The Loophole that Wasn’t

[This is the fourth in a Higher Ed Watch series “Revisiting the 9.5 Student Loan Scandal.” The series takes a closer look at the origins of the scandal with the purpose of trying to resolve unanswered questions and dispel lingering myths surrounding it. Links to earlier parts of the series are available here, here, and here and are included in the post.]

More than four years since the 9.5 percent student loan scandal was first exposed, a stubborn myth persists that lenders were engaged in perfectly legal activities. According to this myth, which was promoted by the student loan industry and unwittingly spread by journalists (including the author of this post when he was a senior writer at The Chronicle of Higher Education), a group of lenders gained windfall profits from the federal government by exploiting a legal loophole in federal student aid law.

In fact, there never was any loophole. As the U.S. Department of Education’s Inspector General concluded in 2006, the lenders’ scheme to aggressively grow the volume of loans they claimed to be eligible for 9.5 percent subsidy payments was “not in compliance with the HEA [the federal Higher Education Act], regulations, and other guidance issued by the Department.” In January 2007, Education Secretary Margaret Spellings concurred with this opinion and barred the student loan company Nelnet and other lenders that refused to submit to independent audits from receiving any further 9.5 payments.

Still some loan industry lobbyists continue to spout this myth. For example, the leaders of several nonprofit loan agencies that were embroiled in the scandal told the Chronicle in September “that their companies were justified in submitting claims under the terms of the law as it existed at the time.” In that same article, a top lobbyist with the Education Finance Council, which represents nonprofit lenders, said that its member institutions had all been in compliance with “legal and longstanding billing standards” at the U.S. Department of Education.

These arguments are disingenuous at best. To understand why, it’s important to recall the details of the scandal.

The roots of the 9.5 student loan case go back to the 1980s when high interest rates and soaring loan costs prompted Congress to take action to keep nonprofit lenders, which use tax-exempt bonds to finance their loans, in business by guaranteeing them a minimum rate of return of 9.5 percent on federal student loans made with these bonds. As interest rates on all other student loans fell in the 1990s, policymakers became concerned that these nonprofit student loan providers were making a killing. So in 1993, Congress rescinded that policy, but grandfathered in loans made from the old bonds, believing that the volume of 9.5 loans would decline as they were paid off and the bonds retired.

Instead, beginning in 2002, a small group of lenders devised a strategy to aggressively grow the volume of loans that they claimed were eligible for the 9.5 guarantee. This was a goldmine for lenders in the existing low interest rate environment (at the time, the borrower interest rate on regular loans hovered around 3.5 percent.) They accomplished this scheme by transferring loans that qualified for the 9.5 subsidy payment to other financing vehicles and recycling the proceeds into new loans that they claimed were then eligible for the subsidy. The lenders repeated this process over and over again.

To justify their loan and bond manipulations, these loan companies cited sub-regulatory guidance the Clinton administration had offered in March 1996. As part of the “Questions and Answers” section of a “Dear Colleague” letter, a deputy assistant secretary at the Education Department declared that a student loan financed by pre-1993 tax-exempt bond would remain eligible for the 9.5 percent subsidy rate even if a lender “refinanced” it with the “proceeds of a taxable obligation.”

The Clinton administration’s guidance was written to reduce federal subsidies in times of very high interest rates, when a 9.5 return would have been lower than alternative subsidy formulas that applied to other federal Stafford student loans. In other words, the department was issuing guidance to protect taxpayer money.

The notion that the Clinton administration, which had an adversarial relationship with the student loan industry, ever enacted a policy to allow lenders to massively grow their 9.5 holdings is patently absurd. After all, the administration had tried repeatedly — but unsuccessfully — to eliminate the 9.5 subsidy rate altogether.

The lawyer and student loan industry lobbyist John Dean admitted as much in a legal opinion he provided Nelnet in January 2004 (which Higher Ed Watch first revealed in October). He wrote that the guidance that the Education Department had provided lenders on the 9.5 percent issue over the years had been “unclear and at times contradictory” and was “producing results that were unanticipated and not, in the view of some, in the best interests of the Department.”

The loan companies that carried out their scheme to bilk taxpayers have every incentive to keep the myth of the “legal loophole” alive. In fact, their ability to hold on to over a billion dollars in overpayments depends on it.

It is time for policymakers to retire the myth and put their sights on recovering the money . Surely it could be put to better use.