Contract Out Student Loans

Recent developments in the financial markets have brought to light a major problem with the Federal Family Education Loan (FFEL) program, the main delivery system for federal student loans. Though the program relies on private lenders to make loans to students on the government’s behalf, it does not include any commitment from lenders that they will follow through and make all (or any) of the loans to which students are entitled.

Congress, schools, and students are naturally concerned when private and non-profit lenders say they won’t make loans anymore, due to credit market disruptions, and, to some extent, reductions in lender subsidies enacted over the last several years by both Republican and Democratic Congresses. Similarly, there is unease over lenders cherry picking colleges with profitable loan volume and bypassing others, leaving students to find another FFEL lender.

Oh Please Make Loans

In April, Congress passed the Ensuring Continued Access to Student Loans Act to prevent any disruptions in the availability of FFEL loans for the 2008-2009 school year. The measure does policy somersaults to provide more subsidies to lenders so they can make loans using funds from federal coffers (never mind the fact that lenders vehemently oppose the Treasury-financed Direct Loan program). Despite its efforts, Congress now can only hope these new subsidies will be sufficient to get lenders to lend, but it has no assurances.

Federal lawmakers are considering taking additional steps to prevent lenders from redlining schools. Sen. Christopher Dodd (D-Conn.) has introduced legislation (and the National Association of Student Financial Aid Administrators has endorsed it) that would bar lenders from refusing to provide federal loans to students based on the type of institution they attend.

Negotiate a Contract (and a Subsidy) To Lend

Unfortunately, these efforts are treatments for symptoms, but do not address the root problems in the FFEL program’s design. As currently constructed, the FFEL program never secures a contract from lenders that commits them to make loans for an upcoming school year. Loan companies, however, would likely resist efforts for a lending requirement without some added incentive. The solution? Lenders should be allowed to set their own subsidy rate in exchange for signing a contract. This is how the federal government administers a number of programs. It establishes the benefits and services that a program will provide, and then asks private companies to submit bids on what they would charge to operate the program. The winning bidder (or bidders) then signs a contract to provide the service.

Under such an arrangement for FFEL, Congress would no longer have to worry whether a subsidy rate it made up years ago will be sufficient to encourage lenders to make loans in future school years. Likewise, the government would reduce its risk of providing overly high subsidy payments that encourage more lender participation than is necessary to get loans to all students. And, as an added benefit, the contract would commit lenders to make loans to students at all schools. In short, lenders would make subsidy bids high enough to cover their costs and earn a profit, while competition between lenders to win the contract would guard against excessive federal payments to loan companies.

PLUS Loan Auction Uses Contracts

The PLUS loan auction program set for the 2009-2010 academic year is modeled on such an approach. Under the auction, the two lenders that submit the lowest subsidy rate bids to the Department of Education will enter into a contractual agreement with the federal government to make all PLUS loans within a given state. [More details on the auction are available here on our Federal Education Budget Project website.]

Certainly, the current form of the PLUS auction isn’t perfect. It will restrict borrower choice to the two PLUS lenders that win the contract. This is indeed one of the tradeoffs for having a competitively set subsidy rate and a contractual obligation from lenders to make loans. Additionally, the cap on subsidy bids (currently set at 1.79 percentage points) probably needs to be modified to allow for robust bidding in a variety of market and financial conditions. Nevertheless, the auction framework does ensure more appropriate subsidy rates for lenders, and by establishing a contract between the lender and the government, the auction should lessen the chance that students and schools face disruptions in the availability of FFEL loans in the future.