Getting to Know Guaranty Agencies: Federal Subsidies and Payments
[In recent months we have cast a critical eye on federal student loan guaranty agencies by taking a closer look at a few specific agencies to show how concerns about conflicts of interests and misaligned financial incentives operate in practice. Previous entries can be found here, here, here, here, and here. Today, our series continues with a look at the actual amount of subsidies and payments provided to these agencies.]
Guaranty agencies are paid to perform three basic functions within the Federal Family Education Loan (FFEL) Program: provide default insurance for lenders; work with delinquent borrowers to help them avoid default; and collect on or rehabilitate defaulted student loans. Though each individual purpose is important; entrusting a single agency to carry out all of these functions creates opportunities for conflicts of interest. Even worse, the financial payment structure provides guaranty agencies with the greatest compensation for letting a student loan default -- the worst possible outcome for borrowers and taxpayers.
According to the U.S. Department of Education, guaranty agencies received $1.57 billion from the federal government in fiscal year 2008 for dealing with defaulted student loans and working with borrowers. Guaranty agencies also ended the 2008 fiscal year with an additional $1.63 billion worth of federal assets held in trust to reimburse lenders for losses on defaulted loans.
A breakdown of the distribution of federal payments to guaranty agencies reveals why taxpayers and policymakers should be concerned about these companies' financial incentives. As the table below shows, 60.5 percent, or $948.8 million, of the federal payments guaranty agencies received in the 2008 fiscal year were for the collection and rehabilitation of defaulted student loans. (The Department of Education does not separate these payments out so we don't know how much agencies got for each function.) By contrast, they received only $177.3 million for helping keep borrowers out of default. In addition, guaranty agencies received $203.9 million to cover the cost of processing and issuing the initial default guarantee on new loans and another $237.9 million for maintaining existing loan accounts.
For some guaranty agencies, collection revenue represents an even greater share of its federal payments. At six of the 35 agencies, collection income represented more than 70 percent of federal payments. Collection payments, for example, comprised over 82 percent of federal income at the Florida guaranty agency, 79 percent at the Educational Credit Management Corporation, and 73 percent at the Connecticut Student Loan Foundation. At the other extreme, the North Carolina guaranty agency received just 20 percent of its federal payments from collecting on defaulted loans.
Guarantors are rewarded for keeping borrowers out of default, but the payments they receive for doing so are much smaller than those they obtain for collecting on and rehabilitating defaulted loans.
When borrowers fall behind on their payments, lenders are obligated to request default aversion assistance from the guaranty agencies in charge of the default insurance on the loans. These agencies then work with borrowers to keep them in repayment. In exchange, the guaranty agency receives an amount equal to 1 percent of the loan's outstanding balance. If the loan defaults, the agency must return 1 percent of the loan's balance at the time of default.
By contrast, when a guaranty agency rehabilitates a defaulted student loan, it receives 18.5 percent of the loan's value at the time of default, plus any interest that has accrued since then (usually around 1.5 percent).[i] In addition, it keeps another 18.5 percent of the loan in the form of collection costs that have been added to the borrower's balance owed. Rehabilitating a loan thus yields the guaranty agency as much as 38.5 percent of the loan's balance.
Similarly, payments for default aversion pale in comparison to those for collection efforts. A guaranty agency receives 16 percent of any amount it collects. In addition, there is no strict cap on collection costs, meaning it could charge borrowers as much as 25 percent for trying to recover missed payments. With payments this high, a guaranty agency has to collect only a small amount of a loan's balance in order to earn more through this activity than what it gets for default prevention.
The significant discrepancy between payments for rehabilitation/collection and default aversion means that the most profitable action for guaranty agencies -- letting a loan default -- is the worst possible outcome for borrowers, taxpayers, and even lenders. The guaranty agency may receive a hefty payday from this action, but the federal government is on the hook for at least 97 percent of the loan's value, while student loan companies suffer the other 3 percent loss. Meanwhile, defaulted borrowers are left with a tarnished credit record, and face wage garnishment, and other types of aggressive collection activities.
Many guaranty agencies portray themselves as advocates for borrowers, working with individuals as they struggle to manage their loans. While we don't doubt that some agencies are sincere in these efforts, the financial figures and compensation structure clearly show why those guarantors are few and far between.
[i] In the past, loan rehabilitation required the guaranty agency to get borrowers to make nine out of 10 payments on a revised payment plan. Once that occurred, the loan was rehabilitated when the guaranty agency sold the loan to an eligible lender. Due to disruptions in the credit markets, however, guaranty agencies were unable to find willing purchasers of rehabilitated loans. As a result, Congress recently granted the Secretary of Education the authority to rehabilitate loans by purchasing them from a guaranty agency. In this situation, the guaranty agency's only compensation is the 18.5 percent of the loan's balance that it charges the borrower for collection costs.