Oversubsidized

For years, student loan-industry officials have complained about the way in which the government assesses the costs of the two competing federal student loan programs.

Federal budget analysts have consistently found that direct lending, in which the U.S. Education Department provides loans directly to students through their colleges, is cheaper for the government to run than the Federal Family Education Loan (FFEL) program, which relies on banks and other types of lenders to deliver federally backed loans to students.

Lenders, however, contend that “biases” in the way the government accounts for the programs provide a distorted view of how much the two competing federal loan programs cost taxpayers. They argue that the government’s estimates are often faulty because they do not reflect the volatility of interest rates year to year, which often results in increased costs to the direct-loan program. In addition, they say, the government fails to take into account the taxes that lenders pay the government and much of the administrative cost that the U.S. Education Department incurs in running the direct-loan program.

Well, a new little noticed study, coauthored by a financial analyst with the Congressional Budget Office and presented at a conference in February hosted by the Northwestern University’s Kellogg School of Management and the National Bureau of Economic Research, contains some good news and bad news for lenders. The good news is that the study’s authors — Damien Moore of the CBO and Deborah Lucas, a professor of finance at Northwestern University — agree that the government’s estimates are flawed and that direct loans are more costly to the government than budget analysts have previously projected.

The bad news for the loan industry is that, even after taking into consideration the flaws in the way the government determines the costs of the loan programs, they found that the FFEL program remains “fundamentally more expensive” than direct lending. Using detailed calculations of the market value of federal student loans and loan guarantees, the report estimates that it costs the government over 100 basis points more to subsidize a FFEL loan than to make a direct loan.

Even more significantly from a public-policy point of view, the report states unequivocably that the subsidies that the government pays lenders are excessive. According to the report:

Guaranteed lenders are paid more than is required to induce them to lend at statutory terms. The excess funds are largely absorbed in competition for borrowers, which occurs through various discounts, marketing activities, and higher service levels and subsidies to educational institutions. To the extent that the market is not perfectly competitive, guaranteed lenders presumably retain some of the surplus as profit.

While the report acknowledges that lenders use some of the excess subsidies to provide discounts on origination fees and interest rates for on-time payment to some FFEL borrowers, and for “higher service levels and subsidies to educational institutions,” it questions whether this money is being put to its best use.

Beyond providing loans, the guaranteed program channels money to students, schools, and guarantee agencies, but such subsidies presumably could be better targeted and controlled if they were separated from the lending function.

The authors of the report do not attempt to determine how much government subsidies for students loans can fall without causing banks to stop lending. This is a key question because Congress is looking to cut lender subsidies to increase spending on Pell Grants and to reduce interest rates on student loans. In January, the House of Representatives voted for a 10 basis point cut in the lender guaranteed rate of return. The White House upped the ante in February when it proposed, as part of President Bush’s budget request, a 50 basis point reduction in the rate of return for all college loan providers. Senate Health and Education Committee Chairman Edward M. Kennedy is reportedly seeking deeper cuts. (Disclosure: The editor of Higher Ed Watch worked for Senator Kennedy.)

In public, loan-industry officials complain that any cut — no matter how large — will drive lenders out of the FFEL program. But sometimes in their official filings with the government, lenders are more candid. In a January 2006 filing with the Federal Reserve, Sallie Mae acknowledged that the FFEL program is very profitable for lenders because it is, in essence, a no lose proposition. “The U.S. government’s guarantee of Guaranteed Student Loans is direct, explicit, irrevocable and effectively unconditional,” wrote C.E. Andrews, who was the company’s chief financial officer at the time. Those who provide funds to Sallie Mae — through bonds and securitization — are taking little risk because their loans “are, in effect, supported entirely by sovereign risk.” That’s another way of saying that taxpayers will cover any losses.

Mr. Andrews, who was recently named the company’s new chief executive officer, estimated that the government guarantee essentially provides Sallie Mae with “80 basis points to 120 basis points of excess spread and 25 basis points of cash reserve.”

Nevertheless, finding exactly the right subsidy price is not something that Congress or anyone else can easily divine. That’s why Higher Ed Watch believes that Congress needs to make lenders compete for the right to make or collect on federal student loans.