Congress is once again debating the notion of introducing a government auction process  into the federal student loan programs, almost a decade after the Clinton administration studied the idea but chose not to pursue it. That decision was unfortunate, because the notion of auctions in student loans remains a good one. If done properly, it would get the government out of the business of guessing legislatively about the market rate of return for student loans and replace it with the market's own assessment of what is required to provide lenders and others with a market rate of return to compensate them for making and holding student loans.
But the focus of the recent discussions in Congress has been on having lenders bid for the right to make student loans in the future. This is unlikely to work. To understand why, it helps to know that the federal government conducts two types of auctions -- one involves selling the rights to acquire an asset, the other auctions existing loans to determine their underlying value.
The basic purpose of a rights auction is to determine who will be able to acquire an asset of limited availability. One example is the process by which the rights to use radio or television bandwidth are determined. Another common rights auction determines which airlines can land and use the gates at a particular airport.
On the other hand, the most common example of an auction of existing assets occurs every week when the Treasury sells U.S. Treasury bonds and notes. For that matter, stock markets are a private auction for selling assets.
Rights auctions are the wrong way to go in student loans for several reasons. First, rights auctions are premised on the notion that there is a precise limit on how much of the asset exists, such as airwaves bandwidth or the number of airport gates. While these may change in the future as a result of technology (the discovery of new bandwidths) or construction (the building of new airports), at least in the near term there is a scarcity that from an economics perspective, invites an auction to determine the market price. In the case of student loans, however, no such natural limit exists. If demand for student loans rises (or falls) for whatever reason, good economics would require that the market be allowed to adjust to those changes.
Second, by creating rights to make federal student loans, they would no longer enjoy the entitlement status in the federal budget process accorded them in the past. The annual volume of loans effectively would be capped and some borrowers would no doubt be left out in the cold, an effect that one would think most of the legislative sponsors would be most loathe to pursue. By the same token, it would seem that the budget examiners at the Office of Management and Budget would be the provision’s most enthusiastic advocates as student loans would no longer be a federal entitlement in which all lenders could make as many loans as they wanted and be assured that future federal payments would be made on those loans.
Third, and perhaps most important, it is not at all clear how a rights auctions for student loans would work. Prospective borrowers who are used to shopping around for lenders would instead be forced to seek a lender who had the rights to make loans. While students with good grades or family money might get very attractive terms and conditions, riskier borrowers would be likely to pay much more in various and often hidden ways so that successful bidders in the rights auction could recoup their investment. None of this would be good for consumer choice, and it would create more inequitable access to loans.
In short, in order to trim federal costs on the margin, the rights auction approach would turn the student loan system on its head and restrict what has been broad consumer choice for loans in which the terms and conditions are fixed in law. Imagine for a moment a mortgage market in which prospective homeowners had to find bankers with the rights to lend.
Congress should be debating instead having the government periodically auction a portfolio of existing loans to determine their underlying market rate of interest. In contrast to rights auctions, a modest auction of existing loans every quarter would hardly cause a ripple in the existing student loan apparatus. Private auctions already happen all the time as Sallie Mae and others acting as secondary markets buy loans from current loan holders at a price competitively set by market forces. Thus, lenders and other loan holders make decisions every day regarding the value of existing loans. The only thing that would change under an auction format is that the federal government would become an active participant in this process.
The principal purpose of the government getting involved in auctioning loans would be to modify or abolish the current practice in which the government makes payments every quarter to compensate lenders for the fact that the federal student loan legislation sets student interest rates at below market rates. This practice started soon after the guaranteed student loan program was established in 1965 when it became obvious that the rate paid by students, at the time 6 percent, was inadequate to attract lenders in an environment of rising market interest rates.
“Special allowance payments” -- now commonly referred to as “subsidies” for lenders -- were first established in the late 1960s, with a committee of government officials responsible for setting the level of the quarterly payments. This committee was replaced by a legislative formula in 1979 that was tied to the 91-day Treasury bill rate plus 3.5 percent. Over the years, the index rate and the percentage add-on have been changed on a number of occasions to try to peg the total return (the rate paid by the student plus the government’s “special allowance” payments to lenders) to an underlying market rate that reflects the fact that these loans are guaranteed by the government at nearly 100 percent of their value.
But it is quite difficult, if not impossible, for a legislative body to determine accurately the market rate of interest for complex student loans and the real market rate remains largely a mystery to legislators. Having the government institute an auction of a portion of existing loans would squeeze the mystery out of the current system.
The price paid by lenders and servicers for a representative sample of loans would provide a much more accurate assessment of the underlying value of federal student loans. This information on price gained from the auction would then allow the government to determine what is the proper additional payment it needs to make to lenders to ensure their continued participation in the program by providing them with a market rate of return on loans in which the government sets the rate paid by borrowers and guarantees the loan against default.
To simplify program administration greatly, the current process of the government making quarterly payments to lenders for each loan in their portfolio could be changed into making a single payment to the lender for each loan made at the time of origination to reflect market assessments of value.
When the loans were then sold -- as most of them are -- the price paid would reflect the fact that there would be no further special allowance payments on that loan. Under such a system, the current process of making special allowance payments quarterly would disappear as old loans were fully repaid or consolidated into new loans that could also be subject to the single special allowance payment, in this case, at the time of consolidation. A much more competitive and seamless student loan market would emerge, with all student borrowers being able to consolidate their loans when they entered repayment at rates that were reasonable both to them and to the taxpayer.
This is a picture much easier to imagine than the chaos that would probably result if the government got into the business of auctioning the rights to make loans. Again, imagine a mortgage industry in which the government was responsible for deciding how much money was going to be available on any given day.
Arthur M. Hauptman is a public policy consultant based in Arlington, VA specializing in higher education finance issues.