History of Federal Family Education Loans and Direct Student Loans

The federal government began guaranteeing student loans provided by banks and non-profit lenders in 1965, creating the program that is now called the Federal Family Education Loan (FFEL) program. The first federal student loans, however, provided under the National Defense Education Act of 1958, were direct loans capitalized with U.S. Treasury funds, following a recommendation of economist Milton Friedman. But when Congress wanted to expand on that start, unnuanced budget rules made the guarantee approach seem more attractive.

Under then-prevailing budget rules, a direct loan would have to show up in the budget as a total loss in the year it was made, even though most of it would be paid back with interest in future years. In contrast, a guaranteed loan, which placed the full faith and credit of the United States behind a private bank loan, would appear to have no up front budget cost at all -- because the government’s payments for defaults and interest subsidies would not occur until later years. This raised concerns among economists, who worried that the government was making financial commitments without accounting for the ultimate costs.

In 1990, economists got what they wanted. With President George H.W. Bush’s signature on the Federal Credit Reform Act (which was included in a larger budget reconcilation bill, the Omnibus Reconciliation Act of 1990), all government loan programs—whether guarantees of commercial loans, or loans made directly from a federal agency—would have to account for their full long-term expenses and income. Every loan program would have an estimated “subsidy cost.”

The subsidy cost is the amount of money that needs to be set aside when the loan is made in order to cover the costs to the government over the life of the loan. According to the Government Accountability Office, the old approach "distorted costs and did not recognize the economic reality of the transactions," while the new approach "provides transparency regarding the government's total estimated subsidy costs rather than recognizing these costs sporadically on a cash basis over several years as payments are made and receipts are collected." More information on student loan budget rules is provided here.

This more rational approach to budgeting changed the nature of policy discussions on Capitol Hill. Student loan programs were among the first to be affected.

Prompted by an analysis from the Bush administration indicating that direct loans would be less costly and simpler to administer than guaranteed loans, Congress created a direct lending pilot program in 1992. In 1993, newly elected President Clinton proposed replacing the guarantee program with the direct approach as part of his deficit reduction plan. Estimates from all of the government's budgeting and auditing agencies showed that direct lending would deliver the same loans to students at significantly lower cost to taxpayers.

As part of the 1993 budget agreement, Congress passed a budget reconciliation bill (the Omnibus Reconciliation Act of 1993) that would phase in direct lending, starting with colleges that volunteered to participate and giving the Secretary of Education the power, if necessary, to require colleges to switch until at least 60 percent of loans nationwide were direct. While the law called for direct lending to replace guaranteed loans, it was silent about what would happen beyond the 60-percent mark, since that was outside of the five-year window covered by the budget.

In 1994, the new Republicans leadership in Congress targeted direct lending for elimination. However, many college and university officials were dissatisfied with the guaranteed loan system and optimistic about the new alternative. Under the guarantee system, financial aid administrators had to deal with what the Government Accountability Office labeled a “complicated, cumbersome process,” disconnected from other federal aid and involving thousands of middlemen. Hundreds of institutions were already participating in the direct loan program, which operated in tandem with the other federal aid programs.

Ultimately, Congressional leaders stopped short of eliminating direct lending. Instead, they passed a law that prohibited the Department of Education from encouraging or requiring colleges to switch to the direct loan program. In theory, this maximized choice: schools could choose to participate in one program or the other. In practice, those profiting from the guarantee system could use their substantial resources to lure or retain colleges and universities, while the direct loan program was not allowed to make its own case. Not surprisingly, campus participation in the Direct Loan Program has declined.

In 2003, a team of investigative reporters at U.S. News and World Report looked into what was causing some colleges to switch back to the guarantee program. Their front-page story found that much like old-time political ward bosses, the student loan industry “used money and favors, along with their friends in Congress and the Department of Education, to get what they wanted.”

Multiple ways of delivering a government benefit may be a good idea in some circumstances. But it can also be costly and inefficient. From a management standpoint, the Government Accountability Office says it is ineffective for the government to run two loan programs. As part of a series of reports on "high-risk" government programs, the auditors said the existence of two competing loan programs leads to "a fragmented operating environment in which two different groups of students, schools, lenders, Department administrators, and other entities participate in two mostly similar programs."

But despite these systemic inefficiencies, college financial aid administrators have seen smaller scale benefits from having two loan programs. For example, in the guarantee program, different lenders and middlemen used to have separate forms, data formats, and processes, imposing heavy administrative burdens on college staff. Because direct lending has a much simpler process, competitive pressure led the student loan industry to standardize and improve systems for approving federal loans. The competitive dynamic, however, comes at a significant cost for taxpayers.