Guaranteeing Complexity

They’re the middlemen of the Federal Family Education Loan (FFEL) program, they engage in some ill-defined activities outside their purview, and in many cases are closely linked to loan companies. Now, thanks to the reauthorization of the Higher Education Act, guaranty agencies will also be playing a key role in the pilot PLUS loan auction program.

As we’ve written previously, the pilot PLUS loan auction is an opportunity to harness market forces (credit market emergencies notwithstanding) to determine the ideal subsidy lenders should receive in exchange for originating student loans. Lenders will bid for one of two spots to exclusively originate PLUS loans in a state, and will keep that authority for two years. [More on the student loan auction can be found on our Federal Education Budget Project Web site.]

The reauthorization of the Higher Education Act improved upon this program by introducing penalties for lenders who win an auction but fail to follow up on their commitment by not making all PLUS loans in a state. These disciplinary measures include reducing the subsidies lenders receive on other loans, banning them from participating in future auctions, or kicking them out of the FFEL program altogether. These measures should ensure that only serious lenders submit a bid.

Oddly, the reauthorization also added a role for guarantors in the PLUS auction, by requiring that all loans made by winning lenders receive a 99 percent guarantee from these agencies. It remains unclear to us why lawmakers chose to add guarantors into the pilot program, as there were no public hearings on this matter. The initial legislation assumed that the federal government would directly administer the guarantee, as it does quite successfully in the Direct Loan program. Not to mention the fact that the government is the ultimate guarantor of all federal loans since it reimburses guaranty agencies for default losses.

Including guarantee agencies in the auction pilot adds unnecessary complexity to the program. It also could compromise the integrity of the auction because of the close ties that exist between guarantee agencies and lenders.

While the guarantor and lender ties are a substantial problem in the FFEL program, they could cause even worse problems in the PLUS auction, where each winner is given a near-monopoly. Guaranty agencies often have existing relationships with colleges by virtue of providing counseling services, financial literacy information, and other instructional materials. If one winning lender is tied to a guaranty agency with substantial connections in the state, the guarantor could potentially exploit its college-level connections to give their affiliated lender an advantage in making a disproportionate share of the new PLUS loans. Moreover, including guarantors could also discourage these agencies, eager to gain loan volume, from engaging in the types of oversight activities over lenders that they are required to perform.

These ties are especially concerning given that the largest lender, Sallie Mae, has a lucrative contract with the largest guarantor, USA Funds. This contract allows USA Funds to sell all of its guarantor functions to the loan giant, a relationship that has been mutually beneficial for the two entities, sometimes at the expense of students.

But USA Funds is not the only guaranty agency where such conflicts exist. Some guarantors, like the Pennsylvania Higher Education Assistance Authority (PHEAA) double as both a guaranty agency and nonprofit lender. Even smaller guarantors, such as the South Carolina Student State Education Assistance Authority, are closely affiliated with lenders, such as the South Carolina Student Loan Corporation. In fact, in South Carolina the guarantor and lender share the same website, and occupy spots in the same office building. It’s hard to expect guarantor employees to properly exercise their oversight role over someone sitting in the next cubicle over.

Unfortunately, legislative constraints mean that the Department likely cannot do much to prevent guarantors from dealing with PLUS loans held by their affiliated lenders. Congress, however, could take action by giving the Secretary of Education the authority to force lenders to choose a new guarantor if there are conflict of interest concerns. This would not remove the unnecessary middleman in the auction program, but would at least lessen the chance of exploiting local connections to gain a complete monopoly over one state’s PLUS loan volume.

The pilot PLUS auction is an exciting opportunity to use market forces to achieve greater efficiency in the federal student loan program. Congress and the Department, however, must be vigilant to ensure that those efficiencies aren’t lost by introducing an unnecessary and conflicted middleman into the process.