Guest Post: Insulating Student Loans from the Credit Crunch

By Art Hauptman

Congress and the Bush administration wisely are trying to ensure that the broadening housing credit crisis does not engulf higher education and thus prevent many college students from being able to borrow. But they need to be careful not to overreact and make matters worse.

First, it’s important to understand the problem. Thus far, it is not with the federal student loan programs as some have suggested. Relative to their overall number, few lenders have withdrawn from the federally guaranteed programs and federal Direct Loans remain a viable option.

The student loan credit crunch problem instead is in the burgeoning private student loan market that now accounts for one-fifth of all borrowing for postsecondary education. The private student loan market has grown because federal loan limits are insufficient to meet demand, particularly among students enrolled in most proprietary trade schools and many private, nonprofit institutions. Unsecured private student loans to high-risk borrowers are drying up as many lenders confront the reality of much more limited access to capital.

The concern among policymakers is that fewer private loans will mean less access to college and that a continuation in overall credit tightness will eventually affect federal student loans as well.

This is hardly the first time that general credit conditions have threatened the viability of federal student loans. Rising market interest rates over time led the government first to create and then increase special allowance payments to compensate lenders for the difference between student rates and market rates of interest. Concerns about limited liquidity led Congress to create Sallie Mae in 1972 and later encourage the creation of state lenders of last resort. Over time, lenders and other participants have reacted to various federal cost cutting proposals by threatening to pull out from the federal program.

The difference now is that the federal Direct Loan program exists. It can provide much needed liquidity for banks and other loan holders by buying up existing student loans, thus freeing up capital. This potential provision of liquidity, along with federal cost savings and much greater competition in the student loan market, are two principal advantages of having a Direct Loan program.

What is curious in the current student loan credit market debate is why some in Congress first turned to state lenders of last resort to augment liquidity. The more recent focus on Direct Loans as the primary backup source of capital is a welcome development in my view. Greater use of Direct Loans as a source of capital could have the added benefit of helping to address a very real problems in student loans — the large and growing number of borrowers who have trouble repaying their loans.

When the Congressional Democrats first came back into power last year, they cut interest rates for new borrowers who already qualify for federal payment of interest while they remain in school. But that left out the millions of existing borrowers who are having trouble repaying their loans. Having the government buy up existing FFEL loans now would greatly increase the number of borrowers who would benefit from income contingent repayment and loan consolidation provisions. A greater policy focus on what happens when students enter repayment rather than when they initially borrow would be a welcome change in the student loan debate.

The most troubling proposal now being debated, however, is one that would greatly increase the amount that students could borrow in the federal student loan programs. These changes in loan limits are surely well intentioned, aimed at letting students shift from risky and expensive private loans to cheaper and guaranteed federal student loans.

But the proposed increases in loan limits have the potential of taking a problem created by the market and shifting it to the federal government. These increases in loan limits represent a bailout of many proprietary schools, some private colleges, and a number of lenders who have come to rely on private student loans to skirt the limits in the federal student loan programs. Particularly troubling is the increase in loan limits for independent students that would grow to an astounding $57,000 cumulatively under the House Committee bill as it could be an invitation for a renewal of large-scale defaults in the federal student loan program.

There are better ways to help those students who now borrow private student loans. All entail greater risk sharing by lenders and institutions.

• Lenders should have to absorb a higher share of default costs in the federal student loan programs;
• Institutions should be required to pay a portion of each loan on which their students default;
• Institutions should be required to offer discounts to student borrowers so that the federal government is no longer put in the position of guaranteeing and subsidizing loans geared to the full sticker price, which fewer and fewer students actually pay; and
• Any increase in federal loan limits should be much more modest with no difference for whether students are dependent on their parents or financially independent — students should be able to borrow a standard amount for living expenses whatever their circumstances.

In sum, the (remote) possibility of a federal student loan credit crunch should not be used to justify a raid on the Treasury in the form of large increases in federal student loan limits. Instead, the federal government should be ready to rely on Direct Loans to provide liquidity and expand income contingent options for borrowers having trouble making their repayments. Greater cost sharing for defaults should be instituted for lenders and institutions, and institutions also should be required to step up to the plate and offer sizable discounts to reduce how much students must borrow to attend their institution.

The latest, perceived student loan crisis should be used to help borrowers in trouble, not bail out lenders and schools that have come to rely on private loans.

Art Hauptman is an independent consultant on higher education finance issues. The views expressed herein are his own and do not necessarily reflect the positions of the New America Foundation.