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Exclusive: Some Ed Dept. Officials Encouraged Lenders to Overcharge the Government

[This is the sixth in a Higher Ed Watch series "Revisiting the 9.5 Student Loan Scandal." The series takes a closer look at the origins of the scandal with the purpose of trying to resolve unanswered questions and dispel lingering myths surrounding it. Links to earlier parts of the series are available here, here, here, here, and here.]

For years, we have known that nonprofit student loan companies engaged in an illegal scheme to gain windfall profits at the government's and taxpayers' expense. But these lenders did not act alone. Higher Ed Watch has learned that they received assistance and encouragement from several officials at a key office within the Department of Education.

FSA's Program Review Timeline

Spring 2005: The Department of Education’s Inspector General opens investigations into lenders, like Nelnet, that had been among the most active in engaging in serial loan and bond manipulations to grow the volume of federal loans they claimed eligible for the 9.5 subsidy rate.

Fall 2005: The Financial Partners division of the Department’s Federal Student Aid office begins conducting program reviews of nonprofit lenders examining their 9.5 loan holdings.

May 2006: Financial Partners releases program reviews on the Kentucky Higher Education Student Loan Corporation (KHESLC) and CollegeInvest in Colorado, that find that these two lenders have undercharged the government on 9.5 loans. The program reviewers invite the companies to determine the additional amount of subsidy payments for which they are entitled.

September 2006: The Inspector General's Office releases its audit on Nelnet, declaring that the company’s scheme and that of other lenders to aggressively increase their 9.5 holdings violates the Higher Education Act and Department regulations. It also releases a separate report that accuses the Financial Partners division for taking its “partnership approach” with the student loan industry too far.

November 2006: In a response to the Inspector General’s audit, lawyers for Nelnet cite three program reviews of lenders that Financial Partners conducted between 2005 and 2006 that they say “should put to rest” any “lingering doubts” about the loan company’s 9.5 claims.

January 2007: Education Secretary Margaret Spellings concurs with the Inspector General’s conclusion that the practices the lenders have engaged in are illegal. She requires lenders to undergo special independent audits to determine the legality of any future claims. She does not, however, require lenders to return subsidy payments they have already received.

April 2009: The Inspector General releases a report blasting the Financial Partners division, saying that its program review reports did not always comply with the Higher Education Act and Department regulations.


In January 2007, then-Education Secretary Margaret Spellings put a stop to what has become known as the 9.5 scandal, in which nonprofit lenders were improperly growing the volume of federal student loans that they claimed were eligible for the 9.5 guarantee available on loans financed through tax-exempt bonds issued before 1993. This was a goldmine for lenders at a time when the borrower interest rate hovered around 3.5 percent.

But between the fall of 2005 and the end of the summer of 2006, the Financial Partners division of the Education Department's Federal Student Aid (FSA) office wrote a series of program review reports in which they signed off on these companies' billing practices and, in some cases, showed the lenders how they could take greater advantage of these inflated subsidies.

The timing of these reviews is curious, to say the least. They were conducted at a time when federal lawmakers had repeatedly taken action in 2004 and again in early 2006 to try to shut these payments off. The Department's Inspector General (IG) had also begun its own investigations into lenders, like Nelnet, that had been the most active in engaging in serial loan and bond manipulations to grow the volume of federal loans they claimed eligible for the 9.5 subsidy rate.

A One-Time Only Offer in Kentucky

One lender that the Financial Partners division had chosen to review was the Kentucky Higher Education Student Loan Corporation (KHESLC), the state's nonprofit student loan agency. Between 2003 and 2004, the Kentucky company became one of the most aggressive participants in the 9.5 student loan scheme, increasing the volume of loans it claimed eligible for the special rate from $140 million to nearly $1 billion over that period of time.

Still, a May 2006 Financial Partners program review report, which Higher Ed Watch obtained from the Education Department through a Freedom of Information Act (FOIA) request, concluded that the corporation had, in fact, "underbilled" the Department. The reviewer provided a spreadsheet of loans that he said were eligible for the 9.5 payments, and he invited the agency to determine the additional amount of subsidy payments it was owed on these loans and others like it. He made clear that this was a one-time only offer -- warning that a decision not to claim these payments, which had to be provided in writing to his office, could not be reversed. "This declaration is permanent and KHESLC may not decide later to recover this special allowance," the report stated. [Efforts by the Kentucky agency to receive these payments were later rejected by the Department.]

In a written statement to Higher Ed Watch, KHESLC officials cited this program review as evidence that the 9.5 percent claims it had made were legitimate. "USDE auditors reviewed KHESLC's practices and determined they were proper," the statement said.

Trying to Put to Rest "Lingering Doubts"

 The Kentucky agency's experience was not an isolated case. Just ask officials at CollegeInvest, a nonprofit lender in Colorado. According to financial statements the company released late last year, a May 2006 program review initiated by the Financial Partners division found that CollegeInvest had undercharged the government nearly $14 million on 9.5 loans. Ironically, the company's own state-contracted auditor had determined three years earlier that federal law did not permit the claims and advised CollegeInvest to return 9.5 payments to the Department, which it did.

Meanwhile, in a November 2006 letter to the Education Secretary (see Exhibit 99.1 in this document), lawyers representing Nelnet pointed to three separate program reviews of lenders conducted by the Department between 2005 and 2006 that they said "should put to rest" any "lingering doubts" about the loan company's 9.5 claims. The lawyers didn't identify the lenders, so it's unclear whether they are referring to the audits of KHESLC and CollegeInvest. But they specifically cited at least one other case from June 2006 in which a lender was told that it had "underbilled" the Department.

The Department's Inspector General came to a very different conclusion in September 2006 when he declared that the lenders' scheme to aggressively grow the volume of loans they claimed eligible for 9.5 subsidy payments was "not in compliance with the HEA [the Higher Education Act], regulations, and other guidance issued by the Department." The following January, Spellings concurred with that opinion and required the lenders to undergo special independent audits to determine the legality of any future claims.

Serious Concerns Raised About FSA's Program Reviews

Recently, the Inspector General's office raised grave concerns about the program reviews that were initiated by the Financial Partners division over the past several years. In a report released late last month, the Inspector General concluded that reviews that came out of the division during this period of time cannot be relied upon, as they were conducted by regional staff without adequate time or training to undertake the reviews properly. What's more, the office said, the division did not consult with the Department's Office of General Counsel before issuing reports that dealt with "sensitive" or "political" issues to ensure that their findings were consistent with the Higher Education Act and Department regulations.

In this report, and one he issued in 2006, the Inspector General faulted FSA's oversight of the student loan industry, saying that its leaders emphasized partnership over compliance in dealing with lenders, guarantee agencies, and servicers. In his latest report, he particularly raised alarms about reviews that were conducted while Matteo Fontana was in charge of the Financial Partners division, including the division's 9.5 reviews. (The 2005-06 9.5 reviews fall into this category.) The Inspector General notes that "potential conflicts of interest existed with the former General Manager of Financial Partner Services," due to his ownership of stock in loan companies he was in charge of overseeing (a fact that Higher Ed Watch first uncovered in April 2007). The inspector general recommended that the Department "evaluate decisions" Fontana made during his leadership of the division to determine if any "were inappropriate," and if so, "to take corrective action as necessary, and assess the impact on the FFEL program."

The 9.5 program reviews certainly raise the question of whether officials in the Financial Partners division were trying to provide the non-profit lenders with cover in the event that policymakers chose to heed the IG's recommendation -- which he first offered in 2005 --and tried to get them to return the excess subsidy payments they had already received.

If that was their intent, they have generally succeeded so far. While Spellings' January 2007 ruling put a stop to the overpayments, she did allow lenders to keep the subsidies they had already received. Later, in explaining her decision, she said that the Department had "significant legal exposure" because it "had some responsibility with respect to that confusion" over the rules governing the 9.5 subsidy rates.

And, as we see from the Kentucky loan agency, lenders continue to point to these reviews to say they never did anything wrong.

KHESLC Review Report.pdf149.24 KB

Curious Timing, Indeed

Curious timing, indeed. The lenders got one of their own in the department to give them cover from the inspector general and the general counsel, and to try to make certain these lenders got the last laugh worth hundreds of millions of taxpayer dollars.

So this is what lenders say is "approval" of their scheme? Sounds more like larceny aided by a mole. Now the inspector general wants "corrective action," but what might that be? How about conditioning the lender bailout money to reimbursement of these illegal claims?

Curious Timing

At least the non-profit lenders who participated in the 9.5% billings gave the money back to student borrowers in the form of benefits on their loans. Arguably, if it was actually the taxpayer's money, they could have been given a say-so, but I've seen the government do much worse things with taxpayer dollars. The for-profit lenders who got the money simply paid it to their executives in the form of bonuses or to their stockholders as dividends. Personally, I prefer the former to the latter.

Conditional Terms for Lender Bailout

During the 9.5 scandal, KHESLC promised students 100% loan forgiveness if they worked in critical needs areas for the state of Kentucky. When the state of Kentucky took about $90 million from KHESLC/KHEAA in 2005 and 2006, the lender chose to dismantle the forgiveness program and leave thousands of teachers, nurses, and public attorneys to pay a bill they were promised to have forgiven.

How about conditioning the lender bailout money so lenders fulfill their commitments to borrowers such as these? Shame on Kentucky for dipping its hands into the 9.5 scandal and shafting its own taxpayers who are working in high needs fields for them.

Best in Class: KY Teacher loan forgiveness program

Since there appears to be blame on both the federal and state levels for the collapse of the Best in Class program, can Congressman Guthrie ask Secretary Duncan at Wednesday’s Committee meeting to explore solutions so that Kentucky teachers are provided the forgiveness they were promised? Higher Education is suppose to pay in Kentucky. The government should not make a promise they cannot keep.

Best In Class

Please help us in our efforts to restore faith in the government's promises to Kentucky Teachers. I believe in what I do, I am a Special Education Teacher and love my job, however, I believed in the statement that the Government would forgive my loan if I went into this field, it will be a financial burden to all of us if the loan forgiveness is taken away from us. Please don't allow this to happen. Help us, Kentucky Teachers, while we dedicate our lives to helping students with disabilities who live in our great state of Kentucky.

Kentucky's Best In fiasco...

It is shameful that a state that has consistently been ranked at or near the bottom in education, and many other things, could trick people into becoming critical needs area teachers then leave them holding huge debts, and at the beginning of their new careers. Most of the teachers involved in the Best in Class debacle are new, and are making a beginning salary. I imagine the same is true for most the people in Best in Care, and Law too. Kentucky state government's, and KHEAA's unfulfilled promise will lead to a "brain drain" just when we really need to keep these people. It appears that they either can't or won't help out these people so those affected can only hope for the federal government to cut their heavy burdens. That is very sad.

Where's the story

Where’s the story? Let’s see, first the author reported that lenders were engaged in an “illegal scheme,” now he claims there is this conspiracy between the lenders and USDE. How can you call the 9.5 floor provision an “illegal scheme” when the practice was based on guidance provided by USDE and confirmed in USDE’s Program Reviews as you have documented?
How is this any different than the IRS providing guidance on tax issues? I may not like certain provisions of the tax code as many seem to be rip-offs but if the IRS says it’s so........the same applies to USDE. The Inspector General does not provide regulatory guidance to schools or lenders so while the IG may have had issues with the interpretation by USDE, its office is advisory to the Secretary, who has the final say. The author in an earlier posting stated Congress passed legislation to “end the practice.” If the practice was illegal why the need to pass legislation??
So much for objectivity……disappointing from NAF.

Reply to Bud

As to comments by Bud: there would be no story if what Bud alleges were true. But contrary to Bud's suggestion, the Department did not provide guidance approving manipulation of the loans and tax-exempt bonds in question. Most lenders did not engage in the practice, considering it illegal, exploitative, or too risky without Department approval. Several lenders returned funds when they understood it was illegal.

Documents obtained through FOIAs attest to the lack of Department approval. An internal e-mail from a regional Department official reads, "When people ask us tax-exempt questions, we respond by saying 'questions relating to tax-exempt financing can be of such complexity that it is best not to to respond unless we are provided with documentation of the specific situation'. We don't hear from them after that."

"We are reluctant to say anything that may jeopardize the Department's ability to recover special allowance payments."

Does that sound like guidance approving the scheme? No. It anticipates recovery of illegal claims, just as the IG has recommended. For its Nelnet audit, the IG was given the Alexander Hamilton Award for the best audit in the federal government for 2006. The IG's Kentucky audit -- released last Friday -- identifies another $80 to $90 million in improper payments.

Bud also asks if the practice had been illegal, why was it necessary to pass legislation to stop it? Senator Jack Reed of Rhode Island gave one of many good answers in Senate debate in 2004. It wasn't that the manipulations were legal, he said, it was that the Administration was not acting to end what it knew was wrong:

"This overpayment has grown dramatically over the past few years, as this administration and Department of Education have failed to intervene and stop it. According to the Government Accountability Office, GAO, the overpayment cost taxpayers well over $600 million by the end of June 2004, up from $209 million in Fiscal Year 2001."

As to the program reviews that Bud mentions, the two most recent IG audits of 2009 debunk the notion that the reviews were credible. They were ordered by a Department employee who avoided legal review and who was dismissed for conflicts of interest.

If anything, there may be more to the story than has so far been reported. Will Department employees step forward with more information? This reader would like to get to the bottom of how this could have happened, and to know if there will be any consequences for this sorry debacle.

Response to the Friends of Students & Taxpayers..a.k.a. Mr. Burd

I would agree with the Friends of Students and Taxpayers …..if that was the guidance used to approve the “scheme” as you cite. I find it hard to believe that would have been the guidance any lender or agency would have relied on to participate in the 9.5 loans. Public non-profits lenders/agencies by their very nature and structure don’t take actions that have even moderate levels of risk. Apparently the “Friends of Students and Taxpayers” didn’t even read the entire NAF Blog on the 9.5 floor loans and the supporting documentation. In prior postings the following would suggest it was a lot more than “an internal email from a regional Department official” as to providing guidance on the 9.5 floor loans:
1. Letter from the Secretary dated 4/18/2004 to Senator Kennedy saying USDE didn’t have the authority to close the 9.5 loophole and that legislation was needed to end the practice.
2. The Institute for College Access and Success, Inc report on “Money for Nothing” citing two loopholes working together and urging the Secretary of USDE to end them.
3. New York Times story on 10/01/2004 that Congress may put a stop to the 9.5 loophole.
4. USDE Secretary Spelling’s testimony before US House Committee on Education and Labor saying the federal government “had some responsibility for the confusion” and had “significant liability potential” on the 9.5 floor loan issue.
5. Washington Post story on 10/20/2007 where Secretary Spelling again reaffirmed the federal government was responsible for the confusion on the 9.5 floor issue and made reference to the GAO’s recommendations to close the 9.5 “legal loopholes.”
These appear to suggest USDE was more than a little complicit in the 9.5 issue and it went far beyond a “regional Department official.” How can something be both a loophole and illegal? It’s either a loophole or it is illegal.

Interesting the GAO report doesn’t refer to the 9.5 loans as overpayments but offers legislative and regulatory recommendations to reduce the cost of the 9.5 loans as they opined that they were not needed to encourage lender participation. This suggests the prior practices were in fact legal.

Again, with all due respect to the IG the IG does not provide regulatory and statutory guidance to schools or lenders. The Financial Partners is the division that provides that guidance and a program review is among the ways they provide guidance. The battle between the IG and the Financial Partners is an internal issue w/ USDE as there are obvious disagreements between the two. The IG is not the Supreme Court and its role is advisory to the Secretary. I dare say all of this suggests there was a lot more than a “regional Department official email” as the Department’s guidance on the 9.5 Loans.

Given all the bailouts to banks, car makers, etc it was rather refreshing to see a state use the proceeds to assist its teachers and nurses and address shortage areas in the state. The federal government should provide incentives to states to continue these programs……gee it sounds a lot like what the President proposed in his budget.

This One's For You, Bud

Thanks for the compliment, Bud, but I am simply a friend of students and taxpayers. I am not a.k.a. Steve Burd, although I admire his work and that of NAF.

Your points are unpersuasive. You neglected to mention Secretary Paige's letter of November, 2004, which squarely stated that the Department never approved Nelnet's manipulations, as Nelnet claimed. What journalists, institutes, or various offices wrote before -- and you know that none of it was sympathetic to your interpretation, or written as a legal analysis -- must be read in the context of Secretary Paige's own subsequent words.

Inevitably, the IG in his audits never found any approval guidance from the Department, just as Secretary Paige foretold. Secretary Spellings and the IG came to an agreement that the whole bond-shuffle gimmick was illegal, and always had been.

This did not surprise a majority of lenders, which has consistently maintained that the scheme to extract billions from the U.S. Treasury was only asking for trouble. Many lenders are furious that this scandal has tainted the whole industry, especially now that the future of FFEL hangs in the balance and Congress's memory is not so short as to forget being sucker-punched.

Secretary Spellings regrettably succumbed to the audacious threat that the Department might be taken to court; she let Nelnet and a few other lenders retain up to a billion dollars in illegal claims in exchange for promises that they would not do the illegal manipulations again. Indeed, there is disturbing evidence of conflict-of-interest complicity by some individuals in the Department, and apparently she knew that. It's this kind of waste, fraud, abuse and mismanagement that gets taxpayers like me upset. If anyone is taken to court, it should be those who made illegal claims. And any bagmen in the Department should be brought to justice.

As to the IG: he is more than just someone who makes recommendations to the Secretary. He is the Department's auditor. If a Secretary overrides an IG finding, the matter is sent to the Department of Justice for review. Trying to diminish the IG is a mistaken approach. The IG was given an award for the best audit in the federal government for his team's work on this scandal. It was a remarkable work that will not be diminished by defenders of the indefensible.

Finally, it is hardly "refreshing" to see what is happening in Kentucky. The teachers and nurses there are nothing more than victims of a huge double-cross perpetrated by the FFEL agency and the state. Kentucky is a poster-child for wrongs that must be righted by all who care about integrity in federal student loan programs.

Responding to "Friend" - Bud Back from Vacation....

The “points” are not an attempt to be persuasive or to even justify the practice but to highlight conflicting interpretations and guidance provided by USDE. It is also disappointing that you and the author continue to be more than a little careless with the facts, even contradicting prior posting and USDE documents of this blog to mislead readers to move your obvious political agenda. Strangely, some of the documents have been removed from this blog?? I would have expected more journalistic balance from Mr. Burd given his prior years at the Chronicle. A few additional points:
• It was in fact Secretary Paige that that acknowledged the loophole “pursuant to a regulatory interpretation “ and urged Congress to pass legislation to close it not because it was illegal but because it wasn’t needed (according to the GAO.)
• Also it was Mr. Burd’s own story in the Chronicle where he stated “USDE officials have determined that the loan companies’ actions are legal”.
• The conflict of interest that you and Mr. Burd cite for the USDE employee, suggesting a link, had nothing to do with the 9.5 issue.
• The fact remains a significant number of lenders; many state based public non-profits received proceeds from the 9.5 loans. As public entities their activities and decisions require transparency, meetings are open to public and policy makers are included on their Boards. To suggest these organizations collectively engaged in a conspiracy that they knew was improper or without guidance has no basis and contrary to how they function- they don’t engage in activities that have the level of risk that the author suggests.
• It appears the Kentucky lender didn’t request additional 9.5 payments after 2006 not because it “refused to submit to an audit” as you proclaim but based on the Secretary’s new guidance as to the definition of eligible loans.
• Apparently the Obama administration has a different perspective on the role of the IG than you. In case you missed it, the IG for AmeriCorps was fired without cause according to media reports.
Bottom line the fact that you had one Division of USDE (Financial Partners) saying to an agency they had under billed for the 9.5 payments and anther arm of the same entity saying the agency overbilled for the same loans is strange at best and clearly contradictory.
The fact also remains that Kentucky used the revenues it received to fund forgiveness programs to those shortage areas is commendable. Interesting the prior administration and Congress created similar programs that regrettably don’t have the flexibility that enable states to address their particular needs (not all states are alike). It is indeed unfortunate that reductions in funding be it at the federal or state level for benefit programs that have such painful consequences for families. We continue to see this in many states as they deal with their budgetary problems.

Welcome Back, Bud

Welcome back, Bud. Hope you had a good vacation. Glad to see you here again; it helps clear up more of the misunderstandings about the 9.5 scandal.

I do not have a political agenda, other than being frugal with the taxpayers' dollars and usually taking the side of students on loan issues. As to what NAF writes or posts, you'll have to take that up with them. The documents NAF has posted in the past have been enlightening; I hope they are still available for reading. To your points:

• I'm glad Secretary Paige cleared up the statement you cited by subsequently writing to Congress that the Department of Education never approved of the 9.5 scheme. It is unfortunate that during his time as Secretary he urged Congress to end it rather than doing it himself, as Secretary Spellings eventually did.

• No one is more critical than I of any reporter who took the bait and proclaimed the scheme legal because its abusers said it was. I admire those reporters who have stepped forward to correct the record.

• The Department of Education employee who was dismissed was deeply involved in the 9.5 issue. To my knowledge, the reasons for his dismissal have not been made public. In its recent audit of this person's office, the IG recommended that the Department evaluate his decisions and take corrective action.

• Some state-based non-profits participated in the 9.5 scheme, but they absolutely are not transparent organizations. In Pennsylvania, the Patriot News had to go to court to get PHEAA documents, for which they won journalism awards for their persistence and analysis. Likewise, the Des Moines Register had to go to court to get access to ISLLC documents. The latter showed that ISLLC took great risks in its 9.5 scheme. A confidential memorandum from the CEO to his board stated that if his trade association's efforts to see the IG "repudiated" over his 9.5 audits were not successful, ISLLC could go "out of business." That's high risk. These documents should be in the public domain to let the public know what happened.

• The Kentucky lender KHESLC did not make additional 9.5 claims after 2006 because most of its claims had never been legal. The Secretary did not put out "new guidance" but re-stated longstanding guidance. That is the exact language of the Dear Colleague letter.

• I'm not aware that the Department of Education's IG office is in any trouble with any Administration. In fact, it seems to be highly regarded, as evidenced by its having received top awards for work unravelling the 9.5 scheme.

• Contradictory guidance from the Department of Education must be viewed in the context that the head of the office responsible for the contradictions has been terminated. The IG has dismissed "alleged confusion" as a mitigating circumstance for illegal 9.5 claims, and two 9.5 claimants have lost their cases in the Office of Hearings and Appeals.

• Kentucky's motivation to use 9.5 revenues for loan forgiveness may be commendable, but its execution has been abominable, leaving thousands of teachers and nurses deeply and needlessly in debt. The IG's estimate of $81 million of 9.5 funds overpaid to Kentucky matches almost exactly the amount state officials took from the lender for their own purposes, gutting the program. What is absolutely not commendable is the Kentucky lender, KHESLC, now telling teachers and nurses to lobby their Congressional delegation to save KHESLC jobs or lose all hope of loan forgiveness forever.

Thanks to NAF for creating a blog that can take up these matters and shed light on them.