In the months leading up to passage of the College Cost Reduction and Access Act, and in the weeks since, student loan providers warned that Congress's decision to cut billions of dollars in subsidies to lenders and guarantee agencies would lead them to reduce the benefits they provide to borrowers. And observers of the student loan industry predicted that the changes would probably result in intense politicking and posturing among lenders looking for a competitive advantage.

Yes and yes, if a situation unfolding in Illinois is any guide.

For several years, the Illinois Student Assistance Commission, the state agency that guarantees student loans and oversees most student aid programs in Illinois, has paid the 1 percent "default" fee that the federal government charges to borrowers in the Family Federal Education Loan Program. The commission's decision to pick up the fee, which amounts to $48 a year on a typical student loan of $4,800 in Illinois ("about the cost of a chemistry textbook," said Andrew Davis, the agency's executive director), has cost the agency (and saved borrowers) about $10 million a year on the roughly $1 billion it guarantees in loans annually. Because some guarantors don't pick up the tab for borrowers, the policy gave the Illinois agency a nice competitive advantage.

In September, the commission's board announced that because of the nearly $22 billion in cuts imposed on lenders and guarantors by Congress in the budget reconciliation legislation, the Illinois agency would no longer be able to afford to pick up the full 1 percent fee, as of December 1. But to "protect a key borrower benefit" and "reduce the cost of borrowing by Illinois college students and their families," the board said it would continue to pay half the fee -- but only as long as the lender that issued the student loan agreed to pay other 50 percent. And the agency said it would agree to guarantee the loans only of those lenders that agreed to pick up its share of the 1 percent fee.

"Our viewpoint was that we want to do everything we can to try to protect the students" from the impact of the Congressional legislation, said Andrew Davis, executive director of the Illinois Student Assistance Commission. "Our understanding was that the intent of the law was for lenders and guarantors to be put on short rations, but not the students." While the budget cuts would make it impossible for the state agency to continue to afford paying the full fee, Davis said, its officials thought that by ensuring that the lenders it worked with paid the other half, students would be made whole. And numerous lenders told Davis that they were on board, he said.

But not all lenders were happy. In a letter this month, three associations of lenders -- the Consumer Bankers Association, the American Bankers Association, and the Financial Services Roundtable -- argued that the Illinois agency's policy would violate the Higher Education Act (the federal law that governs the student aid and student loan programs) by requiring lenders to pay a fee that the law allows loan providers to charge to borrowers, and by imposing a requirement on a lender that benefits the guarantor.

"We are also very concerned," the lenders wrote, "over the harm that the ISAC policy will have on the competitive market, because we believe it may operate effectively to deny borrowers the right to choose a lender that declines to participate in the revised ISAC program. Because many schools in Illinois feel compelled to use the ISAC guaranty because of the joint administration of that guaranty program with Illinois grant programs, lenders not participating in your program have no opportunity to make loans to students attending a large number of Illinois schools. This results in a denial of borrower choice for these student and parent borrowers."

(Although the lenders' letter did not explicitly say so, they also suggested that the new policy -- while it would clearly help students -- would also benefit the Illinois agency itself, by giving it an ever-larger competitive edge against the growing number of guarantee agencies that are choosing not to pay the default fee in the wake of the budget reconciliation law.)

The lenders' groups also asked the U.S. Education Department to look into whether the Illinois agency's policy violated federal law -- and on Friday, department officials sent the student aid commission a letter insisting that it "immediately cease implementation" of the new policy requiring lenders to cough up half of the default fee.

"ISAC contends that the policy is designed to 'encourage' lenders to share payment of the fee," wrote Patricia Trubia, acting director of the Federal Student Aid office's Financial Partner Eligibility and Oversight Program Compliance division. "However, the policy goes beyond providing 'encouragement' by requiring lenders to agree to pay" the fee. Such a policy violates federal laws and regulations on several counts, the letter said.

Davis said Illinois officials believed they were on solid ground in imposing the requirement, since "we weren't telling [guarantors] what to do, we were only telling them what they would have to do if they danced with us." Borrowers in Illinois are not required to use the state agency to guarantee their loans, and only about half do, Davis noted.

He said he remained confident that enough lenders would voluntarily agree to pay half the default fee that many if most students would avoid paying it. But agency officials are "disappointed that the department has taken this very narrow legal construction" to viewing the situation. "They're the regulator here, but I think they missed an opportunity to help students and help ensure that [the budget law] does not have a negative impact on students. We're sorry they did not bless this initiative."