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Loans and the Deficit

July 18, 2011

WASHINGTON — For much of the last decade, the federal student loan programs served as a piggy bank as Congress looked for money to cut or redistribute for other purposes.

The “profits” from lending existed mainly because the revenues produced (as borrowers with high interest rates repaid their loans) significantly exceeded what it cost the banks and the government to make the loans.

But because significant proportions of the programs’ profits flowed to banks and other lenders, slashing them – to increase spending on grants to students, or even to pay down the federal deficit – was often portrayed as taking money from “fat cat” companies to give to needy students, as Congress did when it poured tens of billions of dollars into the Pell Grant Program in 2010.

Today, the federal student loan program still produces significant profits – and as politicians here scour the federal budget for ways to cut the deficit as part of negotiations over increasing the federal debt limit, the student loan program is once again on the hit list. But now that the government itself is the sole provider of federal student loans, those revenues are flowing into the federal treasury, and it is clearer than ever before that the “profits” that would be redirected to deficit reduction and other purposes are coming from the borrowers themselves. And that gives the proposed transfer a slightly different look than it had when the profits that were being tapped were being taken away from banks and other lenders.

"The federal government is making a lot of money on students and on parents," says Becky Timmons, assistant vice president for government relations at the American Council on Education. "There’s a risk of almost treating students like an ATM machine."

For decades, the federal government has made loans to students to encourage college-going. Students (or parents) borrow government funds and repay them over time with interest -- some with the government covering the interest payments while the students are in college, others not. For many years, the government used a system of banks, other financial institutions, and state and nonprofit agencies to lend and guarantee the loans. Beginning in 1993, the government began making and servicing some of the loans itself; in 2010, the entire system became government-run.

The revenues from the loan program have often helped to finance government spending on other forms of student aid, but the savings have been applied to the deficit since at least 2005, when lender subsidies were cut by $15 billion by the Republican House of Representatives during the “budget reconciliation” process. At the time, Democrats condemned the move as a “raid on student aid,” arguing that the student loan programs should not be cut at all and that, if they were, the savings should be redirected into other areas of financial aid.

In 2007, in the College Cost Reduction and Access Act, lender subsidies were cut again, that time by $18 billion. Much of that money went to other financial aid programs, including lowering the interest rate on subsidized student loans. But because the bill was also passed using budget reconciliation, which requires that the measure reduce the government’s deficit, some of the savings were not put back into student aid, said Mark Kantrowitz, the publisher of Finaid.org.

In 2010, the Student Aid and Fiscal Responsibility Act eliminated bank-based lending entirely, for a savings of about $67 billion in subsidies over 10 years. While about two-thirds of that revenue went to increasing the Pell Grant to its current $5,550 maximum level, about $20 billion was redirected to reduce the deficit.

“$20 billion is a substantial amount of money,” Kantrowitz said. “It’s the amount of the [current] funding shortfall in the Pell Grant program. If it weren’t for this, we wouldn’t have a funding shortfall in the Pell Grant program. We wouldn’t be in the financial difficulties with student aid that we have.”

Ending bank-based lending also ended the last source of politically easy subsidies to cut: it “scraped the bottom of the barrel,” Kantrowitz said. Revenue that had previously been diffused among student lenders, loan servicers and other companies now flowed overwhelmingly to the federal government. In the meantime, the Pell Grant Program exploded, with more recipients due to the recession and bigger grants due to funding increases and eligibility changes. The program grew so big that even many supporters say it now needs to be reformed.

But the perceived need to find areas in the budget to cut is growing, not shrinking. With no lender subsidies left, and few places to find new money to continue supporting the growing Pell Grant Program, legislators (and the Obama administration itself) have begun proposing eliminating subsidies that previously went to students instead. The president’s 2012 budget called for ending subsidized Stafford loans for graduate students, as well as transforming the Perkins loan program, which serves a relatively small number of low-income undergraduate students, into unsubsidized loans. The savings from both changes would be used to fund Pell Grants.

But more recent proposals would have the government hold on to the savings rather than spend them. The most recent proposal, from Republicans in the tense, secretive negotiations over increasing the federal debt ceiling by Aug. 2, would reportedly end all subsidized Stafford loans. The $46 billion in savings would be used to pay down the deficit. Some students could owe as much as $9,000 more in federal loans by graduation under the proposal, said Pauline Abernathy, vice president of the Institute for College Access and Success.

“In the past, proposals have been made of this nature, but they have been rejected,” Abernathy said of using the savings solely for deficit reduction. “Even after recent increases in the maximum Pell Grant, it will cover less than a third of the cost of attending a four-year college next year, which is actually the smallest share in the history of the program."

Much of the tension between loan revenues and grant expenditures springs from the shift away from bank-based lending. The federal government borrows money for student loans at a far lower rate than is available on the market, and, while the interest rate on loans is often below the market rate, there is still a gap that swings in the government's favor. In the past, lenders pocketed much of the difference. Now that the government is the sole lender, it has made more transparent the extent to which the federal student loan process makes significant money from student loan borrowers (mostly middle-class families) and uses it to support other students or achieve other federal goals.

The current student loan interest rate, 3.4 percent, is about as low as it has ever been -- the end of a five-year gradual decrease that began as a campaign promise when Democrats gained control of the House of Representatives in 2006. Next year, the rate will return to its previous rate, doubling to 6.8 percent.

If subsidized loans for undergraduate students are eliminated, and if the interest rate goes up to 6.8 percent, some students could end up owing a third more by graduation than they would if they borrowed now, Kantrowitz said. "You’re talking about an additional $9,000 in debt on top of everything else," he said. "That starts getting to the point where students will routinely be overborrowing."

Given the current political environment, that increase in how much students pay and the government takes in is unlikely to be accompanied by a significant increase in need-based grants. Many advocates say they are simply hoping that the Pell Grants are not cut back to pre-recession levels.

But the pending increase in the interest rate is likely to exacerbate the perception among students and families – a perception with a strong basis in reality -- that their payments are subsidizing other government priorities. That is especially true to the extent that federal policy makers stay on their current track of believing that reducing the deficit is more important than spending on financial aid.

President Obama and some lawmakers in both parties are reluctant to impose significant cutbacks on the Pell Grant Program, but they seem willing to trade away many other financial aid benefits for students – including the in-school interest rate subsidy -- to protect Pell.

Although the proposal to end subsidized loans drew immediate criticism from advocacy groups and financial aid experts, who say such savings should be directed toward other financial aid programs and not used to pay down the deficit, the subsidized student loans typically have not had the same vocal constituency and support that Pell Grants have.

Their benefits are more opaque: the loans' interest rates affect how much students owe after they leave college, but are less likely to determine whether they can afford to attend at all. There is little evidence that they affect college completion rates. And although a cut in Pell Grants would immediately be noticeable, changes in the interest rate, or in subsidies for borrowers, might not be, said Jason Delisle, director of the Federal Education Budget Project at the New America Foundation. A report from the College Board's Rethinking Student Aid panel backed ending the in-school subsidy, although it said the savings should be redirected to Pell Grants.

"It’s a very sort of roundabout way of accomplishing a policy goal which is not really explicit, which is trying to lower the cost of college education for students," Delisle said. "It doesn’t change how much they can borrow, it just changes what they end up with in the end. It’s also not very transparent... Most students aren’t quite aware of what’s happening, that they’re getting this benefit or how much it is. If it’s taken away, will they know?"

Even if interest subsidies were to be eliminated, he added, the loans are still a better deal for students than what they might get on the private market. They often go to students with poor credit and no qualified co-signer; if they were borrowing from banks, these students might not be able to get loans at all, or would have to pay high interest rates.

The same is true for the interest rate's increase to 6.8 percent, he said, adding that by a conservative estimate it will save the government $15 billion to $20 billion over 10 years. “That’s a big subsidy when you’re lending to a student at that kind of rate,” Delisle said. “It’s a subsidy the taxpayers are being asked to bear by effectively saying, 'Given the loan, given the risks, given the going rate, we’re going to lend at less than that.' ”

Whether borrowers and their families will see it that way when the interest rates go up remains to be seen. The entirely government-run lending program is still new – only a year of issuing all federal student loans – and, as the costs and benefits of that approach become clearer, some changes might be made, Timmons said.

“We’ve only got a couple of years’ experience with direct lending in an economic environment unlike any other we’ve ever seen in our lifetimes,” she said. “I think once there’s some experience with the government running [all] direct lending, people will need to sit down and see if policy adjustments are necessary to make sure rational policy is being achieved.”

The renewal of the Higher Education Act in 2013 might be a good time to tackle those questions, she said, adding that a key one would be “determining what is a reasonable amount of administrative overhead without being a serious profit-making engine.”

The risk, of course, is that in deficit-minded times, a program that is a profit-making engine might be considered more rational than most.

 

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