A Questionable Arrangement

An internal strategy document from Sallie Mae says a whole lot about how the company makes its money from taxpayers, from students, and then again from taxpayers. On Tuesday, Higher Ed Watch described the subsidies on federal loans that remain Sallie Maes priority #1 to keep, while yesterdays item explained why the company is intent on maintaining the special status that private student loans have in bankruptcy (priority #2).

Next on Sallie Maes list is to protect its debt management operations, “especially Guarantor Services.” In two recent articles (here and here), Paul Basken of The Chronicle of Higher Education revealed how Sallie Mae employees in one division of the company effectively run a student-loan guarantee agency that is in charge of monitoring the activities of other divisions of the company, while both sides aim to maximize profits.

That questionable arrangement came into existence in 2000 when federal and state regulators turned a blind eye to Sallie Maes purchase of virtually all the assets of a non-profit guarantor known as USA Funds. The deal left in place a non-profit shell that contracts with Sallie Mae, whose employees now do the federal oversight work for which USA Funds is responsible. Last year, federal money passing through USA Funds accounted for 32 percent of the revenue in Sallie Maes debt management operations division.

How did this lucrative deal for Sallie Mae evolve? Here’s some background:

WHAT IS A GUARANTEE AGENCY?

When the federal guarantee system for student loans was created 40-plus years ago, the idea was that state agencies and public charities would serve as co-guarantors, reimbursing loan providers for defaults — while shouldering a portion of the default costs — and taking on the front-line responsibility for overseeing lenders to make sure they did everything by the books. However, this model failed as few states and non-profits were willing to take on the risk. Congress responded by sweetening the deal, eventually assuming the entire program cost while retaining the “guarantee agency” oversight structure. The agencies now are essentially contractors for the federal government paid through formulas set by Congress.

THE MORPHING OF USA FUNDS

In 1990, the country’s largest guarantee agency, a non-profit organization headquartered in Indianapolis known as USA Funds, requested permission from the Internal Revenue Service to create a support organization, USA Group. The new entity quickly became the umbrella for several new non-profit corporations and at least seven for-profit subsidiaries. In addition to serving as a guarantee agency, USA Group became a lender, a loan collector for bank clients, and other businesses that went far beyond the IRS-approved charitable activities. (This history is chronicled in an investigation I worked on when I was on the staff of Senator Paul Simon (D-IL).

THE SALLIE MAE PURCHASE

On December 31, 1999, USA Group entered into a “strategic alliance” with Bank One, one of the largest originators of federal student loans. Six months later, USA Group executives agreed to sell its assets — the buildings, equipment, employees, intellectual property, and the Bank One alliance — to Sallie Mae. The result: Sallie Mae could make loans, buy loans, collect on loans in repayment, and then get paid by the government to oversee their own operations and to collect on the defaulted loans they failed to capture the first time around. It was a highly profitable move: the company reported that its after-tax fee income increased by $128 million that year primarily because of the USA Group acquisition.

On its face, the sale didn’t give Sallie Mae control of USA Funds. Federal law forbids for-profit lenders from owning nonprofit guarantee agencies. But Sallie Mae found a creative way around the restriction. As part of the deal, it gained control of USA Group Guarantee Services, a for-profit subsidiary that provided administrative services to help the guarantor carry out its function. The deal also required USA Funds to contract its loan guarantee services to Sallie Mae.

USA Funds is now a shell of its former self, with only about 75 employees. Meanwhile the guarantor pays Sallie Mae $250-million a year for staffing and other payments, according to The Chronicle.

Both the Government Accountability Office and the Education Department’s Inspector General have raised concerns about these types of relationships, which effectively put the fox in charge of guarding the henhouse. The Inspector General went as far as saying that the arrangement between Sallie Mae and USA Funds violated the law and needed to be severed in order to protect borrowers. An Education Department official who had worked for Sallie Mae for 11 years before joining the agency ultimately rejected that recommendation to the great benefit of his former employer.

Federal policy makers at the Department and in Congress need to revisit that decision and do right by students and taxpayers.