A Consolation Prize for Student Loan Companies

The student loan reform bill released by the Democratic chairman of the House Education and Labor Committee includes a consolation prize for the student loan industry. The bill cuts private lenders out of the administration of newly issued federal student loans almost entirely — a major defeat for the industry and its lobbyists. It appears, however, that the bill’s crafters have granted the industry one concession. They would allow lenders to change the index used to calculate the federal subsidies they receive on all outstanding FFEL loans issued since 2000. While this proposal raises some concerns and questions, it might actually be a fair solution to vexing interest rate problems caused by the credit crisis.

The LIBOR Switch

Currently, interest rate subsidy payments made to private lenders holding federally backed student loans are indexed to commercial paper interest rates. Lenders, however, usually need to finance the loans using LIBOR, a different index. When credit market disruptions hit full tilt last year, the two interest rates diverged radically, even though 3-month LIBOR historically had been only slightly higher. Spiking LIBOR interest rates squeezed the return lenders earned on loans. Although rates have since come back in line, the risk of another divergence remains.

We reported last year that the student loan industry was working the back rooms of the Capitol to persuade lawmakers to switch the index for all outstanding loans made since 2000 to the higher LIBOR rate. And in January we pointed out that the provision had been snuck in to an early version of the economic stimulus bill, but was then quietly dropped.

Now the provision has been included in the House-proposed student loan reform bill, but with one significant change. While the loan industry had lobbied for the 3-month LIBOR index, the House bill would use the 1-month LIBOR index, which given its shorter duration, reflects lower interest rates. In fact, the index has historically tracked the 3-month commercial paper rates quite closely. In other words, the future costs of such a change may be a wash.

Let This Be a Lesson

If the change is indeed cost-neutral, then it is hard to argue that the interest rate subsidy the federal government provides to lenders should not be based on LIBOR. After all, these rates better reflect the cost of capital for lenders financing federal student loans than commercial paper rates do. Yet the LIBOR saga perfectly illustrates why the House bill makes the right choice to end the FFEL program.

To get private lenders to make loans under FFEL, Congress must adequately compensate them. But Congress is not skilled at setting a payment rate that is neither too high nor too low, or that encourages the optimal number of lenders to make loans to all students. Worse yet, congressional subsidy setting is subject to dangerous amounts of student loan company influence. This is particularly true when issues are steeped in financial complexity, such as yield spreads between commercial paper and LIBOR, or interest rate swaps and asset backed securities.

The LIBOR issue is an important reminder to Congress and the Obama administration that ending the FFEL program and replacing it with the Direct Loan program is good public policy. The Direct Loan program has never required continuous, ad-hoc legislative tinkering and subsidy setting, nor does it invite the rent seeking, lobbying, and loophole exploitation that has led to so much waste and abuse in the FFEL program.