With health care reform’s progress making a tortoise look like Usain Bolt (Saturday’s vote notwithstanding), efforts to reform the federal student loan programs have been more or less stuck in a holding pattern for the last seven weeks. Such inaction has provided time for new ideas and proposals to emerge and for those opposed to the legislation to trot out new messaging campaigns or spokespeople.
A second effect of the delay is that debates over student loan reforms have become focused almost entirely on cost savings estimates, losing sight of the policy merits that also arise from a fundamental restructuring of the program. On the cost side, there is one major proposal that came out of the legislation from the U.S. House of Representatives with a counter idea being pushed by the loan community. The House version’s changes (PDF) are estimated to save between $87 and $80 billion over 10 years (the discrepancy is the inclusion of increased administration costs). The Student Loan Community Proposal, meanwhile, is expected to save about $67 billion (PDF).
What’s even larger than the cost savings discrepancies, however, are the relative policy merits of the two plans. In that respect, the lending community plan comes up quite short, focusing on replicating pieces of the status quo through targeted carve-outs, rather than improving efficiency or program integrity.
The terms and conditions on federal student loans are determined in Congress, meaning that the options for students never vary beyond an occasional 1 percent discount, which is worth $60 if you take out the maximum loan as a freshman. Nevertheless, loan companies compete with each other to secure volume from students and get recognized by institutions as preferred lenders. This system in the past has produced a series of scandals or questionable practices involving illegal payments or gifts for placement on a preferred lender list or trading exclusive federal loan volume in exchange for making loss-leading private loans that indebt students.It also means that the competition must occur on a largely superficial level, leading to an increase in spending on marketing or ancillary products.
The student loan reforms passed by the House end the institution- and individual-level competition and instead addresses larger issues of capacity and quality through a competitive contracting bidding process held by the U.S. Department of Education. Such a process makes it possible to hire only a few larger companies to oversee accounts, creating opportunities for economies of scale and allowing for better oversight and evaluation since the Department controls how much volume a servicer is allocated.
By contrast, the lending community proposal preserves this superficial competition by continuing to have private lenders make loans and then sell them to the Department shortly thereafter. The originating lender is then given guaranteed servicing rights, provided they meet some low thresholds. This process not only continues this superficial competition, but it also introduces unnecessary inefficiency. Instead of a straightforward process where the Department gives the money directly to the school on behalf of the student, loans would have to go through a complicated three-step process of having the private company find loan capital, making the loan, getting it to the student, and then moving that same loan over to the Department. Each step, especially the final one, has its own set of costs that do not exist if lenders are not part of origination. Yet in the end, the same result arises either way—private companies service the loans. Why pay the extra money to end up at the same point?
A major component of the House legislation is the creation of a new College Access and Completion Innovation Fund, a pot of money that expands the federal role in higher education to include efforts at improving retention and graduation. In the House version of the bill, about 30 percent of these funds would be given to states with the option to direct it toward nonprofit or state agencies to provide financial literacy functions that would be lost with the elimination of origination functions. States that do not feel like this is a worthwhile use of money thus have the option to put it toward other purposes.
The lending community plan, however, provides no such leeway. One-third of College Access and Completion Innovation Funds must be distributed to states and then passed onto these nonprofit or state agencies. In addition, an unspecified amount of funds must go to these same agencies to provide outreach services. This provision ensures that a significant portion of the fund will be devoted toward financial literacy and informational activities that have no proven utility in improving college retention or completion. Since awards are guaranteed, there is also no competition whatsoever in this fund—severely limiting any incentives for innovation.
That is not the only carve-out the bill contains for nonprofit agencies. It also allocates $550 million each year directly to guaranty agencies as a borrower assistance fee to cover loan counseling, information on repayment options, help to avoid default, the administration or regular program reviews, and several other functions. This money comes with zero accountability framework, meaning there is no way to judge its efficacy.
Conflicts of Interest
One of the biggest problems with the existing federal student loan system is that it relies upon the same entities, known as guaranty agencies, to both prevent default and handle collection. Making matters worse, subsidies for these activities are skewed heavily toward collection, so there is less incentive to help borrowers stay in repayment. The House version of the legislation ends this contradictory setup, but the lending community plan does not. Instead, guaranty agencies are given the aforementioned borrower assistance fees to help keep individuals in repayment, but the Secretary is then required to tap these same entities for post-default collection services. Not only does this preserve the conflicts-of-interest, but it introduces an unnecessary middleman into the process—most guaranty agencies just subcontract this work to collection agencies anyway.
More than Money
At a basic level, the reforms to the federal student loan program are about creating a stable system that saves money so that students can receive larger Pell Grants and provide more funding for college completion. But it’s important to remember that these reforms are also a policy change, one that streamlines the currently disjointed system, reducing costs by using the capacity built up by private sector servicers, and changing the competitive focus from product-based to outcome- and quality-based. Reform is more than a numbers game.