-based loan company Nelnet, unsuccessfully tried to get the Senate to scale back the size of the subsidy cuts last summer when the College Cost Reduction Act first came up for a vote in that chamber. (He lost 61-36.) Now, in a statement he issued this month, he laid the blame for the loan industry's current troubles at least in part on his Senate colleagues for having defeated his amendment:

"I am disappointed my warnings against serious cuts to the FFEL program were overlooked and that my attempt to temper those cuts was defeated. Now we are seeing financial vulnerability in the student loan marketplace and students now face serious obstacles because of the capital market crisis."

Of course, as the Chronicle of Higher Education laid out in an article a few weeks ago, the widely reported trouble among some non-bank lenders in financing student loans is the result of their use of auction rate securitization -- not Congressional subsidy cuts.

Trouble of Their Own Making

In layman's terms, auction rate securities are a type of bond issued by companies and cities, including both non-profit and for-profit student lenders. Unlike conventional bonds, which carry a fixed interest rate, the interest rate on these items resets over short periods even though the underlying bond may not mature for many years. Because the interest rate resets frequently, as per an auction, it is lower than rates on longer term bonds and thus cheaper for the company issuing the auction rate security to finance a student loan. Auction rate securities therefore allow a lender to issue long-term debt that carries short-term interest rates. (See the testimony of Paul Wozniak in the House Education Committee hearing for further explanation.)

Financing loans with auction rate securities worked well...until no one showed up to buy them earlier this year. When there are no buyers, the interest rate automatically doubles or even triples to a pre-set level for underlying long term bond. This raises financing costs for the lenders to the point where income from disbursed loans is no longer profitable -- or at least less so. Of course, the lenders took that risk when they decided to pursue auction rate securitization as opposed to more traditional financing.

What's the connection between Congress' recently passed lender subsidy cuts and auction rate securities? There isn't one. The subsidy cuts took effect for loans disbursed after Oct. 1, 2007, which represents only a small fraction of the total outstanding loan volume. With the exception of the most recent cohort, all federal student loans carry a high level of taxpayer subsidies. The overwhelming majority of the securities in failed student loan auctions contain loans with these higher subsidy rates. Were credit crunch problems limited to the lower subsidy loans, then only securities issued to finance these loans would be failing. But this isn't the case -- there are problems with auction rate securitizations throughout the entire student loan market and the markets for many other types of debt.

The true causes of auction rate securitization failures is the overall lack of available credit in the financial markets -- a problem that is by no means isolated to, or caused by, student loans.

Watch for a Backfire into Direct Lending

Given that failed auction rate securitizations and recently enacted lender subsidy cuts are unrelated, the move to restore subsidies comes across as little more than an attempt by lenders to maintain inflated profit margins and cushion against inflated risks that lenders voluntarily and unnecessarily took in entering the auction rate securitization market. This explains why there has been so much misinformation, false panic, and questionable statements about the student loan credit crunch, and also why lenders have raised so many flags about a potential loss of access to student loans.

The simple fact remains, however, that as of now there is no federal student loan crisis. There are still over 2,000 lenders in the Family Federal Education Loan Program, including some, such as JP Morgan Chase and MyRichUncle, that have announced voluntary interest rate cuts for borrowers and lending expansions in the hopes of gaining market share.

Fear mongering and threats of availability won't bring back lender subsidy levels. Instead, it's more likely to convince schools to follow the recent lead of Penn State and Northeastern University into the Direct Loan Program -- an outcome we are fairly certain the loan industry doesn't want to happen.