Student Loan Inefficiencies
The guaranteed student loan program, the Federal Family Education Loan Program (FFELP), gives many corporate, state and nonprofit entities a contractual right of payment from the U.S. government. These guarantees and subsidies, promised to thousands of intermediaries, function as entitlements. While intended to keep enough money flowing through the system to ensure that all eligible students can get the loans they need, they are not necessarily cost effective.
The current guarantee structure is vulnerable to a range of inefficiencies because each entitlement is set and adjusted through the congressional policy-making process, without the benefit of competitive market forces. In addition, if one of these entitlements turns out to over-compensate lenders or other entities, the Secretary of Education is often unable to correct the situation. When this happens, resources that could be used to increase access to college are diverted, and taxpayers get an unnecessarily low return on their investment in student aid.
Inefficiencies in the FFELP program have been well documented and analyzed by academics and government agencies. In the 2005 budget President Bush submitted to Congress, the Office of Management and Budget (OMB) states in its Program Assessment Rating Tool that "there is evidence of significant cost inefficiencies in the [guaranteed student loan] program." Work done by staff at the Congressional Budget Office in a 2007 paper concludes that the federal government over-subsidizes private lenders making FFELP loans. The report uses financial modeling to determine the value that the loan subsidies have in the private market.
Examples of Inefficiencies
Unnecessarily High Interest Subsidies
The government has been guaranteeing a return of 9.5 percent to holders of certain loans financed by pre-1993, tax-exempt bonds. Through creative financing, lenders have expanded the pool of loans that are entitled to this high interest rate. To meet this excessive obligation, taxpayers have paid billions of dollars in interest to lenders during a period of historically low market rates. The federal government’s non-partisan watchdog agency, the Government Accountability Office, issued a report documenting the abuse of the 9.5 percent bonds.
Non-differentiated Subsidies
Federal Family Education Loan Program lenders borrow money in the credit markets that they subsequently re-lend to student loan borrowers. Taxpayers, through the federal government and FFELP program, provide participating lenders a subsidy or what is called a "special allowance payment" for each penny re-lent to student borrowers. This special allowance payment is a government paid interest rate subsidy to student loan providers equal to an amount that matches the prevailing market interest rate for commercial paper borrowing plus 1.79%. In other words, the federal government reimburses lenders for their cost of capital with an added bonus.
But all lenders receive an interest rate subsidy payment equal to the general commercial paper rate plus 1.79%, regardless of what is their costs to service and finance the loan. Large lenders can obtain financing capital at lower costs than small lenders, and can service the loans more efficiently because of economies of scale. But the government sets the special allowance payment rate at a level high enough to ensure the financial viability of the smallest of the more than 1,000 student loan providers, creating a substantially inflated government subsidy for large lenders.
Disproportionate Allocation of Risk
Originally created by the government to create a secondary market for student loans, Sallie Mae is now the largest private holder of federal student loans. According to the company's disclosures to the Securities and Exchange Commission, the government assumes virtually all of the risks on guaranteed loans, making them "high quality assets with very little credit risk." While taxpayers bear the risk, Sallie Mae earns record profits from the returns, ranking in the top 12 most profitable companies in the Fortune 500. Other large student loan providers are similarly able to reap benefits from making loans shielded from risk with federal taxpayer funds.
Conflict of Interest
The financial collapse of one guaranty agency, the Higher Education Assistance Foundation, cost taxpayers $280 million. A contributing factor was the agency's effort to expand its operations to include loan servicing. Guarantee agencies were created to provide oversight for entities including loan servicing providers.
