One Step Closer on Student Loan Reform

Last night, the U.S. House of Representatives voted 219 to 212 to pass a bill that would make significant changes to the country’s health care system. The legislation represents the biggest victory to date in a process that’s been ongoing since 1993. Later this week, the Senate is expected to have another opportunity to end a policy process that also started that same year: federal student loan reform.

The same year that President Bill Clinton first began working on health care reform, Congress created the Direct Loan Program—an initiative that allowed the Department of Education to use U.S. Treasury funds to issue student loans directly to individuals instead of the existing and costlier model of guaranteeing and providing subsidies for identical loans issued by banks.

In September, the House passed the Student Aid and Fiscal Responsibility Act (SAFRA) a bill that ended the bank-based system for good. Last night, it voted to end those payments again by passing the Reconciliation Act of 2010 (PDF). In addition to student lending provisions, this bill also contains fixes to the health care legislation that has now passed both houses of Congress and can be signed by the president. The bill now goes to the Senate where it can pass with 51 votes and cannot be filibustered.

If passed, the bill would end all subsidies for lenders to make federal student loans. Instead, the federal government would make all loans directly and then contract with private companies to service the loans, which means securing payments from borrowers and helping them avoid default.

From a lending standpoint, the bill is a solid piece of policy work that eliminates a conflicting subsidy structure and also makes loans less subject to market concerns. In that regard, there are a number of things to like about this legislation.

For one, the subsidies and payments made to lenders represented a significant and unnecessary government expense given that the exact same product could be offered by the Department of Education. The Congressional Budget Office (CBO) estimated that ending the bank-based program would save more than $60 billion over 10 years. Some of those savings are a result of the government’s lower borrowing cost, but a different CBO estimate found that eliminating subsidies would reduce spending by $47 billion over a 10 year period. Taking that money away from banks makes it possible to increase the maximum Pell Grant. And as Higher Ed Watch explained on Friday, it also replaces expiring stimulus funds, the disappearance of which would have caused cuts in the award.

Second, the bill dramatically improves a subsidy structure that in the past led to concerns of illicit activity and also skewed priorities more toward default collection than prevention.

The existing version of the bank-based system provides subsidies to lenders as a percentage of each loan they make. As a result, the incentive is to make as many loans as possible because the marginal cost of a new account is outweighed by the available subsidies. Moreover, because loan terms are set by Congress, the competition with other lenders over securing these additional loans revolved around convincing financial aid offices to get added to a preferred lender list distributed to students. In some cases, this resulted in handouts and illicit payouts to aid officers to secure one of these spots.

A second result of marketing to schools was that lenders frequently used their federal offerings to also sell private loans to students. This debt carries far higher interest rates and less favorable repayment terms than federal options and making it more difficult for lenders to market these products to students is a good outcome.

While ending subsidies for lenders would clearly address the two issues outlined above, the proposed legislation produces an additional set of benefits related to default prevention. The bank-based program currently relies on a set of non-profit and state entities known as guaranty agencies to handle both preventing borrowers from defaulting and collecting loans that have not been repaid. The subsidies associated with these two activities, however, are far from equivalent. Guaranty agencies get 1 percent of a loan’s value if they keep it from defaulting, but they keep up to 16 percent of any amounts they collect on the same loan, plus collection costs that can be worth anywhere from 18 to 25 percent of a loan. Cutting guaranty agencies out of the collection role and relying on private servicers to handle default prevention is a good way to fix these issues.

The student loan changes also eliminate many of the conflicted interests held by lenders, guaranty agencies, and servicers. In the current system, many guaranty agencies also serve as lenders. This is problematic because the subsidies associated with collecting defaulted loans may be greater than the payments given to lenders for loans that are in good standing. As a result, it may be more profitable for a company that both serves as a lender and guaranty agency to allow some loans to default. Additionally, guaranty agencies are expected to monitor and oversee loan companies, something that is difficult to perform when the two are interconnected.

Finally, eliminating the bank-based system restores much needed stability to the federal student loan program. The last year-plus has been filled with concerns about federal loan availability as many companies exited the program because the subsidies paid were not high enough to offset the cost of borrowing capital to make loans. As a result, many schools constantly had to find new lenders, while students may have had to deal with the confusion of borrowing from multiple companies.

Of course nothing is perfect and there are some hiccups in the legislation. The cost of administering the loan program will end up being higher than it should be because not-for-profit servicers secured a carve out that guarantees they will be given a  set number of loan accounts and be paid more to service those loans. That’s not the most efficient way to allocate loans, but the Department will be able to take away volume from non-profit servicers that do not perform well. In addition, the policy gains that come from splitting servicers, lenders, and guaranty agencies also make this change somewhat worth the inefficiency.

The second concern is that lowered savings estimates coupled with increased Pell Grant costs mean that the bill that goes before the Senate lacks the exciting programs aimed at postsecondary completion and community colleges that were originally planned. That’s a shame because these efforts are important for improving the graduation rates of Pell recipients and ensuring that the new massive investments help produce more degrees and certificates.

Those concerns notwithstanding, the move to 100 percent direct lending makes a lot of sense from a policy perspective. It eliminates many conflicts of interest, improves the incentive structure and also removes a crucial avenue for luring students into dangerous debt.

Successful Senate passage of the bill this week would mark the end of a 17-year process. But if this bill is going to be more than a landmark change in the way loans are made it must be a new beginning as well. The additional money for the Pell Grant program would be the fourth major money infusion into federal student aid since 2007. All of that funding has been focused on college access. But as graduation rates show, just getting a student into college is not enough. Instead, the federal government must expand its higher education activities to include efforts aimed at completion and academic success. Incredible amounts of funding are poised to go to colleges and universities. Now it’s time to ensure it’s money well spent.

Tagged as: College Access, College Completion, Congress, Federal Student Loans, Student Aid and Fiscal Responsibility Act