In response to New York Attorney General Andrew Cuomo’s inquiries and a spate of unseemly behavior in student lending, federal officials have quickly embraced patchwork solutions for the industry. As a consequence, they are in danger of overlooking the opportunity for a thorough reassessment of college financing.
Some of the behavior raising eyebrows is clearly troubling and inappropriate, such as incidents at Johns Hopkins University and the University of Texas of lenders and financial aid officials engaging in “payola” and in-stock dealings. Other reputed scandals, however, are more ambiguous and say more about the state of the loan sector itself than those involved in it. For instance, Nelnet has been under scrutiny for its marketing deals with university alumni associations; Sallie Mae for providing call-centers for colleges and universities and offering “opportunity loans” to students who might not otherwise qualify; and various lenders for “revenue sharing” with universities and paying for travel and lodging while courting financial aid officials.
These “scandalous” behaviors actually amount to the relationship-building and aggressive marketing one finds in any business dependent on sales. They may be uncouth or unlovely, but these activities simply reflect loan providers struggling for advantage within the murky rules of the existing market. Meanwhile, financial aid officials juggle considerations of cost, institutional need, and provider quality in a constantly changing market place. It’s no wonder that we are unhappy with the results.
We should expect private enterprises to tiptoe up to the edge of what’s permissible. Pushing boundaries is what drives the process of innovation, marketing, and cost cutting, the results of which we enjoy until we are exposed to their unseemly underbelly. If we do not like where those lines are drawn, then it is appropriate to move them.
Cuomo’s code of conduct will help on this count, but criticizing loan providers or financial aid offices for fostering associations with one another is unfair when we remember that today’s reviled “preferred lender” lists themselves were largely a response to federal direction. In the Omnibus Budget Reconciliation Act of 1990, Congress made reasonable student default rates a condition for the participation of colleges and universities in the FFEL program, thereby giving institutions incentives to prefer lenders with a record that federal officials would deem satisfactory. Compelled to favor lenders with lower default rates, colleges and universities created “preferred lender” lists, and lenders began to compete for places on them. In short, Congress’s earlier directive -- reasonable and eminently defensible -- helped foster the relationships that legislators now decry.
The Big Picture
When the Guaranteed Student Loan program was created in 1965, just 18 percent of college age students pursued college. Today, that number is over 50 percent. Federal lending has played a key role in expanding access to college, but its success has created a new world with its own challenges.
Policy makers in the 1960s and ’70s assumed that banks would be reluctant to provide the necessary funds to students who are mobile, small-dollar and risky borrowers, and thought it necessary to provide resources and incentives to ensure an adequate financing pool.
In response, Uncle Sam promised to reimburse lenders for defaulted loans, raised the statutory interest rate, provided a supplemental rate of return for lenders (called the “special allowance”), and created the Student Loan Marketing Association (known as Sallie Mae) to buy extant loans, thereby creating liquidity for new loans. Those efforts have succeeded to a degree that their early architects could scarcely have imagined. Private student lending has exploded to over $17 billion a year, equal to about 25 percent of the federal loan volume, suggesting that those early efforts and developments in credit markets have met many of their goals -- at least for serving some segments of the lending market.
In fact, the furor about the cost of college centers on the price of private schools; two-year and four-year public schools -- which enroll 80 percent of college students -- remain a remarkable bargain. While the median price tag for tuition and fees at a private four-year college is $22,000, and well over $40,000 at top-tier schools in college ranking surveys, it is less than $6,000 on average at a public four-year university. Four years of tuition and fees at a public institution average less than $25,000. In short, college is extraordinarily expensive -- for those who choose to attend extraordinarily expensive private institutions.
Contemporary discussions about student lending often fail to distinguish between two very different aims: the first is that of access, which is primarily important for low-income families; and the second is that of educational choice, which is most relevant for middle-income students weighing more expensive schools against cheaper, in-state public institutions.
Expansions in the federal loan program since the 1970s have primarily called upon taxpayers to help subsidize college choice and cash flow management for families without demonstrated need. The Middle Income Student Assistance Act (MISAA) of 1978 removed the income cap on loan eligibility, and today even students without subsidized loans still benefit from deferred interest payments and taxpayer-provided loan guarantees. In 1980, the Parental Loans for Undergraduate Students (PLUS) program began allowing parents to take out additional, separate loans under the Stafford program, with no restrictions on family income. By 2005, PLUS loans constituted 14 percent of Stafford borrowing.
Today, less than 60 percent of federal student aid is provided on the basis of need. In fact, Harvard University’s Bridget Terry Long has calculated that in 2003-4, nearly one in three dependent students from the highest income quartile took out Stafford loans and borrowed just as much on average as students from the lowest income quartile. It’s one thing to argue that taxpayers should help ensure that every child has the opportunity to attend college; it’s another thing entirely to suggest that they should subsidize the ability of students to attend any school they want.
A Forward-Looking Agenda
What does all this mean for the future of student lending?
First, and most obviously, the push for increased transparency in the industry, clear codes of conduct, and a more level playing field are all to the good. But transparency alone won’t change existing incentives -- and reactionary policy making could forfeit important opportunities.
For instance, Cuomo has expressed concern that lenders are engaging in differential treatment depending on the institution a student attends. However, should this be regarded as a problem, or an opportunity? If lenders are eager to serve some students, either because they appear to be good credit risks or because lenders are eager to cultivate banking relationships with prospects deemed likely to be high-earners in time, this may be a development worth celebrating.
As with any publicly nurtured market, the optimal course is the development of a mature, responsive and transparent private market, in which students’ needs are met, to the extent practicable, without public guarantees or funds. Obviously, given the fact that the private market will not serve all students, there remains an important role for public subsidies and loans, but that ought not blind policymakers to the fact that the contemporary loan sector can and will serve a substantial population of middle- and upper-class students without public subsidies or financing.
Second, there are few incentives for financial aid officers or guarantors, beyond benevolence, to be innovative or efficient, or to safeguard the interests of borrowers. While this model may have worked in the cloistered, paternalistic lending environment of an earlier time, recent headlines suggest the need to revisit assumptions about roles, rewards and accountability.
Third, if the federal mission is to ensure access to college rather than choice of college, better targeting of the allocation of funds is necessary. Policy makers might focus on using guarantees and subsidies to ensure access to loans for low-income students who are often higher credit risks and on establishing strong consumer protections for borrowers better served by the growing private loan industry.
Today, Washington seems to be leaning the other way. Earlier this year, in line with its Six for ’06 pledge, the Democratic majority in the House of Representatives voted to cut interest rates on student loans in half, without any effort to direct this new benefit to low-income students. Given that the 6.8 percent rate for federal Stafford loans was already highly competitive with market interest rates, such untargeted measures seem a poor use of taxpayer funds.
Fourth, we should embrace the success of earlier efforts to create liquidity and credit availability in higher education. Private loans comprised just 6 percent of the loan industry in 1996-97 but now amount to roughly 20 cents of every dollar borrowed. The $17 billion that for-profit lenders are eagerly offering to college students suggest that a vibrant credit market has been created for at least part of the college-going population. The challenge is to understand how large of a population that sector can serve and what will most effectively help the students whom lenders deem less attractive.
The emergence of private lenders and the accumulation of data on borrower performance have led to new advances in pricing models and customer service. The risk is that private lenders use aggressive marketing to entice students into debt they are unprepared to handle. On the other hand, these providers also have the potential to experiment with pricing and repayment options and otherwise pioneer loan products that may be cheaper, more convenient, and more customized than those that exist today.
Fifth, we should rethink the machinery that impedes comparison shopping and makes loan providers less sensitive to student needs and repayment ability. The need to rethink the FAFSA and move to a more user-friendly and predictable system for determining student aid has been widely recognized. Another step is to push state-funded institutions to be more transparent about the provision of student aid.
A less familiar measure would address the risk that securitization encourages originators to issue loans with little concern for a student’s ability to repay. Loan originators package and resell loans to third party companies. In purchasing these “securities,” these third parties adopt the risks associated with those loans. This process of securitization diffuses loan risk and protects loan originators from the risk of ill-advised loans; this process may, in turn, encourage originators to make loans to borrowers who are uncertain credit risks.
This sequence of events has recently played out in the subprime mortgage industry. A corrective might be new guidelines requiring the lender or school in question to adopt a credit risk position in the loan, thereby incentivizing loan originators to exercise prudent judgment when originating loans and financial aid officials to more carefully monitor the quality of the loans their students are receiving.
While attending to student need, it is also important to foster student responsibility. It is widely estimated that students who graduate from college will earn $1 million more than their peers over the course of their working lives. There is, of course, a tension between ensuring that cost considerations not deter students from attending college while asking those who reap the benefits of higher education, rather than third parties, eventually bear the costs. Precisely how to balance this tension is an open question, but—frequent caterwauling about the put-upon student aside—it is not inappropriate to ask students to accept loans that will permit them to ultimately shoulder a substantial portion of the cost of postsecondary schooling, lest opportunity be mistaken for entitlement.
Frederick M. Hess and Juliet Squire
Frederick M. Hess is director of education policy studies at the American Enterprise Institute and editor of Footing the Tuition Bill (AEI Press 2007). Juliet Squire is a research assistant at the American Enterprise Institute.
It seems that each new day brings more bad news about America’s housing crisis. Sales have plummeted, prices are dropping with no end in sight, and millions of desperate homeowners now face the very real prospect of losing their homes to foreclosure. Banks that bought shaky mortgages are also feeling the pain, ensuring that the financial burden hits both Main Street and Wall Street.
While everyone is focused on housing right now, financial history tells us that another bubble lurks beneath the surface. Indeed, it was only eight years ago that we stood panicked at the prospect of dot.com companies going out of business and the chance to buy a house through innovative loan products seemed like a prudent decision. Predicting exactly where the next bubble lies is difficult, if not impossible. But given our research, we believe that a persuasive case can be made that higher education and the student loan industry are inflating a massive bubble. Trying to reform this bubble before it explodes should become a priority for lawmakers.
Here are the facts. In an effort to increase access to higher education, the government has been lavishing financial aid on students. The largest of these subsidies are the loan programs (primarily the federal direct and guaranteed loan programs, Perkins and PLUS), which accounted for just under 70 percent of all federal financial aid last year, according to the College Board. But there is reason to believe that these subsidies do not achieve their goal due to an unintended consequence, specifically, the incentive the subsidies give to colleges to increase their tuition.
Most government subsidies lead to lower prices for consumers, as profit-maximizing businesses expand production to satisfy the higher demand that subsidies bring about. This is not the case with student loans in higher education, however, because the field is dominated by public and nonprofit institutions that seek to maximize the prestige of their institutions, not their profitability. Admitting more students (expanding production) will, other things equal, lower the quality of students admitted, and therefore reduce the prestige of the institution, which is precisely why many schools are willing to forgo the business of many potential customers. The best schools turned away more than 90 percent of applicants this year. Raising the demand for higher education through more student financial aid does not increase enrollments a lot.
To make matters worse, there is very little information available about the actual output of colleges (what and how much students learn). Without this information, it is difficult to conduct a cost benefit analysis of going to college, let alone compare various schools. Without a measure of output to prove otherwise, high tuition charges are sometimes seen by students and their parents as indicating high quality of a school, meaning that outrageous prices do not necessarily scare students away.
So what does increasing loans for students accomplish? Just put yourself in the shoes of a college administrator to find out. The 61 percent increase in inflation-adjusted federal loans over the last decade leaves virtually all their students capable of paying more in tuition. The schools can either raise tuition, using the additional money to help build a better (more prestigious) college , or could leave tuition unchanged in an inflation-adjusted sense. The decision they made is obvious from U.S. Department of Education data. Over the last 10 years, after adjusting for inflation, tuition is up 48% at public schools and 24% at private schools.
Giving schools more money to build better institutions may not seem like a bad idea, but keep in mind that their goal is to increase prestige. This means that they will not necessarily use the money to improve the education their students receive. For example, Inside Higher Edrecently reported that less than half of employees at America’s institutions of higher education are faculty, information reinforced by a new study released this week. Today’s universities are congested with vast bureaucracies that stifle innovation and waste resources. Princeton University recently constructed a fancy dorm that cost $70,000 more per bed than the median home price. This unnecessary largess should show that what increases prestige may have very little effect on the education of students. Moreover, much of the extra money for schools ultimately comes from the students, who have seen the average debt upon graduation steadily increase to over $20,000 last year.
The analogy to the housing bubble is nearly perfect. Low interest rates arising from expansionary Federal Reserve policies led to rising housing demand, rising home prices, and excessive lending to individuals with dubious credit worthiness. Similar things have happened with student loans. The federal government has provided subsidized, low interest credit, often to students whose prospects for graduating from college are marginal and whose credit histories are non-existent. Student loan defaults are rising along with tuition fees. Already, some private lenders are exiting the market and federal officials are starting to become increasingly worried about the availability of student loans. The government-induced housing bubble is paralleled by what could be thought of as a tuition-loan bubble.
Even if the bubble is beginning to peak, we think that it has a long ways to go before it reaches crisis stage. Remember, it took us almost three years from the apex of the housing boom to today’s sad state of affairs. And it’s entirely possible that we may never hit that point in the student loan-tuition bubble.
Nevertheless, we think it would be wise for policy makers to seriously examine the dysfunctional system of student loans and tuition now and start recommending broad, fundamental reforms to solve this problem before it gets worse -- possibly a lot worse. The underlying long-run solution, of course, involves reining in the excessive rise in college costs.
Short term, rather than simply engaging in a costly bail out of loan providers and borrowers (seemingly the solution of President Bush and Congress), maybe we should move to new methods of financing, such as students selling “equity” (a share in future earnings) in themselves to newly created human venture capital funds in return for funds for schooling. Maybe affluent colleges should lead the way in doing this, using their own endowment funds as the financing vehicle. And, to be politically incorrect for a moment, if some students are denied funding this fall because of the lending risks involved, this is not the end of the world, since many who borrow for college fail to graduate anyway. Remember, in 2005, you were thought the fool if you warned somebody about the risks of a no-money down mortgage with an ARM. Housing prices would rise from now until the end of time, or so we were told.
We now know the fallacy of that thinking. Let’s make a real effort to avoid the same mistakes for the students and families who pay tuition bills.
Andrew Gillen and Richard Vedder
Richard Vedder and Andrew Gillen are, respectively, Director and Research Director of the Center for College Affordability and Productivity. A full version of a report comparing the housing bubble to the tuition bubble can be found on the center's Web site.
In fact, though, it presents an opportunity not only to avert a possible current “loan crisis” but also to try out a different method of funding FFELP loans that could substantially reduce the program’s future cost to taxpayers. The latter opportunity arises from the use of lower-cost federal money, a use that had previously been rejected in principle by many of the lenders and policy makers who embrace it now.
A quick primer: Under FFELP, borrowers pay their private lenders below-market interest rates set by Congress. The federal government supplements borrower interest with Special Allowance Payments to give lenders adequate financial incentives to make the loans. Special allowances are paid according to legislated formulas based upon the differences, or spreads, between borrower rates and a proxy for lenders’ own costs of funding. (If those spreads exceed the statutory amounts, lenders make payments to the government.) Unfortunately, lender subsidies and particularly special allowances, which are changed on a frequent basis, have tended to be based more on budgetary needs and lenders’ political standing of the moment than on financial analyses of the incentives actually necessary.
The authority to purchase FFELP loans has some roots in last fall's College Cost Reduction and Access Act of 2007, in which Congress reduced both borrower interest rates and special-allowance formulas. The Congressional Budget Office then estimated the total reduction in lender subsidies to exceed $40 billion over 10 years -- cuts that lenders deemed excessive, and others deemed inadequate. Such claims are common whenever lender subsidies are changed, particularly given the subjective political process by which they are determined. That debate is now largely moot in light of the unanticipated severe and systemic disruptions subsequently occurring in the capital markets. It would have been at least difficult for FFELP lenders to have weathered this storm even with the pre-2007 subsidies.
In today’s generally disrupted markets, “securitization” of FFELP loans has been particularly affected. By using this structured form of collateralized financing, a lender can extract most of the capital from a portfolio of loans it has made while still retaining substantial attributes of owning that portfolio. Securitization usually results in a lower cost of borrowing than traditional forms of collateralized financing.
It was originally developed in the mortgage market; but, in anticipation of losing its implicit government guarantee when it became a private corporation, Sallie Mae had developed a market to securitize FFELP loans. That new market had also enabled other lenders without ready access to capital in their own names to originate loans and then replenish their funds. It has been estimated that 75 percent of FFELP loans were being securitized. One important form of such securitization, auction-rate securitized notes, may never again be available. Many traditional forms are presently prohibitively expensive, if available at all.
Before the new legislation, lenders formerly representing some 15 percent of FFELP loan volume had publicly suspended lending through that program. Other lenders, particularly commercial banks with access to capital in their own names, had stated intentions to increase their own FFELP volume. They had not made known, however, either the magnitude of those increases or whether they would be across the board or only for the loans with greater profit potential (mainly large in amount and/or with low risk of default) abandoned by others, potentially leaving some groups of students (often the neediest) without access to FFELP loans.
Before the new legislation, the Department was unaware of any widespread institutional complaints about loan availability. Because future widespread unavailability could not be ruled out under current conditions, however, the Department had been preparing to intervene, if necessary. Two vehicles already existed for such intervention.
One is the Federal Direct Loan Program, in which the U.S. government itself is the lender, using its own funds. Direct lending once accounted for a third of total federal loan volume but is now down to 20 percent. Since the size of the direct loan program is not limited by appropriation, the only potential obstacles to its expansion, other than the willingness of institutions to use it, are operational. The Education Department believes that it can double the capacity of the program for the upcoming lending season to accommodate increased demand, and dozens of colleges have announced plans to shift their allegiance from FFELP to direct lending or use both programs.
The other existing vehicle is the Lender-of-Last-Resort Program, under which the government provides FFELP guaranty agencies with capital to originate loans themselves. The Department owns the loans, which must be assigned to it on request. It pays the guaranty agencies a fee in lieu of borrower interest and special allowances. Although only minimal use has previously been made of this program (and certain technical problems were solved by the new legislation), it is also not limited by appropriation. Here, too, the only potential obstacles to large-scale use are operational.
Neither direct lending nor lender-of-last-resort is financially attractive to FFELP lenders. They obviously do not favor an expansion of the competing direct loan program. FFELP lenders also do not favor large-scale implementation of lender-of-last-resort, in which their only possible role is as contractors to the guaranty agencies. They heavily lobbied for an additional vehicle for possible federal intervention that would maintain their traditional role as lenders.
Only in Washington would the solution offered for potential operational challenges in ramping up two existing programs on an expedited basis be the creation of a wholly new and unfamiliar one to be implemented in the same time frame!
That is exactly what Congress provided in the new legislation, which gives the Education Department authority until July 1, 2009, to purchase existing FFELP loans from the lenders (and to enter into forward commitments to do so). The purchase price is to be determined according to criteria established by regulation, but it must be at least cost neutral to the government. Existing servicing arrangements for the loans may be maintained, although they must be at least cost neutral, also.
Like direct lending and lender-of-last-resort, the new purchase authority is based on federal funding, which is much more reliable in the face of increasingly unanticipatable, systemic problems in the financial markets. But we should not overlook financial implications of federal funding.
The U.S. government is perhaps the most cost-efficient funder in the world. Private lenders pay more for funds on the same terms. For example, even at today’s very low interest rates the government pays about one-half percent less on 91-day Treasury bills than corporate borrowers pay on comparable commercial paper. This spread tends to be wider in absolute terms at higher rate levels. Because of the special-allowance structure, the government in essence subsidizes FFELP lenders for the difference between their own cost of funds and the lower cost at which the government could have provided them.
This spread is responsible for the bulk of the savings in direct lending over comparable FFELP loans. With total existing FFELP loans currently at some $400 billion and growing rapidly, it does not take much imagination to project huge savings from the use of federal money to fund large amounts of outstanding and/or new FFELP loans and thereby eliminate special allowances entirely or at least reduce them by the spread between federal and corporate funding costs.
The government has moved with unusual alacrity to set the financial parameters for the new legislation. It has interpreted its new authority to allow it to purchase loans currently, to grant FFELP lenders an option to sell loans to it at a future date (without the customary up-front payment to one who grants such an option) and to offer short-term collateralized financing to FFELP lenders (through the purchase of participation interests in their FFELP loans). Although neither the second nor third alternative has the full cost-reduction potential of an immediate outright purchase, the financial parameters set for all three will at least generate some savings for the government and have apparently averted a threatened massive lender withdrawal from FFELP.
When federal funding of FFELP loans was first discussed almost a decade ago, FFELP lenders were highly suspicious. They feared becoming dependent on the government and subject to its control. The funding of FFELP loans was then itself a substantial profit center for lenders, as they were able to trade other securities related to their FFELP loans, an activity that the nation now painfully understands from the mortgage market. FFELP lenders did not want to give up their trading opportunity, which would at least have been substantially reduced if the government provided their funds.
Some in the federal government then thought that federal funding of FFELP might set a bad precedent and open the Treasury to other requests for federal funding of private lenders. No one has yet, however, been able to identify any other federal program in which the government guarantees private lenders an interest spread above their own cost of funding. In the face of possible shortages of FFELP loans, both sets of objections in principle to the use of federal money have apparently melted away.
In one substantial respect, the new loan-purchase authority is more attractive than the form of federal funding discussed previously. That earlier one would have left the special- allowance structure intact and therefore also required an auction mechanism using market forces to compensate for the subjective political process by which the formulas were set. But such auctions can be cumbersome, particularly in assuring that loans with less profit potential for lenders are made.
Although the 2007 budget legislation did also create a pilot program to test an auction mechanism, it has not been implemented. In any event, outright government purchases of FFELP loans might still be made by some form of auction; but there are alternatives, such as the fixed premium over loan amount announced by the Department. The choice of pricing method would not be driven, however, by the need to compensate for the current political process for special allowances.
Like the lender-of-last-resort program, the U.S. government would own the purchased loans outright and therefore receive the special allowances that it paid. Although the intricacies of government accounting might not attribute both the payment and the receipt to the same account, on a true economic basis there are no longer any special allowances on loans purchased outright.
Unlike the existing auction-rate test, the new authority to purchase is not formally labeled a pilot program. But what is a pilot other than a short-term experiment to test out a new concept and discover any kinks to be addressed in a permanent program if the experiment is generally successful? Despite the great speed of last week’s announcement, it may still be difficult for the government to establish a whole new operational system for the complex transactions that it envisions before the temporary authority to purchase loans expires. Hopefully, there will be no protraction of current market disruptions requiring an extension of the new authority.
Even if the new loan-purchase authority is not widely implemented now, it will still be there on the shelf stripped of its former objections in principle. The next time the government needs billions annually in additional budgetary savings, it will merely need to dust off it or some other form of federal funding. Funny how the acceptance of a good idea depends not only on its own merits but on the times in which it is considered!
Donald M. Feuerstein
Donald M. Feuerstein was a senior adviser to the U.S. Department of Education from 1993-99 and is a long-time advocate of federal funding for FFELP loans.
Last fall, my wife and I drove to Philadelphia for a long weekend. We spent Sunday afternoon wandering along famous Benjamin Franklin Parkway, the street that Rocky ran down before sprinting up the steps of the Philadelphia Museum of Art and raising his arms to the sky. There was some kind of fair going on that day, and the parkway was lined with food vendors, jugglers, and booths where various companies hawked their wares. Many of the companies seemed to be selling something involved with education, but it wasn't clear what. So I walked up to the booths, which were all staffed by friendly, attractive 20-somethings handing out free T-shirts, Frisbees and pens that light up if you twist them the right way. They turned out to be for-profit student loan companies. They were selling debt.
Debt, we are told, is a good thing. Cultural prohibitions against borrowing have caused whole civilizations to falter in the modern world. Our current maybe-recession has been pinned on the "credit crisis" – i.e., not enough available debt. Borrowing has become an ordinary, acceptable feature of American lives. We've come a long way since Franklin warned against becoming "a slave to the lender."
And few sectors have embraced debt with more enthusiasm than higher education. As the price of college has increased sharply in recent years, debt has followed. According to the College Board, total federal student loans increased by 61 percent in inflation-adjusted terms from 1997 to 2007, to nearly $60 billion per year. But that still wasn't enough to match rising costs -- the percent of borrowers maxing out on federal loans increased from 57 percent to 73 percent during roughly the same time. The private loan market (the nice people with the Frisbees) stepped in to fill the void, exploding from $2 billion in loans 10 years ago to over $17 billion today. More students are borrowing more money for college than ever before.
The logic is compelling: Given the huge earnings differential between college degree haves and have-nots, it seems like there's no amount of money one could borrow for higher education that wouldn't be worth it in the long run. Debt opens the doors to opportunity for people with no collateral other than the promise of their older, better-educated selves. College debt is an investment in their future, and it’s a chance that everyone feels good about taking.
But somewhere along the line our unreserved enthusiasm for college debt has gotten out of hand. It has masked tough choices and allowed pressing problems to remain unsolved, in a way that harms the most vulnerable students. This is partly because we tend to talk about debt in ways that obscure its meaning. We've allowed the lofty promise of higher education and the cold-blooded realities of borrowing to become confused. Sometimes we speak as if debt isn't debt at all.
Grants and loans, for example, are routinely bunched together under the common label of "financial aid," as when the College Board noted that "more than $130 billion in financial aid" was distributed last year. This isn't unusual -- everyone in higher education talks this way. And when federal loan programs were first established in 1965, it made some sense. Credit standards were far tighter then, and students had no recourse in the private market.
But the world has changed, dramatically so -- the debt vendors on the parkway are evidence of that. While federal loan programs undoubtedly give some students access to loans they couldn't get elsewhere, for many students the only real "aid" is the subsidy, the amount they save in terms of deferred or reduced interest compared to what they could have gotten in the private market. In an era of single-digit interest rates, the subsidy often amounts to only pennies on the dollar. Now that federal loans have a 6.8 percent fixed interest rate and PLUS loans stand at 8.5 percent, for some students there may be no subsidy at all.
It's true that the credit crisis has tightened the student loan market temporarily, but that's what crises are—temporary. As of this writing, the private lender Think Student Loans (they gave me a pen) is offering to lend students up to $250,000, with funds disbursed within 48 hours and online applications approved "in as fast as one minute." That's with no government subsidy – we're not going back to 1965. Characterizing student aid as the amount of the loan instead of the amount of the subsidy dramatically overstates the real assistance students receive.
The conflation of debt with real financial aid is abetted by individual colleges and universities, which present aid "packages" to incoming students that allegedly make up the difference between the ever-rising price of admission and the family's "expected contribution." For many students the "aid" consists mostly of lightly-subsidized debt -- as if paying money back, with interest, doesn't qualify as a "contribution." The easy conflation of real aid and debt also taints federal policy -- as with the recently-enacted "TEACH Grant" program, which purports to give grants (thus the name) to students who agree to teach in high-poverty schools. Yet due to eligibility restrictions, the U.S. Department of Education estimates, 80 percent of the "grants" will actually turn into unsubsidized loans.
Lenders, meanwhile, are eager to rhetorically bind their product with the greater good of higher education. Sallie Mae isn't so much lending money as "helping millions of Americans achieve their dream" while Nelnet "makes educational dreams possible" and Brazos promises to "help you finance your dreams." I don't fault the dream-weavers in the student loan industry for marketing their services, but seriously: when Capitol One tries to sell me a credit card or a car loan, it doesn't pretend to serve some ethereal higher purpose. It's hard not to see parallels in the sub-prime lending crisis, where unaffordable and sometimes predatory loans were dressed up in the rhetoric of homeownership.
Why does all of this matter? Because the rapid expansion of student debt, combined with the soft-pedaling of debt's true meaning, has served to forestall higher education's inevitable day of reckoning when it comes to price. While a few massively wealthy institutions have recently taken steps to reduce borrowing at the margins for the middle- and upper-middle class, constantly rising prices and debt to match remain the norm elsewhere
There are two main culprits here. Traditional colleges and universities, protected from competition by regulatory barriers and buoyed by public subsidies and rising demand, have managed to avoid most of the difficult choices inherent to becoming more efficient and restraining price. There are exceptions -- University of Maryland Chancellor Brit Kirwan has held down tuition in recent years by cutting operating costs, centralizing purchasing, and increasing faculty productivity (with the support of the faculty). At the same time, the Maryland system re-focused student aid dollars on lower-income students, reducing their need to borrow. Unfortunately, few other higher education leaders can make similar claims.
Governors and state legislatures, meanwhile, often treat universities and students as revenue source during economic downturns, shifting the funding burden to tuition as a means of softening the impact of fiscal crises brought about by their incompetent stewardship of the public treasury.
Debt has been an enabler for both groups. By grabbing money from the future income streams of students and parents, colleges and policymakers have managed to put off hard choices today.
The consequences of these bad actions have largely been hidden from public view. Student loan default rates have been a non-issue since the early 1990s, when federal policymakers cracked down on unscrupulous fly-by-night colleges that were abusing the system. But the most commonly-used measures -- the institutional two-year default rates that were established after the scandals -- are seriously flawed. As my colleague Erin Dillon recently noted, the average time to default is four years. While widely-reported 2-year default rates hover below 5 percent, the 10-year default rate for low-income students is more than 15 percent. For students who borrow more than $15,000, it's more than 20 percent. For black students, it's nearly 40 percent. These numbers, moreover, are for students who graduated from a four-year college. Default rates for drop-outs, of which there are many in higher education, are substantially worse. But since colleges get paid up front, and the federal government guarantees most lenders' loans, there are few incentives for those institutions to care.
The tectonic shift toward debt-financed higher education reinforces the notion that college is a fundamentally private good -- exactly the wrong message in a time when the nation's collective prosperity is increasingly tied to competition for information-age jobs that can cross national borders with ease. It has embroiled college financial aid offices in embarrassing scandals. It limits the life choices of debt-burdened graduates, and can devastate the financial futures of those who default. It fuels inefficiency, price escalation and public disinvestment in higher education while transferring scarce resources from families and students to financial giants' bottom line. Debt in moderation is the right choice for some students, some of the time. But it's no substitute for efficiently-run universities supported by real aid policies for students in need. Higher education debt has grown into far too much of a good thing.
Some choices, like whether to take a crushing amount of debt to go to your first choice college or settle for second best, are difficult.
Other choices, like whether to cut a wasteful government program that is prone to corruption and then use the savings to make college more affordable for low and middle income students, should not require much deliberation.
Yet student loan giant Sallie Mae, other lenders, and several members of Congress have come out against common sense reforms to the federal financial aid system proposed in President Obama’s budget plan. Of chief concern to critics is Obama’s decision to eliminate the Federal Family Education Loan Program (FFELP) and funnel all lending to students through the existing Direct Loan Program (DLP).
The president’s plan will save taxpayers $94 billion over 10 years by ending pointless subsidies to loan companies and using government funds to lend directly to students. Because loan repayment is guaranteed by the federal government, private lenders assume very little risk under the FFELP and yet are rewarded handsomely -- a subsidy that makes little economic sense. Much of the savings from the move to direct lending would be used to increase the maximum Pell grant award to $5,550 for the 2010-11 school year, and make the Pell grant a mandatory government program guaranteed an increase -- inflation plus 1 percent -- every year.
There are other important reasons to make the change. For one, the FFELP program is prone to corruption. A 2006 audit of the student lender Nelnet by the U.S. Department of Education’s inspector general revealed that the company had received more than $1 billion in taxpayer subsidies by gaming the system. Another investigation in 2007 led by New York Attorney General Andrew Cuomo found that lenders were lavishing gifts, payments, and other inducements on college financial aid officers in order to encourage them to recommend their loans to unwitting students.
Beyond its susceptibility to nefarious practices by loan companies, FFELP is also less reliable for students. In fact, Congress was forced to put the industry on life support -- by purchasing FFELP loans in order to provide struggling companies with fresh capital -- late last year.
So, what is the holdup?
Naysayers are voicing fears that eliminating lender subsidies could result in job losses. These concerns are, at best, overblown; a large work force will still be needed to process loans under the direct loan program, and companies like Sallie Mae can still have a role in servicing loans made through the program. Further, if Sallie Mae is so concerned about the job security of its employees, perhaps it should do some soul searching: Despite announcing losses of $213 million in 2008, the company paid its CEO more than $4.6 million and its vice chairman more than $13.2 million -- plus use of the corporate jet.
Seeing their golden egg slipping from their grasp, lenders are proposing a compromise that they claim will achieve up to 82 percent of the savings of a direct lending plan. The problem with the plan is that even if it does deliver on its promises, it will still result in over $17 billion in wasteful spending. To put it in perspective, this amount is equal to the cost of awarding more than 3.4 million young people the 2009-2010 maximum Pell grant award.
The student loan industry’s influence in this debate cannot be separated from their extensive campaign contributions to federal lawmakers. For example, The Hill newspaper recently reported that during the last campaign cycle, Rep. Howard P. (Buck) McKeon (R-Calif.), the senior Republican on the House Education and Labor Committee, received $20,000 in donations from major loan companies Sallie Mae and Nelnet, the most of any representative. Responsible members of Congress should be more concerned about supporting policies that will allow us to live up to President Obama’s pledge that “by 2020, America will once again have the highest proportion of college graduates in the world.” With the Lumina Foundation for Education estimating that by 2025 we will face a shortage of 16 million college-educated workers, this call to action must be heeded immediately.
Our country faces too many challenges for us to be providing pointless corporate welfare to loan companies. Our generation is inheriting a climate crisis, an economic crisis, a health care crisis, and a persistent crisis of severe economic and racial inequality. If Congress plays pork barrel politics rather than investing in the potential of America’s young people, then they are setting us up to fail at a time when failure is not an option.
Pedro de la Torre III and Carmen Berkley
Pedro de la Torre III is a senior advocacy associate at Campus Progress. Carmen Berkley is president of the United States Students Association.
Not long ago, one of the authors of a recent Inside Higher Ed Views article, “Aid for Students, Not for Banks,” proposed the creation of “State/Federal Partnerships for College Access and Completion Rates,” arguing that there are “too few programs addressing” these issues.
If the Obama administration’s budget proposal to eliminate the Federal Family Education Loan Program succeeds, there’ll be even fewer. That the author of is unaware of the extraordinary work done by guaranty agencies and lenders in the areas of college awareness and access speaks volumes of the quality of the debate around the administration’s proposal – and the need for more careful examination.
Clearly, battle lines have been drawn. Advocates for the proposal have quite effectively stoked populist rage against the organizations that make and service student loans. But just as any fair-minded person should be wary of claims that are “too good to be true,” they should be equally wary of charges that are “too bad to be true.” It should count for something that the picture being painted is unrecognizable to the overwhelming majority of the nation’s financial aid administrators and student loan borrowers.
Finally, does anyone seriously think the lives of borrowers will improve with the government not only becoming the (only) banker, but also needing to make large profits on loans in order to fund the proposed Pell Grant expansion?
As Congress moves forward with abbreviated consideration of the proposal under budget reconciliation, the student loan community implores policymakers to weigh two questions:
Are the projected cost savings from eliminating FFELP real? The short answer is No.
The Office of Management and Budget claims that the proposal will save $46 billion over 10 years; the Congressional Budget Office, $94 billion.
That the government’s budget agencies produced such divergent estimates ought to be reason enough for healthy skepticism.
But real grounds for skepticism exist. This year OMB revised its cost estimate of about 10 years' worth of FFELP loans. It said it was $18 billion too high. Since 2004 FFELP’s costs have been chopped by $23 billion.
Did the Direct Loan program get cheaper? Nope. OMB has revised its cost estimates upward by $12 billion. That amounts to a $30 billion swing.
In other words, the cost savings projected could very well vanish. Congress could wind up eliminating the more cost effective program.
Finally, the government’s cost estimates are problematic in other ways. For example, the department’s growing costs for administering direct loans would not be counted. These and other flaws have been well documented by the CBO, OMB, Congressional Research Service, and PricewaterhouseCoopers, among others.
Healthy skepticism is warranted for another reason. “Subsidy costs are estimates about an uncertain future and could be manipulated,” a 2004 OMB memo explained. “There is pressure on occasion to manipulate the estimates.”
Apart from whether the savings are real is what they actually represent: The government profiting on its low, low borrowing costs (close to 0 percent), while the borrower rate is as high as 6.8 percent.
The second question that should be weighed is, “Are there elements of today’s FFELP that are worth preserving?”
One of its greatest strengths is its accessibility: wherever Americans with dreams of going to college live, whether it’s on the plains of Nebraska, in the mountains of West Virginia or on the bayous of Louisiana, there’s almost always a nearby lender, bank or credit union that makes federal student loans.
And, almost always, the guaranty agency that serves the community sponsors college nights and other college awareness programs, as well as financial aid workshops. These programs have helped countless numbers of low-income and first-generation college students.
Another strength is the program’s default prevention activities, which have given FFELP lower lifetime default rates. Beyond the numbers is the personal aspect: the thousands of men and women who work for guaranty agencies really care about doing a good job -- and that job is to help borrowers manage repayment and avoid default.
A third strength is the program’s continuous innovation. Lenders have invested millions of dollars in developing more convenient processes, such as eSignature, and improving customer service. Consider this: almost every major processes and convenience used by the Direct Loan program was invented by FFELP’s private sector participants.
Finally, FFELP has to be one of the government’s most small “d” democratic programs. Not only do schools get to choose which program to participate in, students get to choose their lenders. With respect to schools, they’ve always preferred FFELP by overwhelming majorities – even today after years of budget cuts and during the current credit crisis.
The administration’s proposal is not a win-win for college access. There will be losers. College awareness and default prevention services will vanish. It will cost jobs and eliminate choice and competition. It will add a trillion dollars to the national debt within a dozen years.
This is no ordinary “budget” proposal. It will affect the “going to college” process for families for years to come. Even though it’s on a legislative fast track, it’s not too late for Congress to slow this train down. As is being done with health reform, all the stakeholders should be convened to explore ways to preserve the best of the current system and build a better one for the future.
An overwhelming consensus has been developing that the Federal Family Education Loan (FFEL) Program should be ended, and all federal student loans should be made through the Direct Loan Program, where students borrow directly from the federal government. The main justification for this is that direct lending costs less than FFEL, where students borrow money from private financial organizations, typically with some federal subsidy. Proponents cite new figures indicating that the government stands to make a lot of money on the switch, money that will be used to fund more Pell grants.
As someone who likes the idea of bigger Pell grants, and thinks that the FFEL subsidies are a waste of taxpayer money, I can certainly appreciate the goals of these proponents.
But a closer look at their argument leaves me quite worried. Advocates are pointing to a figure of $94 billion that could be saved. This number is derived from the subsidy rate calculations of the loan programs produced by the Congressional Budget Office (CBO) through a process known as “scoring.” Proponents are using the CBO figures to argue that shutting down FFEL will save massive amounts of money -- a strange argument given that a former head of the CBO has explicitly warned against drawing such conclusions.
The warning appeared in "Budget-Scoring Barriers to Efficient Student Loan Policy," a paper prepared for and presumably financed by groups of lenders. The author was Douglas Holtz-Eakin, the former head of the CBO. The paper describes the reasons why the CBO subsidy rate calculations are not sufficient for making policy decisions. Such decisions should be based on a cost-benefit analysis. Though no fault of its own, the CBO has a good handle on neither of the required totals.
To begin with, the CBO does not even look at the benefits of the programs. Advocates are assuming that both programs have the exact same benefits, which is highly questionable, given what Holtz-Eakin terms “a plethora of anecdotal evidence that private sector lenders offer a portfolio of un-priced borrower benefits (fee waivers, rate reductions, etc.), credit counseling, expedited delivery, superior information technology, college access in initiatives and other enhancements and programs not offered by the [DL], but not easily quantified.” It is also possible that DL provides greater benefits. The point is that we should not assume both programs have the same benefits.
Moreover, the CBO does not look at all the relevant costs. As Holtz-Eakin summarizes, the CBO figures do “not capture the economic cost of the loan programs. This is not a secret. The [CBO] itself has acknowledged the fact” in a 2005 report stating that “the subsidy calculations … are not designed to fully capture the economic costs to the government … nor do they capture all of the effects of the programs on federal spending and revenues.”
The CBO provides some of the most authoritative, objective and accurate estimates on a wide range of budgetary issues. Thus, if you are going to take issue with their numbers, you had better have a good reason. While I am not qualified to offer a detailed critique, as the former head of the organization, Holtz-Eakin is, and he’s offered a number of reasons to doubt the usefulness of the estimates.
As he explains, these programs are required to be scored according to the Federal Credit Reform Act (FCRA). But the fact of the matter is that DL and FFEL “do not receive equal treatment under federal budget scoring rules.” While the switch to FCRA removed a bias in favor of FFEL, it instituted one in favor of DL. A few of these differences in treatment that lead to bias are explored below.
To begin with, there are risks that are not accounted for by budgetary scoring. The two big ones are interest rate risk (the uncertainty about what rate the government can borrow at) and market risk. Market risk is a broad category that accounts for uncertainty due to fluctuations of the economy. For instance, will the recession push up default rates? While these are real risks with real costs, those costs are “not captured by federal scorekeepers.” This puts FFEL at a disadvantage since they face the cost of insuring or hedging against these risks, while for DL, these risks and costs are simply ignored.
Then there is the risk of programmatic failure (DL had to shut down in 1997, and without FFEL to fall back on, students would have incurred substantial hardship) and indirect taxes (FFEL lenders pay significant corporate income taxes), neither of which is reflected in the budgetary scoring.
The differences that have been getting the most attention are administrative and guarantee costs. These costs were generally not included in the scoring, but some estimates by the OMB and CBO indicate that these costs for FFEL are higher than previously thought. What doesn’t seem to get mentioned is that while taking these costs into account is appropriate, this is a relatively minor source of difference in program cost.
Most importantly, according to an earlier CBO report, the key way in which the programs are treated differently is that for the DL program, “principal and interest payments are discounted at a different, and generally lower, rate than the borrower pays. The result is a net budgetary gain to the federal government that does not exist in the FFEL program.” This gain reflects the fact that the government expects to borrow the money for DL at low rates (0.76 percent in 2010) and charge students 6.8 percent.
This substantial gain would be reported for any program that borrows at the Treasury rate, and lends at a higher one. But that doesn’t mean it’s a good idea. To understand why, note that the exact same logic -- that the government can borrow more cheaply than it lends -- could be used to argue that the government should take over all lending in any market.
Consider an analogy to mortgage lending. Just as with FFEL, there are private lenders that have received subsidies from the government (we’ve already provided Fannie Mae and Freddie Mac $200 billion, and are on the hook for losses on their $5.2 trillion combined portfolio). By the logic of the pro-DL advocates, this subsidization is much more expensive than if the government provided the mortgages in the first place, so why not have the government take over all mortgage lending? I don’t know of anyone who thinks the government should be the only provider of mortgages, but there seem to be quite a few who think such a policy is a good idea for student loans.
In spite of these concerns about the relevance of the CBO figures in comparing the costs of these programs, advocates of switching to DL continue to rely on them. If this is how policy is to be made, then perhaps we haven’t quite put faith based initiatives behind us after all. In the words of former CBO director Holtz-Eakin, “When the budgeted cost of a federal program fails to reflect its actual economic cost, policy decisions regarding that program are likely to be skewed. The federal student loan programs provide a case study.”
Andrew Gillen is the research director of the Center for College Affordability and Productivity.
An unintended consequence of making access to college an entitlement readily available to all high school graduates is that serious study in high school has become optional, even for those intending to go to college. Without an incentive to study diligently, many students are disengaged in high school and, as a result, underprepared for college. Some freshmen arrive at college thinking that having fun is the main reason they are at college and that the pursuit of knowledge should be available for when they have nothing better to do.
This situation came about relatively recently, partly the result of a change in the meaning of financial aid. Until World War II, financial aid referred to traditional scholarships that were awarded to academically meritorious students who mostly also were needy. The G.I. Bill, which financed college for discharged veterans of World War II, foreshadowed broader programs of federal grants and loans -- 20 at present from the federal government, 17 from the Department of Education and 3 more from other federal agencies -- that essentially universalized "financial aid." Few of them require better than mediocre previous or current academic achievement. As a consequence, about 30 percent of incoming freshmen at four-year colleges and over half the freshmen at two-year colleges are assigned to remedial courses in writing, mathematics, or other courses.
Nevertheless, federal grant programs, though supplemented by state and private grant programs, were never able to cover the financial needs of the millions of college students whose families could not afford the rising costs of attending college. So Congress established several loan programs, some indirect loans whose federal subsidies made attractive to banks, credit unions, and other financial institutions, and some financed directly by the Department of Education. Unlike Pell Grants and other federal grant programs for college students such as work-study programs for needy college students, which do not have to be repaid, loans must be repaid with interest after graduating from or leaving college.
Repayment is a problem for student borrowers. Many of these loans are subprime -- toxic in the same sense that some mortgages were toxic. They are even more likely to be subprime than mortgages are; the only collateral is usually the student’s future earning prospects after graduating, presumably enhanced by what he or she has learned at college. Student borrowers who do not learn enough from their educations to get jobs that permit then to repay what they have borrowed are likely to default on their loans, leaving taxpayers liable for them.
The student financial aid system was created by Congress not as an integrated system but in pieces: to do a variety of things for a variety of reasons. One major objective was to help youngsters from low-income families gain access to higher education. In the light of our egalitarian ideals, limiting educational preparation for good careers to children fortunate enough to have educated, affluent parents seemed immoral. A second reason for promoting college access for youngsters from low-income families is that, as Jefferson argued, persons of extraordinary talent may be born in humble circumstances, and giving them educational opportunities might enable the American economy to be more productive. The knowledge explosion during the 20th century demonstrated that ideas are extremely important to the "creative destruction" that a market system needs in order for the economy to grow. Institutions of higher education are where many new ideas are developed by adults through research and transmitted to youngsters through teaching. Politicians are referring to this economic growth function when they speak euphorically about student grants and loans as "investments." Realistically speaking, however, only a few federal grant programs -- and none of the loan programs -- seek out top-notch students who will presumably contribute most to the productivity of the American economy; others aim only to make accessible the college experience for children of lower-income families. The existing system is an uneasy compromise between these two objectives.
It is an uneasy compromise partly because promoting access for youngsters from low-income families sometimes conflicts with the meritocratic ideal of educating youngsters most capable of making great intellectual contributions to knowledge. A better compromise could be made to realize these two objectives by targeting the grants and loans devised by the federal financial aid program to needy students studying diligently in order to prepare to go to college. Instead they were set up mainly as incentives simply to go to college, prepared or not. Congress apparently assumed that the colleges would screen admissions appropriately or perhaps Congress was afraid to appear elitist by imposing meritocratic conditions. Thus, federal aid to college students removed most financial barriers to attending college. Applications increased as high school students heard the message that college attendance led to well-paid, interesting careers, and was now affordable. Many colleges expanded facilities and lowered academic standards for admission; virtually any high school graduate could get into some college. Students might have had an incentive to work harder in high school if they had had to demonstrate academic achievement both to gain admission to college and to obtain financial aid to cover expenses while enrolled. The unintended consequence of failing to set this requirement is students graduating from college without good job prospects, a problem made worse in an economy where the unemployment rate has now risen above 10 percent. The predictable result is a growing rate of student loan defaults.
I am about to propose to change federal loan programs to college students but not to change federal educational grants to college students. Why the difference? Both suffer from the same drawback; they entitle mediocre as well as able students to obtain federal financial aid. A different approach is justifiable because federal loans have much worse consequences for both students and taxpayers than federal grants.
Consider grants first. As gifts from American taxpayers that students do not have to repay, it is true that grants are a complete loss to taxpayers if students do not make contributions to American society as a result of going to college. On the other hand, grants involve less than half as much money as loans in the aggregate as loans. And even individual cases of defaulted loans, accompanied as they are by interest and penalties, can be very large burdens both to American taxpayers and to individual student borrowers. In a November 2009 case decided by a panel of five New York State judges who ruled against admitting a student borrower to the New York bar, the panel said, “His application demonstrates a course of action amounting to neglect of financial responsibilities with respect to the student loans he has accumulated since 1983.” The student owed nearly half a million dollars. This admittedly unusual case shows the advantage to both students and taxpayers of grants over loans. Because there are strict limits to the annual grants that students can receive from the Department of Education in any academic year, students cannot attend college whose costs are way beyond their means.
With the help of Pell and other grants, students can afford a community college even if they cannot get loans rather than an expensive private college, especially if they live at home and commute. Students who start at community colleges and are successful academically can transfer to four-year colleges for their junior and senior years. In other words, student grants ignore academic merit even though everyone knows that students who have not done well in high school are unlikely to do better in college. These grants are an expression of American society’s willingness to make higher education available even to students who are poor risks. Giving Pell Grants is a societal bet -- though a long shot -- that mediocre students are late bloomers and can do better scholastically in the future, not that mediocrity is acceptable in itself.
This bet is riskier for loans, and consequently I recommend that loans be treated differently. Congress and the President should start to require the Department of Education to make student loans contingent on the best available evidence of the student’s prospects for repaying them, such as good job prospects based on high school and college grades, curriculum in which they enrolled, and their credit ratings. Defaults would still occur. Predicting the earning potential of college students is chancy. However, many young people would almost certainly be saved from financial ruin, and American taxpayers would almost certainly not have to bail out as many subprime student loans.
As theologians have said, we mean well and do ill and justify our ill-doing by our well-meaning. The unintended consequences of good intentions apply to our system of financial aid to American college students, as it did to our providing mortgage money to borrowers who could by no stretch of the imagination have kept up payments on their mortgages.
To sum up: Federal grants give mediocre students a chance to become late bloomers. Loans, however, are expected to be repaid, and mediocre high school students with bad credit ratings are likely to default on their loans, causing serious financial problems for themselves and financial complications for the American economy. Targeting loans to students with good prospects for repaying them is more prudent financially and makes more sense educationally. Some illiterate high school graduates have already sued their high schools for educational malpractice; disappointed college graduates may follow suit. Some diplomas are "tickets to nowhere."
By now, most prospective college freshmen have already found out which colleges they’ve been admitted to, and the grueling process of refreshing e-mail accounts and camping out by the mailbox has ended. But for many of these students, the worst anxiety begins now, as the reality of paying for college sets in. The U.S. college loan system has recently undergone important changes, with the goal of easing the burden on graduates, but serious problems remain. Those facing high debts may still find themselves struggling to make payments, and confused about their options.
It is of great interest to note that this predicament was addressed and solved in Australia in 1989 – through income-contingent repayment systems that go beyond anything in the United States. The system has been effectively copied in many other countries. The U.S, system remains fraught with problems even though the solution has been transparent for over 20 years.
To finance the staggering costs of education, students in the United States have increasingly relied on both federal and private loans. The debt burden facing recent graduates during what are often their least financially fruitful years has serious consequences. For those students who make it to graduation, the reality of impending repayment obligations may cause them to choose higher paying jobs instead of lower paying jobs with high social value, such as teaching and social work. Students who find themselves overwhelmed by their debt burden or unable to make payments may default on their loans, harming their credit and fueling the need for government-funded collection costs.
Recently, policies have been enacted in the hopes of alleviating some of the debt burden facing graduates. A 2007 law created a new repayment method for federal loans, Income Based Repayment (IBR), which in theory allows graduates facing economic hardship to tie their loan repayments to their future income and allows borrowers to defer payment during years in which their incomes fall below a certain threshold. IBR caps graduates’ repayment obligations at 15 percent of their discretionary income, in theory, and forgives remaining debt after 25 years of consistent repayment. The Reconciliation Act of 2010 made IBR more generous for students taking out federal loans after 2014.
These developments are encouraging, but this new approach does not go far enough to relieve the incapacitating debt burden experienced by many graduates. The convoluted nature of the federal lending system and the limitations of these reforms call into question the extent to which people will make good use of IBR. As such, it is very likely that the expected improvements in college access and loan default reduction will not be fully realized.
The process of qualifying for IBR requires substantial administrative effort to prove economic hardship. Navigating this process and understanding the multiple repayment options that exist is very complicated, and will prove unworkable for some borrowers. IBR cannot offer the greatest comfort to graduates concerned about sudden changes in post-graduation income, as the period of time in which a borrower can apply for IBR is only 45 days at the beginning of each year. Consider what has to be done by graduate debtors with respect to IBR when events in their lives change. IBR allows for lower payments than a standard repayment plan when the borrower’s income is above a certain level. Eligibility is determined by calculations that consider both a measure of the borrower’s tax liability, called “Adjusted Gross Income” (AGI), and 150 percent of the poverty line. Both AGI and poverty line calculations can be affected by many different factors, meaning that IBR eligibility calculations can also vary considerably over time.
For example, the AGI changes if a debtor experiences an income change (for example, through promotion, salary cut, or job loss). The poverty line calculation is affected if a debtor gets married or separated, has a spouse whose income changes, or experiences a change in the size of his or her household (eg, from having a child). When each of these (commonplace) changes occurs, graduates must provide their lender(s) with convincing income documentation (payslip, letter from employer, bank statement, etc). Each year, lenders will assess income and family size to adjust the IBR repayment accordingly. A typical person moving, changing jobs, getting married or having children will have to do this each time, and separately for each of their lenders.
Perhaps even more problematic is the fact that although debt remaining after 25 years of loan repayment is meant to be forgiven, the amount of this remaining debt is still treated as taxable income, undermining the goal of assisting those borrowers who face the most difficult economic situations. Additionally, while IBR is a more reasonable repayment method in concept, its implementation may do little to address the expensive inefficiencies associated with the complicated federal lending system. The creation of a more efficient lending system devoid of unnecessary complications and expensive collection agencies could create even more cost savings and free up more funds to help those students with the greatest financial need realize their professional goals.
The data on the incomes of American college graduates suggest strongly that a significant proportion of students with debt will be in a position that requires IBR action. For example, we have calculated that 40-70 percent of those who attend college can expect to have the relevant income and poverty level sometime in the 10 years following graduation. If, as expected, college graduates find the income-based repayment process confusing and daunting, they may remain in a standard repayment plan in which those with relatively poor financial circumstances will find themselves allocating substantial proportions of their incomes to loan repayment. We have calculated, for example, that those ending up in the bottom quarter of young graduate income earners with average student debt of $20,000 would need to devote around 30 percent of their incomes to service the debt. A significant proportion of college dropouts with debts of just $10,000 will have to allocate over 25 percent of their incomes towards this end. For many, this will lead to significant burdens and even default.
This important U.S. problem seems very odd to outsiders. In Australia, for example, student loans do not cause these sorts of collection problems because they are repaid not on the basis of regular set amounts, but instead depend directly and automatically on a graduate’s income as recorded by income tax authorities. This is an example of an automatic income contingent loan, a concept which was thought up, independently, by two Nobel winners in economics, Milton Friedman and James Tobin.
Australia led the world by introducing automatic student loan repayment in 1989, paid through the income tax system. The policy was designed to achieve all the protections inherent in the current U.S, moves toward income-based repayment, and to do so without the complicated administrative arrangements or detailed planning that characterize IBR. Student borrowers don’t have to clear any hurdles when they experience low incomes.
The Australian system is known as the Higher Education Contribution Scheme (HECS) and it works as follows: when students enroll in college they may elect to pay their tuition later in a way that depends on their future incomes. Eighty-five percent of students take up this option. The debt is recorded with the Australian Internal Revenue Service and is taken from a graduate’s income, at a maximum of 8 percent of incomes, but only when incomes exceed about U.S. $35,000 a year. If the former student is in poor circumstances, for example from being unemployed or in a low-paying job, no payments are required, and no action is needed by the debtor to prove these circumstances. There are no poverty line recalculations, no need to adjust repayments with marriage or separation or the birth of a child; it is all automatic and simple. When Australian college debtors’ incomes recover, their repayment amounts increase, yet never to more than 8 percent of incomes.
The very simple facts about the Australian versus the U.S. loan systems are that in Australia there is no default because of low income, people with debts face no repayment hardships and graduates do not have to take high income jobs in order to be able to afford repaying their loans. And all this happens with no action needed by Australian graduates, and with no required expertise or information needed on how to master complex and demanding administrative arrangements.
The success of HECS has encouraged a quiet international revolution in college loans, away from the U.S.-style and toward the Australian. New Zealand adopted a similar plan in 1991, South Africa in 1991, the UK (partially at first in 1997 and now in full swing), Hungary in 2003, and similar efforts are planned for Malaysia, Ireland and other countries in the near future. All the evidence is that these systems have worked well and the government gets back the vast majority (85 percent) of the debt without defaults or repayment hardships from low incomes.
It seems that U.S. college students are being left behind in terms of international reforms of loan arrangements. Automatic loan collection offers distinct advantages over current U.S. approaches, and given the demonstrated success and fairness of these systems in other countries, the time seems right to debate the issue in earnest in the United States.
Bruce Chapman and Yael Shavit
Bruce Chapman is professor of economics at Australian National University. Yael Shavit will be starting Yale Law School in September.
In February 2009, at a meeting of the American Council on Education, I challenged a group of university presidents and other leaders of higher education to focus on the need for greater innovation in higher education. I encouraged those leaders to heed the lesson offered by George Romney to the auto industry in the 1970s to innovate or lose their advantage: “There is nothing more vulnerable than entrenched success,” he said. I followed up in October 2009 with an article in Newsweek entitled "The Three-Year Solution: How the reinvention of higher education benefits parents, students, and schools."
The response has been pleasantly surprising.
Over the past year and a half, a growing number of institutions of higher education came forward with proposals to offer three-year degrees to their students. Here are a few examples:
Grace College, in Winona Lake, Ind., is offering an accelerated three-year degree in each of its 50-plus major areas of study. Dr. Ronald Manahan, Grace's president, cites the cost of college as a driving force behind the decision. “We have listened to people’s concerns about [the cost of] higher education and we are answering them,” he said.
Chatham University, in Pittsburgh, Pa., is offering a three-year bachelor of interior architecture without summer classes, allowing students to get into the job market a year earlier. School officials have reconfigured the four-year degree by cutting Studio classes from 14 weeks to just seven, and when compared to similar programs, these students graduate two years earlier.
Texas Tech University, in Lubbock, Tex., is offering an accelerated three-year medical degree, rather than the usual four. The program is aimed at making it easier and more affordable for students to become family doctors.
As institutions of higher education look into the possibility of offering a three-year degree, some have run into federal policies that seem to interfere with their ability to innovate. For example, this May I received a letter from Jimmy Cheek, chancellor of the University of Tennessee-Knoxville, describing a potential obstacle to a three-year degree surrounding student loans.
Here’s the issue: Under the Higher Education Act, student loan limits are tightly set to prevent over-borrowing by students. Federal annual loan limits and lifetime loan limits establish a maximum amount one can borrow under the federal student loan program. The annual loan limits are designed to pay for two semesters per year (see chart below).
Example: Scheduled Academic Year
Scheduled Academic Year 1
Fall 2010 and Spring 2011
Scheduled Academic Year 2
Fall 2011 and Spring 2012
Scheduled Academic Year 3
Fall 2012 and Spring 2013
Scheduled Academic Year 4
Fall 2013 and Spring 2014
For most institutions of higher education, and most students, this works and makes sense. But 3-year degree students often take a third semester’s worth of classes over the summer. The federal limits appear to prevent students from obtaining a loan to pay for those summer courses.
Fortunately, there is a solution. Working with the Congressional Research Service, and the staff of the U.S. Department of Education, my office has identified an option that exists under current regulations to give flexibility on these loan limits to institutions of higher education and students. Instead of following a standard “Scheduled Academic Year” as outlined above, an institution of higher education offering a three-year degree could award loans to students through a “Borrower-Based Academic Year," per the chart below:
Example: Borrower-Based Academic Year
Scheduled Academic Year 1
Fall 2010 and Spring 2011
Scheduled Academic Year 2
Summer 2011 and Fall 2011
Scheduled Academic Year 3
Spring 2012 and Summer 2012
Scheduled Academic Year 4
Fall 2012 and Spring 2013
This option would use the same annual loan limits and lifetime loan limits, but compress them to match the student’s academic schedule. Compared to the typical “Fall-Spring” academic year over each of the four years, a three-year degree program could use a “Fall-Spring, Summer-Fall, Spring-Summer” structure to allow for a compressed academic schedule.
I have been told that this “Borrower-Based Academic Year” option is currently not well used because it is administratively complicated for institutions to offer both “Scheduled Academic Year” and “Borrower-Based Academic Year” loan structures at the same time for individual students. But for an institution that offers a comprehensive three-year degree program involving a number of students, this seems to make sense as a way of helping students in that program afford the tuition and fees.
I have asked Chancellor Cheek to let me know if this option would work for the University of Tennessee, or if more flexibility needs to be added. When Congress last reauthorized the Higher Education Act in 2008, we made several changes to the Pell Grant program to allow that funding to be used on a year-round basis. There is no reason students should not have that same flexibility with their student loans.
It is my hope that more institutions will explore innovative ways to provide a high-quality postsecondary education. The three-year degree is one idea for some well-prepared students, but it is vital to our competitiveness as a nation that we develop other ideas to improve the efficiency of higher education and expand access to more Americans.
Institutions of higher education are rightly feeling pressure from parents, students, state and local leaders, the business community, Congress, and the Obama administration to do a better job of providing more Americans with a quality college education at an affordable price. That pressure will likely grow more intense every year as more jobs require higher education, advanced certificates, or technological skills from their applicants.
Some have asked whether all colleges and universities should be required to offer a three-year degree. My answer is a resounding no. Just as the hybrid car isn’t for everyone, all students and all institutions won’t want a three-year degree. The last thing we need is more federal mandates on higher education.
The strength of our higher education system is that we have 6,000 independent, autonomous institutions that compete in the marketplace for students. It is that marketplace that needs to develop the new ideas for the future -- and not become a victim of its own “entrenched success" -- so that our students, and our country, can continue to thrive.
Senator Lamar Alexander
Sen. Lamar Alexander (R-Tenn.) is chairman of the Senate Republican Conference and a member of the Senate Committee on Health, Education, Labor and Pensions. He served as U.S. secretary of education under President George H.W. Bush and as president of the University of Tennessee.