Dumping Loans

As the Federal Family Education Loan (FFEL) program has come under a torrent of criticism in recent months, loan industry officials have begun testing out a new line of attack in their long-running campaign to discredit the alternative Direct Loan program. The lenders claim and have convinced (hopefully temporarily) some conservative commentators that the program, in which the government provides loans directly to students through their colleges rather than through banks and guarantee agencies, has become overrun with defaulted loans.

But like their attacks in the past, which have centered on debunking consistent findings from federal budget analysts that the direct lending is cheaper for the government to run than the bank-subsidized program, their arguments are flawed and designed to distort reality rather than shine a light on the real problems that afflict the government loan programs.

Commentators with the Lexington Institute, a conservative think tank, cite data included in President Bush's 2008 budget request that projects there to be a significant jump in the lifetime default rates of loans in the Direct Loan program. Budget officials in the Department of Education have projected that the weighted average default rate in the Direct Loan program to be 16.65 percent in the 2007 fiscal year, up from 12.6 percent a year earlier. Meanwhile, the corresponding rate for FFEL loans is projected to be 11.7 percent, which is about a half of a percentage point lower than it had been in 2006. (The lifetime default rate is different from the cohort default rate, which measures the percentage of borrowers who have defaulted within 12 to 24 months of leaving college. That rate, which the government uses to monitor the performance of colleges, is approximately 5 percent for borrowers in both the FFEL and Direct Loan programs.)

Conservative commentators say that the rising projected default rate in the Direct Loan program shows that the federal government is inept at running a loan program and that any efforts to expand direct lending -- as some Democrats are advocating -- would be disastrous for the country. "Already 3.1 million Direct Loans are expected and the increased burden to taxpayers would be significant if the program was expanded," Leslie Carbone, an adjunct scholar with the Lexington Institute, wrote in a column that recently ran in The Washington Times.

Default rates are less of a problem in FFEL, Ms. Carbone says, because "private companies have both the incentive and the ability to be innovative in keeping tack of borrowers, enabling them to prevent and recover bad debts."

"Private companies are often better equipped than government agencies for keeping track of their customers," she goes on to say. "Government bureaucracy is inherently less efficient. Even the most diligent civil servants are hamstrung by the fact their public bureaucracy moves slowly and less able to take advantage of the best practices of the most successful private companies."

"Giving a federal agency more direct responsibility, in student lending or anything else, is likely to make its inherent inefficiencies costlier to taxpayers," Ms. Carbone concludes.

What's missing is recognition that the FFEL program has become so highly dependent on government subsidies and government guarantees that in many ways it's more of the big government program than even the Direct Loan program which competitively contracts out many of its functions -- including loan collection -- to private entities.

In addition, a closer look at the data reveal that there are only very slight differences between the government's loan programs when looking at the lifetime default rates of borrowers who have taken out federally subsidized Stafford Loans, Unsubsidized Stafford Loans, and PLUS Loans, the latter which go to parents and graduate students.

Why then are the overall lifetime,default rates in the Direct Loan program going up? The data shows that the problems reside in the Direct Loan Consolidation program, in which borrowers refinance and shift their loans into direct lending in order to take advantage of the more generous repayment terms available in that program as opposed to FFEL program.

The Education Department projects that nearly one-third of borrowers with Direct Consolidation Loans are expected to default on their debt in the 2007 fiscal year, compared to 13.3 percent of borrowers who refinance in the bank-subsidized program. And the data (see chart) shows that there has been a surge in defaults in the Direct Loan Consolidation refinancing program. In 2006, just 13.6 percent of borrowers with direct consolidation loans defaulted. In 2007, 32.9 percent of borrowers with Direct Consolidation Loans are projected to default.

So what's really going on here? Stephen Koff, the Washington bureau chief of The Cleveland Plain Dealer, has the answer.

In a timely article, Mr. Koff writes of an increasingly popular practice among student loan guarantee agencies known as "dumping," in which the guarantors unload bad debt -- FFEL loans that have become uncollectable -- to the government through the direct consolidation loan program. In other words, after the agencies determine that they can't get another penny from the debtors, they persuade the borrowers to take on "a new government loan, issued under the federal Direct Loan program." Not only does the guarantor get to wipe the bad debt off of its books, but it collects a generous fee from the government -- until recently 18.5 percent of the loan balance -- and gets to make the Direct Loan program look bad to boot.

Now, it's not necessarily bad public policy to give borrowers who have defaulted on their loans a second chance to rehabilitate themselves through direct lending, which unlike FFEL, offers them the chance to repay their loans as a percentage of their income. The problem is that some guarantors appear to have overused the process and abused it by dumping loans that borrowers clearly can't or won't repay.

According to Mr. Koff, the practice accounted for 46 percent of the industry's so-called default recoveries in 2004 and 45 percent in 2005 -- 'recoveries' because on paper, the industry can claim it recovered the debt, even though it merely rolled it into a new government loan."

Meanwhile, a large proportion of these borrowers end up defaulting on their new direct consolidation loans. Department officials have determined that between 1995 and 2005, about 34 percent of these borrowers redefaulted, costing taxpayers as much as $400-million that might never be collected. In his article, Mr. Koff says that some in the Department believe the problem is only getting worse. One Department analyst he talked to "says that over the long-term life of these loans, the default rate could approach 60 percent."

So in reality, the root of the problem is not inefficient government bureaucrats -- once again, it's loan industry officials feeding at the trough of overly generous government subsidies. Nevermind the harm done to loan borrowers and taxpayers.

Never underestimate the student loan industry. They create a problem and then blame the government for it. Talk about having your cake and eating it too.