Higher Ed Watch Exclusive: Sallie Mae’s Alternative Student Lending Plan

By Ben Miller

Sallie Mae has been busy in Washington, D.C., circulating a plan that would preserve a modified version of the Federal Family Education Loan Program (FFEL) rather than eliminate it in favor of the more taxpayer efficient Direct Loan program as President Obama has proposed. Obama dedicates his proposed savings to turning the Pell Grant program into a true entitlement for low-income students. Higher Ed Watch has obtained a copy of Sallie Mae’s alternative plan (both the legislative language the company has proposed, a discussion memo about it, and a letter sent out today to schools). Sallie Mae, the leading FFEL lender, has hired two high-powered, well-connected Democratic lobbyists to pitch the plan.

According to Sallie Mae’s reported estimates, the lender’s plan would sacrifice approximately $17 billion in funding the Congressional Budget Office has identified as potential savings from eliminating FFEL. Under the President’s proposal, that money would go to expanding Pell Grants. Under Sallie Mae’s proposal it would be used, in effect, to continue the two competing loan programs.

Ultimately, the company wants to modify the bank-subsidized FFEL program that it currently dominates. It would allow lenders to use their own capital to issue federal student loans and guarantee that those loans would be sold to the Education Department within 120 days of full disbursement. The servicing rights (what regular people call billing and collections) associated with these loans would be retained by the lender or handled by one of the Department’s contractors, with the added twist that the servicers would be penalized for defaulted student loans. Colleges would continue to choose which origination platform they would use to disburse the loans — the one the government uses for Direct Lending or those of individual lenders.

Here is a breakdown of Sallie Mae’s plan, with some initial explanation of why this is a good deal for the loan giant, but not worth sacrificing the $17 billion in savings. More analysis will come tomorrow.

Origination

As outlined in a three-page summary of the proposal, lenders would place federal student loans in a participation trust, in which the U.S. Secretary of Education would purchase a 100 percent interest — for an amount equal to the principal disbursed. Lenders would still be in charge of servicing loans placed in the trust, since the Education Department would not actually hold title to the loans. Within 120 days of a loan’s final disbursement, however, the Secretary would be required to take full title of loan. In return for transferring the title, the lender would receive $75 — the same amount currently paid by the Department for loans that are sold to it as part of the ECASLA “put option.”

In this respect, the origination process as proposed by Sallie Mae is very similar to the way most lenders are currently issuing loans through ECASLA, with the small wrinkle that the Sallie Mae plan requires that loans be sold to the Department and that the sale must occur at an earlier date. (Under ECASLA, lenders have until September to decide whether or not to sell the loan.)

Payments to Lenders

The other major deviation from ECASLA is more noteworthy, because it will result in more government payments to lenders in the current financial climate.

Currently, FFEL subsidies are structured such that lenders keep a quarterly special allowance payment equal to commercial paper (CP) plus 1.19 percentage points from a borrower’s interest that accumulates while he or she is enrolled in an institution of higher education. If the special allowance rate, CP plus 1.19 percentage points, is above the borrower’s interest rate (6.8 percent on unsubsidized Stafford loans), then the government must pay the lender a subsidy to make up the difference. In cases where the borrower’s interest rate payment is above the lenders’ guaranteed rate of return, the lender must remit to the government those excess borrower payments.

The credit crunch has significantly reduced the CP rate, meaning that the special allowance rate (the lenders’ guaranteed rate of return) is well below the borrower’s interest rate. Thus, lenders at the moment must pay the government an amount equal to the difference between the borrower’s interest rate and CP plus 1.19 percentage points. The Education Department for the last several quarters has actually been receiving quarterly payments from lenders on in-school loans.

Sallie Mae’s proposal moves away from this current setup to one in which a lender would received a “spread” payment of an annualized rate 0.60 percent of the loan’s principal for the time between the disbursement of the first loan payment and its sale to the Secretary. This spread would be paid regardless of other financial circumstances, guaranteeing some compensation for lenders.

Servicing

Under the ECASLA program, the lender loses all servicing rights once a loan is sold to the Department of Education. This means it no longer receives any compensation whatsoever for that loan. That is not the case in Sallie Mae’s proposal.

In its summary of the proposal, Sallie Mae says loan servicing would be handled by one of the Department contractors that are determined via competitive bidding, with an option for private lenders to retain servicing rights if they meet standards set out by the Department. The servicer for loans originated by a lender that doesn’t retain servicing rights or as part of the Direct Loan program shall be selected by the borrower’s institution.

Sallie Mae’s proposal thus highlights why the winners of the Department’s proposed servicing contract are more important than ever. Those that are selected will receive a guarantee to keep the servicing rights on all their loans, with a chance to take on the rights for even more loans. Left unsaid, of course, is that Sallie Mae is a heavy favorite to win one of these contracts.

The servicing compensation under Sallie Mae’s proposal would also allow, for the first time, for servicers to receive differentiated compensation based upon a borrower’s institution and type of loan taken out. In other words, servicers could receive greater compensation for loans taken out by riskier students, such as the borrowers at proprietary institutions that Sallie Mae has had exclusive arrangements with in recent years.

Default Aversion

The final component to Sallie Mae’s proposal is default aversion activities. Servicers would be asked to engage in default aversion practices to help borrowers stay in repayment. If, however, the servicer is unsuccessful in its efforts within four years of a loan entering repayment (and provided it had serviced the loan for at least two consecutive years), then the servicer pays the Department a penalty equal to 3 percent of the loan’s balance at the time of default. This percentage is equal to the amount that a lender currently loses on a loan if it goes into default. Starting Oct. 1, 2012, however, under current law, lenders’ loss rate on a defaulted loan is supposed to increase to 5 percent. Sallie Mae’s proposal thus would result in a lower loss in the future.

Here too, Sallie Mae also includes legislative language that would benefit its ability to win default aversion contracts. According to its proposed language, “the Secretary shall enter into contracts only with entities that have relevant experience and demonstrated effectiveness in loan servicing and default aversion and that meet the financial responsibility requirements proposed in regulations prescribed by the Secretary.”

Competitive Bidding

An additional selling point of Sallie Mae’s is the use of competitive bidding starting in 2012 to determine the fees paid to lenders for selling the loan, the spread while holding the loan, and the fees paid for servicing the loan. The actual mechanisms for this process are not outlined beyond the fact that it would occur once a year on a national basis to determine both fees simultaneously. But there’s no guarantee that this proposed competitive bidding would not lead to an inefficiently high subsidy rate due to oligopolistic pricing. If Sallie Mae’s proposal were implemented, there would be very little reason for any lenders besides those who won servicing contracts to stay in the program — the compensation on the loan itself would likely not be high enough to make it work. In that case, the roughly five or so lenders that also act as servicers would likely be the only lenders submitting bids on these fees across the nation — hardly a true representation of “the market.”

A Good Deal for Sallie Mae, a Bad Deal for Taxpayers

Not surprisingly, Sallie Mae’s proposal would be a great deal for the Virginia company, resulting in additional compensation to sell its loans to the Department, guaranteed servicing rights, and the ability to get paid even more for targeting loans to low-income borrowers at proprietary schools. While they may successfully be able to exploit a budget gimmick or two to make their plan seem to save almost as much as the Obama administration, don’t be fooled. This plan is a good deal for Sallie Mae and other large lenders. But how about the taxpayers and students that serve to gain under the President’s proposal?

Is competition among the two student loan programs which has given rise to all kinds of inefficiencies and corruption worth what is conservatively at least $17 billion in Pell Grant scholarship aid? That’s the question policymakers will need to consider when they evaluate this proposal.