Congress Blinks in Game of Chicken with Lenders

On Monday, the U.S. House of Representatives gave in to pressure from the student lending community by agreeing to a one year postponement of the pilot PLUS loan auction that was slated to begin just under two weeks from now. The Senate is expected to follow suit.

Auction opponents are on the verge of winning the delay because they have threatened to not participate and have made claims that the competitive bidding process rests on too much uncertainty for all involved. We understand why these claims would resonate with lawmakers, but the facts of the auction process simply don't bear them out. Instead, the fear and panic raised by the auction's detractors resulted in an unnecessary game of chicken between lenders and Congress. It's clear who blinked first.

The House included the delay as part of legislation it approved on Monday that aims to make mostly technical corrections to legislation it passed last summer reauthorizing the Higher Education Act. The bill is still waiting on Senate action before it can head to President Obama's desk, though little opposition is expected.

Calls for the delay have come mostly from private lenders and the National Association of Student Financial Aid Administrators (NASFAA), parties that have opposed the auction since its inception as part of the 2007 College Cost Reduction and Access Act. While their arguments against the competitive bidding process have varied, most recently they have had four main talking points:

• Lenders would not bid, leaving the system with a lot of uncertainty.
• The auction would take too long to announce winners, bringing uncertainty for colleges putting together aid packages and families trying to take on loans.
• The auction would lower subsidies for lenders, making it unprofitable to make loans.
• Financial conditions make it too hard to bid on a long-term contract

While these arguments all make for good talking points, they are not all borne out by the facts of the PLUS loan auction. Let's take a closer look at these claims.

No Bidders Creates Uncertainty

Several big name lenders, including Sallie Mae and Nelnet, have announced over the past several weeks that they would not be participating in the initial round of bidding on April 15. The lenders' refusal to bid raised concerns that the auctions would fail in many states, and a lack of bidders would result in uncertain borrowing conditions for parents.

But this argument lacks merit for two reasons. First, the auction legislation provides for a lender of last resort that would make all PLUS loans in a state where there are no winning bidders. Under this setup borrowers would be guaranteed to receive their loans and would know exactly from whom they are borrowing. Second, states with no winning bidders and no lender of last resort just return to conventional PLUS lending, in which companies compete to make loans with a 97 percent guarantee against default losses and a typical subsidy rate. A complete auction failure across the country would leave the PLUS loan market completely unchanged. In that case, borrowers would be no more or less certain about receiving PLUS loans than they are in the current market.

Long Timeframe

Another common concern raised by auction opponents is that it would take too long to announce the winners, hindering efforts by schools to put together aid packages and parents to begin taking out loans.

But consider the actual timeframe involved. The auction was set to take place on April 15, less than two weeks from today. Winners would be announced nine days later, on April 24. In the meantime, the final round of college admissions letters did not even go out until the end of March or early April. Students then have until roughly the beginning of May to select their school. In other words, the PLUS loan auction winners will be announced before many students commit to an institution, let alone start the process of taking out loans.

Lower Subsidies Make Loans Unprofitable

As we've written previously, claims that the competitive bidding process would drive down lender subsidies to the point where making PLUS loans is unprofitable fail to consider the additional benefits winning lenders receive.

The two lenders with the lowest subsidy bid rates receive a higher guarantee rate against loan default (99 percent versus 97 percent) and do not have to pay the 1 percent federal default fee required of conventional PLUS lenders. Both of these benefits reduce the cost of a loan. As a result, if lenders were to submit subsidy bids at or around the current rate (3-month commercial paper plus 1.79 percentage points), then the auction could very well reduce their costs. And that's without taking into account ancillary benefits, such as the need to no longer employ large marketing and sales staffs to solicit more PLUS loan volume.

Financial Conditions

Unlike the other talking points, we are sympathetic to concerns by lenders that they may not have the financial capability to guarantee that they can make all of a state's parent PLUS loans for the next two cohorts of students. But winning lenders will still have the authority to sell their loans back to the Department of Education as they are currently allowed to under the Ensuring Continued Access to Student Loans Act. This authority expires after the 2009-10 school year, but it provides some cushion for lenders to figure out their financing.

More broadly, however, if lenders do not have the capital to fulfill their duties as an auction winner, then they should not bid. In a sense, the auction rewards those that that are in good enough financial standing to serve as a winning lender. And as we said before, if no one bids, the system reverts back to business as usual and no one is any better or worse off.

Why Delay?

So let's review. Worst case scenario, no one submits bids, and by April 24 we know that the market will continue to operate as it had. Parents will still have time to find loans before their children enter school in the fall and lenders' financing will be no different. If lenders and NASFAA are so sure that is what would happen anyway, why not just wait the three weeks and get proven correct instead of raising panic levels unnecessarily?