Troubles Mount for Student Loan Industry

You know that a scandal has reached critical mass when the country’s biggest newspapers start paying close attention. So the fact that both The New York Times and The Washington Post had highly critical investigative articles on their front pages Sunday ( here and here, respectively) about differing aspects of the student loan industry is only the latest sign that the scandal’s burgeoning impact is likely to keep lenders (as well as college financial aid directors and government regulators who might be singed by it) on the defensive for weeks if not months to come.

But amid the escalating headlines and body blows that threaten the reputations of individual loan companies (more are coming today: The New York Times reported Monday that Education Finance Partners will settle claims made against it by New York's attorney general for $2.5 million and that bankers and private equity firms will announce a deal to buy Sallie Mae for $25 billion), the much bigger potential threat to the viability (or at least the profitability) of the commercial student loan industry lies in federal efforts redraw the lines on the playing field on which loan companies and the U.S. government’s direct student loan program compete.

So perhaps the most significant news out of Washington this week is a set of Higher Education Act proposals from Democratic leaders in the Senate that would cut subsidies and raise costs for student loan companies (to the tune of more than $22 billion over five years) and direct the Education Department to experiment with two different models for an auction-based system for the rights to originate and disburse federal student loans.

According to the “college aid proposal” distributed to some lobbyists last week, the cuts would pay for increasing the maximum Pell Grant to $5,400 by the 2010 fiscal year and beyond, cutting the interest rate on most student loans to 5.8 percent over five years, capping student loan repayments at 15 percent of a borrower's total income, and letting more low-income students benefit from an “automatic zero” family contribution to their federal financial aid costs.

A spokeswoman for Sen. Edward M. Kennedy (D-Mass.), who heads the Senate Health, Education, Labor and Pensions Committee, said in an e-mail message that she could not comment on the proposals, which she emphasized were part of “pending negotiations” over pending Congressional legislation to renew the Higher Education Act. “They’re just that -- negotiations,” the spokeswoman said, so discussion of what might or might not be in the legislation is inappropriate at this point. She made clear that the proposals had been released prematurely, and inappropriately.

That, however, didn’t stop officials in the lending industry from decrying the proposed cuts, which Joe Belew, president of the Consumer Bankers Association, said were “best described as a proposal to end the Federal Family Education Loan Program.” The combination of proposed cuts – including cutting the return that lenders receive on federal loans by 0.6 percentage points (0.4 percentage points for nonprofit lenders), greatly reducing the government reimbursements lenders receive for loans that go into default, and increasing to 1 percent the one-time fee that lenders must pay the government to consolidate a borrower’s loans – would result in “a negative return for most lenders,” Belew asserted. “This would make continuation in the FFEL program impossible for virtually all loan providers.”

This is a common pattern: Congressional Democrats, or even the Bush administration (which suggested in its own 2008 budget plan many of the same cuts that Kennedy’s draft calls for), proposes cuts in lender subsidies or increases in lender fees, and loan providers reply with sky is falling rhetoric.

The exercise takes on added significance now, though, given the intensifying beating that the loan industry is taking right now. The bankers’ statement about the Senate Democrats’ plan goes on to say that “it seems apparent that the drafters of the proposals are attempting to replace the FFEL program with a government monopoly -- its Direct Loan program…. This would occur by default as a result of FFEL lenders withdrawing from the student loan market as opposed to the Direct Loan program successfully competing with FFEL.”

But supporters of the direct loan program and critics of the guaranteed loan program are quick to argue that the unfolding scandal in the loan program has resulted in large part from intensified competition among lenders to try to woo colleges away from the direct loan program, and from federal policies that permitted if not encouraged that competition and the shift away from direct lending.

That was an underlying theme of Sunday’s front-page article in The New York Times, which points out that many of the lenders’ practices that are earning condemnation from New York’s attorney general and others now were designed specifically to attract colleges with benefits that are not available in direct lending, which has seen its share of the student loan market shrink over the last decade. (Lenders argue that their benefits and service are superior, and that that – not because of the financial incentives they offer – is why direct lending has declined.)

After November’s election, some financial aid observers speculated that Democratic efforts to level the playing field for direct lending -- which foundered during years of Republican control of Congress -- would gain at least a little steam under the new power structure on Capitol Hill, though lenders remain powerful.

But as embarrassing and painful as the steady drumbeat of bad-news headlines are for the loan industry, the truly devastating impact that could result from the burgeoning scandal would be if it undermines support for lenders in Congress and strengthens the hand of lawmakers who want to cut the loan industry’s profits and change federal law to encourage colleges to join the direct lending program. (Legislation to do that is pending in both houses of Congress.)

Other Developments in the Loan Scandal

Sunday’s front-page article in The Washington Post reports concerns among financial aid officials and government regulators that loan companies have improperly conducted repeated searches of a federal database of student borrowers, seeking personal information for use in marketing their products.

The article says that the Education Department is considering a temporary shutdown of the National Student Loan Data System while they review policies and tighten security.

In addition, a department spokeswoman declined to comment further on information released late last week about the extent of stock ownership in a lending company by a department official who oversees the loan industry.

The department released financial disclosure forms showing that Matteo Fontana had reported sale of stock in Education Lending Group, Inc., in both 2002 and 2004, but the information left many questions unanswered, including whether Fontana received new stock after selling the original stock in 2002, and whether the department took any action upon learning in mid-2005 that Fontana had owned more stock than he reported selling in 2002.