Ending an Experiment

Nearly a decade ago, when it last renewed the Higher Education Act (yes, it's been that long), Congress made a change designed to deal with a fundamental contradiction in the federal student loan program: Because the U.S. government pays student loan guarantee agencies primarily by reimbursing them for loans that go into default, the guarantors have a perverse incentive not to keep students out of debt, in direct conflict with growing public policy concerns about escalating student indebtedness.

The potential solution Congress enacted in 1998 -- a "pilot" program in which a small group of guarantors entered into "voluntary flexible agreements" aimed at changing their financial rewards to encourage them to come up with new ways to reduce and prevent loan defaults and delinquencies -- has by most accounts been a strong success.

While the rates of student loan borrowers defaulting on their loans have fallen across the board, thanks to aggressive efforts by the government, colleges and lenders, the five guarantee agencies that struck the experimental agreements with the Education Department have demonstrated particularly striking results. Massachusetts-based American Student Assistance, for instance, has seen its so-called cohort default rate fall to 1.6 percent, about a third of the national average of 4.6 percent in 2005. Great Lakes Higher Education Guaranty Corp., another voluntary agreement recipient, had a rate of 2.7 percent in 2005. (The other voluntary agreements are with the California Student Aid Commission, Texas Guaranteed Student Loan Corporation, and Colorado Student Loan Program.)

Successful as the VFA program appears to have been, however, the Bush administration has had it in its sights. President Bush proposed eliminating the program in his last two budget plans, citing concerns about its costs to the government. And this month, the Education Department sent letters to the five agencies that it was unilaterally abandoning their agreements, saying the arrangements no longer meet the legislative requirement that they be "cost neutral" -- or no more expensive to the government than the agencies would be under the government's traditional method of paying guarantors.

In the partisan environment in Washington public policy circles, especially on an issue like the government's student loan programs on which party lines are often sharply drawn, an action like this one that appears to hurt some high-profile institutions in the guaranteed student loan program might be expected to bring howls of protest from Republican lawmakers and loan industry officials and quiet (or boisterous) applause from Democrats and critics of the guaranteed loan program.

But the department's decision regarding the voluntary flexible agreements confounds those expectations, drawing condemnation from a bipartisan group of U.S. senators and representatives and from advocates for students who rarely find themselves on the same side of an issue as lending officials.

"I'm generally a fan of the VFA concept and of aligning compensation with the public policy goals for guarantee agencies," said Robert Shireman, president of the Project on Student Debt. "This is the way that the relationships with guarantee agencies should operate," with the government paying guarantors to "incentivize good outcomes" as opposed to paying them based largely on the percentage of defaulted loans, which "can create incentive to allow students to default." He added: "It is unfortunate to see the department summarily abandon the approach."

Fifteen members of Congress -- including Democratic leaders on education such as Sen. Edward M. Kennedy and Rep. George Miller, but also Republicans like Sen. John Cornyn and Rep. Paul Ryan, all of whom represent the states where the five guarantors make their homes -- made much the same argument in their letter this month to Education Secretary Margaret Spellings.

"To date, VFA guarantors have already saved the federal government hundreds of millions of dollars in prevented defaults," they wrote. "We're concerned that the department may terminate a model that has been successful in preventing students from defaulting on their student loans. If these guarantors are forced to return to the traditional guaranty agency model, it's obvious that student loan default rates will rise."

At the core of the department's decision appears to be the view of its officials that the voluntary agreements have come to cost the U.S. treasury significantly more than the government would have to pay them if they were operating under the traditional model. To the extent that's true, it is so for two primary reasons.

First, traditional payments to guarantors have decreased in part because the number of defaulters has fallen and, notably, because Congress over the last two years has steadily cut federal subsidies for banks and guarantors, most recently in the College Cost Reduction and Access Act that President Bush signed last month. The department's letter cites the fact that the new law will cut to 16 percent from 23 percent the proportion that guarantee agencies can keep of the funds they collect from borrowers who default on their loans. (Currently, for instance, the government pays American Student Assistance 18.5 percent, which has been far less than the 23 percent it pays to traditional guarantors.)

The second reason that the cost to the government of the voluntary agreements has risen, ironically, is largely because the government's (and lending industry's) efforts to reduce defaults -- and particularly those of the VFA guarantors -- have been so successful. Because the recipients of the voluntary agreements are paid based on how well they keep student loan borrowers from entering default, the fact that fewer borrowers are failing to repay their loans has resulted in an increase in the payments to the guarantors operating under the voluntary agreements.

Paul C. Combe, president of American Student Assistance, finds it perplexing that the government would punish his agency for its success. He suggests that the government's definition of "cost neutrality" -- unfairly excludes the money the government saves because fewer borrowers are defaulting. "They're really just looking at "fee neutrality," said Combe -- whether the government is paying his and other agencies more in cash outlays than they would be without the voluntary agreements. "But to truly look at 'cost neutrality,' you have to look at all the activities of a guarantor -- every default you avert is a huge savings."

Combe said that he believes it would only be fair for department officials to renegotiate the voluntary arrangements on terms that acknowledge the full range of contributions the guarantors make, including the money they save the government by eliminating defaults.

A senior official in the Education Department, noting that the voluntary agreements were supposed to an "experiment" rather than a permanent fixture, said the agency "would entertain" the possibility that a guarantee agency could "come back to us with a proposal" and that department officials would "work with them on finding a cost neutral fee structure."

But the official rebuffed the suggestion that guarantors should appropriately be credited with saving the government significant sums by reducing defaults since, under federal accounting rules, the government "never loses money to a debt, because we can always get the money back," through garnishment of wages and other means. "But from a budget standpoint, we'll give them some credit, but it's not as significant."

The department official said that the administration's financial analysis leading up to its 2008 budget plan in February showed that the five voluntary agreements would cost the government $2 billion over 10 years. If that weren't bad enough, the official said, the costs of the arrangements versus those for traditional guarantors will grow now that Congress has passed the college cost law, which "significantly reduces standard payments from the Department of Education to guaranty agencies," as the department argued in its letter to the VFA guarantors. " "The cost neutrality of these agreements started to come into question in recent years," the official said. "Now we know they’re definitely not cost neutral, because of changes in that bill."

A Senate aide said members of Congress hope that the department will renegotiate the agreements, although the aide said that department officials had not responded to the lawmakers' letter this month.

The aide joined Shireman of the Project on Student Debt and Combe in expressing disappointment that the department was willing to jettison a program that seems to have thrived, so much so that Congress tweaked the repayment scheme for all guarantors two years ago to reward them financially -- at least a little -- for preventing default. Especially, they note, at a time when concerns about student debt have never been greater.

"At the very point in time where debt is a major social problem, and we have a program that can demonstrably show improvement in that," said Combe, "it just doesn’t make sense."