For many months, student loan watchdogs have been charging  that lenders have taken advantage of a loophole in federal law to reap billions of dollars in profits to which they were not entitled. Late Friday, the U.S. Education Department’s inspector general strongly backed their view, releasing an audit  that accused the National Education Loan Network (Nelnet) of having received $278 million in federal subsidy payments for which it was not eligible and of inappropriately charging the government for as much as $882 million more.
The inspector general’s office urged Education Secretary Margaret Spellings to order Nelnet to return the improper payments it has already received and to instruct the company to revise its estimates for future payments to exclude funds for the contested loans. Meanwhile, officials at Nelnet, a Nebraska-based company,  disputed the audit’s findings but said they would work with the department to resolve them.
At issue in the case is Nelnet’s use of an exemption in federal law that allowed lenders that financed the student loans they issued using tax-exempt bonds issued before 1993 to earn a government subsidized interest rate of 9.5 percent. Congress engaged in several aborted attempts to fully close the loophole throughout the 1990s and the early part of this decade, but some lenders continued to find ways to take advantage of it by recycling the pre-1993 loan funds, before Congress, as part of the Higher Education Reconciliation Act, finally closed it permanently this year. 
In the audit, the inspector general describes a process by which Nelnet seemed quite purposefully to try to expand its pool of loans that would qualify for the 9.5 percent “special allowance” payments from the federal government. “Through Project 950,” as the company’s effort was called, “Nelnet used a series of transactions to increase the amount of loans ostensibly funded by tax-exempt obligations from approximately $551 million” in March 2003 to $3.66 billion in June 2004, according to the audit.
The company, the inspector general found, moved loans into and then -- “as little as one day later” -- out of a non-taxable trust estate with the goal of making those loans qualify for the 9.5 percent rate.
The audit recounts exchanges in 2003 and 2004 in which Nelnet sought and believed it had gained Education Department approval for its practices regarding the 9.5 percent loans. But the inspector general says that Nelnet’s inquiries did “not appear to reflect a comprehensive disclosure by Nelnet of the nature or effect” of its effort to increase its volume of loans eligible for the higher rate.
A 1993 letter outlining the practice, the audit says, “did not identify the eligible source of funds that would be used to purchase and qualify loans for the 9.5 percent floor, did not state directly that the process would be repeated many times, and did not state that the process would result in a substantial increase in the amount of loans billed under the 9.5 percent floor.”
The audit incorporates a response that Nelnet officials submitted to an earlier draft of the audit this summer, which the inspector general notes “strongly disagrees with our finding and recommendations and requested that our draft report be withdrawn.”
In a prepared statement, Nelnet said company officials believe the inspector general's report is "incorrect" because it is "inconsistent with the Higher Education Act, applicable laws, policy, department regulations, and the guidance to student loan companies previously issued by the Department."
Nelnet will "seek a resolution of this matter with the Department and will also examine all other available remedies that prove the merits of our position," said Mike Dunlap, the company's chairman and co-chief executive officer.
Critics of the lenders’ continued use of the 9.5 percent loophole heralded the inspector general’s audit. "The depth and breadth of Nelnet's failure to comply with the law is breathtaking, and the cost to taxpayers is staggering,” said Rep. George Miller (D-Calif.), the senior Democrat on the House of Representatives Committee on Education and the Workforce. "In an era of high budget deficits, we must be vigilant about ensuring that available tax dollars are used to provide affordable college loans to families, not to provide excessive subsidies to banks."
Miller and others, including Sen. Edward M. Kennedy (D-Mass.), who pushed the Education Department to look into the Nelnet matter, and watchdog groups like the Project on Student Debt, urged Spellings to back the inspector general. “The secretary of education should make sure that Nelnet pays back every penny they've wrongly claimed and should use the near $1.2 billion saved to help students and families pay for college,” said Michael Dannenberg of the New America Foundation, who has aggressively criticized  the 9.5 percent rate practice.
A spokeswoman for the Education Department, Katherine McLane, said that Spellings "takes protection of American taxpayers very seriously and is concerned about the issues raised in the inspector general's report." The department, she said, "is reviewing the report and will consider Nelnet's response before issuing a decision on how to proceed."
Watchdog groups fear that precedent favors Nelnet. Last summer, the inspector general released a similar audit recommending that the department collect $36 million that it concluded the New Mexico Educational Assistance Foundation had wrongly collected by taking advantage of the 9.5 percent rate loophole.
In that case, Spellings rejected the auditor’s findings.