Can Reform Solve Federal Student Loan Conflicts of Interest?

Media coverage of pending legislation to eliminate subsidies for bank-based federal student loans and redirect savings into the Pell Grant Program has recently focused on the fierce lobbying effort made by Sallie Mae and other lenders to get the U.S. Senate to accept their own reform proposal–an alternative that saves less money while also keeping much of the flawed policy structure that makes the current bank-based program inefficient and open to waste, fraud, and abuse.

While lenders do represent a massive portion of the bank-based program, they are not the only actors who stand to gain a good bit from prolonging the existing operation. There are a host of other actors, including guaranty agencies—which administer the insurance on these loans, help prevent default, and take over the title of defaulted—and collection agencies that also take in substantial federal subsidies for their involvement. But while many of the subsidy recipients are distinct companies, some are also the same group of familiar faces. In that regard, this quote that Tim Ranzetta from Student Lending Analytics picked up from Sallie Mae’s recent investor credit meeting is pretty enlightening:

The collections side of the business is a great business for Sallie Mae.  One of the things where we really stand out.  We help collect for guarantors or the Dept. of Education on previously defaulted federal student loans.  We are #1 collector in terms of size in this space and in terms of performance.

In other words, Sallie Mae is not only the largest federal student lender, but is also the biggest collection agency. Sallie Mae also provides services for enough guaranty agencies that it should also be considered the biggest guaranty agency as well.

Having one agency overseeing so much of the loan volume, guaranty agency functions, and collection activity is distressing because it can undermine the logic behind many of the existing subsidies and the incentives they hope to achieve.

For example, lenders currently receive quarterly subsidies when loans they hold are in repayment. Their incentive is thus to keep borrowers active and not to let them default, for if they do, the lender could lose around 3 percent of the loan’s value. By contrast, guaranty agencies and collection agencies get sizeable subsidies for defaulted loans. When a loan defaults, the guaranty agency can tack on collection costs that can easily be upward of 20 percent. The agency also gets to keep 16 percent of any amounts it collects. If the guaranty agency, collection agency and lender are the same company, that subsidy can certainly be enough to wipe out any other losses it might sustain from a default.

That’s basically the situation we have right now with Sallie Mae, though similar circumstances are also duplicated at a number of other loan companies throughout the country. In fact, the not-for-profit agencies that receive their own special carve-out in the version of the student loan legislation that passed the House of Representatives, are the ones that most frequently have these subsidy-distorting connections.

As the stalled health care legislation further extends the time frame for student loan reform, the discussion of this legislation is increasingly turning to political concerns, such as job loss claims, while ignoring the policy implications. Ending the lender role in originating the loans and placing some of these companies solely in charge of servicing them would help ease these conflicts of interests. Creating new servicing contracts represents a chance to rewrite subsidies that favor default prevention over collection and establish new standards for helping borrowers. It also means that the Department can make decisions about moving borrower accounts to different collection companies if it is concerned about conflicts of interest. This isn’t a perfect solution–I’m guessing that some lenders will still continue to serve as collection companies. But at least it would be a first step toward eliminating many of the gross conflicts of interest that currently exist in the bank-based program.

Tagged as: Federal Student Loans, Sallie Mae, Student Aid and Fiscal Responsibility Act