Loan programs

Financial aid 'experiment' would let colleges set borrowing limits for some federal loans

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An experimental financial aid program would let colleges restrict students' borrowing for federal unsubsidized loans as part of a test run.

Obama proposes changes to student loan programs

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Obama proposes changing income-based repayment and pushing students to consolidate their loans -- part of a campaign to work around lawmakers.

U.S. warns colleges about financial aid 'fraud rings'

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Education Department calls on colleges to do more to prevent and detect financial aid "fraud rings."

Counterpoint: Lenders Respond

The final report of Education Secretary Margaret Spellings’s Commission on the Future of Higher Education, released late last month, is already generating a strong debate, including a column by Senator Edward M. Kennedy.

The Spellings commission and Senator Kennedy are right about the need for increased federal support for higher education.  Achieving “a higher education system that is accessible to all qualified students in all life stages,” a Commission goal we all share, will require new and significant federal investments in both need-based grant aid and low-cost student loans.

The reasons are largely demographic. The largest secondary school classes in history are graduating over the next few years. Equally important, the growing diversity of secondary school graduates creates challenges; there are cultural and information barriers that need to be addressed.   

Senator Kennedy is correct in pointing out that the federal student loan programs are the single largest source of financial aid, making them an essential component of any plan to increase the accessibility and affordability of postsecondary education.

So while America’s Student Loan Providers agrees that “every student in the nation should have the opportunity to pursue postsecondary education,” we do not believe that this shared policy goal can or should be achieved by eliminating the guaranteed loan program, as the senator suggests. This would jeopardize the fulfillment of educational goals for the millions of students and 6,000 colleges, universities and technical schools that rely on guaranteed loans. 

Such a one-size-fits-all government solution wouldn’t be good for students, parents or schools.  Nor is it good policy.  

Indeed, it is the public-private partnership of the guaranteed loan program that will make $56 billion available to nearly 7 million students and parents this year alone.

Equally troubling is the assertion that the program is without risk to lenders and other guaranteed student loan participants and that it somehow encourages students to default on their loans. When a student is unable to repay his or her loans and goes into default, it harms the student, the lender, and the taxpayer. That’s why student loan providers have implemented innovative strategies to assist borrowers in understanding and meeting their repayment obligations, and that’s why student loan default rates today remain near the lowest level in history.  

Finally, it is widely recognized that the federal methodology used to calculate program costs overstates the cost of the guaranteed loan program and understates the cost of the direct loan program. Other analyses conclude that costs of the two programs are either virtually identical or that the guaranteed loan program is less expensive. The point is that major decisions about the future of the loan program that millions of students depend on shouldn’t be based solely on questionable cost assumptions.

For 41 years, the guaranteed loan program has helped make postsecondary education possible for millions of Americans. One of the original Great Society programs, it has been hailed by Democrats and Republicans alike. It’s one reason why a 2000 Brookings Institution study called increased access to postsecondary education one of the federal government’s most significant accomplishments.

Clearly, this is one government program that is deserving of support.  We welcome the opportunity to work with the Congress and administration for the benefit of those seeking educational advancement.

Kevin Bruns
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Kevin Bruns is executive director of America's Student Loan Providers.

Student Loans, the Baby and the Bathwater

It is not often that one’s research topic is the lead story in the national media, but the topic of financial aid has been in the forefront of the American consciousness from San Diego (home of Student Loan Xpress) to Albany, N.Y., (home to New York Attorney General Andrew M. Cuomo) and points in between.

The stories of scandals, kickbacks, influence peddling, and fleecing -- to highlight just a few of the phrases used by politicians and reporters -- in the student loan business have dominated the headlines the last two weeks. I have chuckled at the many e-mails and comments I have received from far-flung friends and relatives who have asked, “Have you read about this student loan stuff?” That is a little like asking somebody who works in the U.S. Justice Department if they have heard about Attorney General Gonzales and the U.S. attorney firings.

We have a couple of key players to thank for much of the scrutiny. Upon taking office earlier this year, Attorney General Cuomo began investigating the relationship between higher education institutions and student loan providers. He was looking to see if colleges and universities receive benefits from the providers in order to place them on the preferred lender lists used to direct students to loan providers. And the New America Foundation, through its Higher Ed Watch blog, broke the story of three financial aid directors around the country (as well as an official in the Department of Education who oversaw lenders) receiving and subsequently selling stock in Student Loan Xpress.

Attorney General Cuomo’s investigation received a fair amount of media coverage, but the story gained real legs and moved to the front pages when the focus shifted from relationships between loan providers and universities to relationships between lenders and specific financial aid officials at the institutions.  As with most scandals, it is a much better story when the media can put the name and face of a real person on it, rather than just the moniker of a multi-billion dollar higher education institution.

Stirred up by the initial disclosures by the New America Foundation regarding high-ranking financial aid officers at Columbia University, the University of Texas at Austin, and the University of Southern California, reporters around the country have uncovered other apparently untoward relationships between financial aid officials and student loan companies. At this point, until all the facts are out, I think it is fair to categorize all that has been reported as “allegations.” 

But the student aid profession is very much on edge these days, with perhaps more officials out there living in fear that something they had done in the past will be discovered by the news media or Cuomo. Dallas Martin, head of the National Association of Student Financial Aid Administrators, has been on the defensive throughout the scandal and probably is rather tired of hearing the phrase “damage control.”

The initial reports of stock grants and sales have been followed by others involving Student Loan Xpress payments of tens of thousands of dollars to financial aid directors at Johns Hopkins, Widener and Capella Universities for consulting or other purposes, including the paying of tuition for one aid director to attend graduate school.

All of these officials (including the Department of Education employee) have been placed on leave by their employers while the institutions try to sort out the facts. If the allegations are proven true as they have been reported in the media, it will be a serious stain on the reputation not just of these officials and their employers but on the financial aid profession as a whole.

Regardless of whether their relationship with Student Loan Xpress influenced decisions regarding preferred lenders, or steering students toward certain loan providers, these officials (and their institutions, if aware of the relationships) should have been more cognizant of the appearance of conflict of interest.  It is not enough to declare that the relationship with Student Loan Xpress did not influence any decisions they made; people will assume the worst.

From these disclosures of fees paid to financial aid officials, the attention in the last few days has shifted to the advisory boards maintained by many student loan providers. In addition to the board maintained by Student Loan Xpress, most of the larger lenders, including companies like Sallie Mae, Citibank, Wachovia, and Wells Fargo, have similar boards made up largely of financial aid officials.

While the companies say they do not pay any compensation to the board members, they do generally pay their travel expenses to attend meetings of the boards. Trying to head off any notion of these meetings as junkets, the loan companies and financial aid officers have been quick to point out that many of these meetings have been held in such less-than-exotic places as St. Paul, Minn., and airport hotels. (We can discuss whether Las Vegas and Orlando, where some of these meetings have taken place recently, fall into the less-than-exotic category).

Both the student loan companies and the financial aid officials have said that these boards are used to help advise the companies on how to best structure their loan programs to meet the needs of students. Since the financial aid officials are on the front lines of working with students, they are in the best position to recommend new programs or changes to existing loan programs that will help their students.

I have sat on numerous advisory boards, and I have firsthand knowledge of the role they can play (my disclosure is that none of these have been for student loan providers). Both the lenders and financial aid officials are correct in stating that the advisory boards provide an important role, one that ultimately can benefit students. It would be a shame if in the wake of this scandal, these boards get dismantled and the dialogue between financial aid officers and lenders is hampered or, worse, forced to go even more underground.

Given the recent allegations, I feel comfortable arguing that there should be no honoraria paid by the lenders to advisory board members. And the lenders should be cautious regarding where these board meetings are held, keeping in mind that they must not be construed as junkets by the media, policy makers, or most importantly, students and their families. Even though I believe that the great majority of financial aid officers are honest individuals who would not be swayed by receipt of a modest honorarium for their service, or through attending a meeting in a warm, inviting climate, the scrutiny under which they find themselves dictates that they have to be squeaky clean.

We should be cautious not to throw out the proverbial baby with the bath water in responding to this scandal. Yes, those officials who made what are clearly some very poor -- and perhaps, even stupid -- decisions should be held accountable for their actions. But let’s not go overboard by eliminating a valuable mechanism for financial aid officials and student loan providers to work together to improve service to students. If we do so, in the end it will be the students who suffer for it.

Donald E. Heller
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Donald E. Heller is associate professor of education and senior research associate in the Center for the Study of Higher Education at The Pennsylvania State University in University Park.  His research focuses on financial aid and college access.

Presidents and the Student Loan Mess

Presidents and financial aid directors are the two educational leaders on campus who are directly responsible for the success of the whole student, I used to tell audiences, with more than too much bravado.

I was trying to make a point. Every administrator needs to be involved to achieve institutional success, of course. But presidents and financial aid officers deal with a big picture stakes – success or failure of the student.

If the student fails, the institution fails. The president takes the blame.

If the institution fails the student, the student loan may not be repaid. The financial aid officer is on the line.

The latest public crisis in student loans reignites a question that has always haunted me: Why do college presidents too often leave the field of public debate when it comes to the specifics of student loans?

“Unfathomable”, “administrative nightmare” and a “policy backwater” are descriptions of the lending debate that would have encouraged CEO indifference to the politics of student loans in the past.

Collectively, financial aid officers, banks, student advocates and executives of national higher education organizations have controlled the options and the course of the nation’s college financing scheme -- they were the ones with time to deal with the arcane.

Today, however, loans account for more than 30 percent of all payments for college tuition costs. Loan volume has more than doubled in a decade and is still growing. Private college loans, providing funds beyond the federal program limits, have increased by 734 percent in a decade, to $14 billion in the 2004-5 school year.

Can individual college presidents, with so much else on their plates, ignore the foundation, structure and details of the nation’s publicly financed student loan programs, and a thriving private sector alternative?

At their peril. And, at threat to the complicated, but working, system of higher education finance in America.

The latest blow-up is over lender payments to colleges and administrators who designate loan products on preferred lender lists. This is just a seasonal hurricane compared to the climate change in store for student lending over the next decade.

Essential public policy issues, emerging new private sector loan products and direct-to-the-student marketing techniques are going to change the way Americans afford to pay for college.

It can happen with or without college president resolve to assure that the interests of their students and institutions come first.

Off campus “student advocates” or “higher education policy experts” are gaming the current crisis politics to achieve long sought ideological change in these loan programs, which may or may not match a student and institutional requirements.

Among a host of issues, there are some that will directly redefine the nature and extent of student loan availability:

  • The future of the bank-based Federal Family Education Loan Program (FFELP) and its sibling the Ford Direct Loan Program (DLP), the latter representing about 25 percent of all federally guaranteed student lending. Advocates for government-as-lender will use the latest crisis to limit the bank program and prefer expanded borrowing from the government, not the market place. Sustainability into all economic futures is the issue here. Will the government assure colleges' access to loan-supported tuition financing under all circumstances? Student loans have become the third largest of the nation’s asset-backed securities markets -- after credit cards and mortgages. The private marketplace has made lending at these levels possible. If not the private market place, can the government swallow the growing need for student loans to pay tuition into the future? At the levels of debt that future costs will require? College presidents might want to assure continued direct access to the market place, not exclusively through policy makers who have various and sometimes conflicting agendas.
  • The role of state-based student financial aid agencies as the Congress and president impose a continued financial squeeze on FFELP administration costs, default prevention efforts and default collections revenues. It could mean the end to federally contracted, state-based guaranty agencies, the student financial aid agency in 27 states that are often the backbone of information and training to colleges, students and families. They are the sponsors of Internet-based, go-to-college and early career and college awareness programs. Many agencies also administer state grants and often the college savings program -- assuring local policy continuity at the state level.
  • Direct-to-consumer lending, bypassing the college financial aid office and making direct deals with students and parents, may end the current coordinated and guided match between grants, loans and college work -- all without assuring that low-cost, federally subsidized loans are considered before more expensive private loans.
  • Consolidation of lenders:Sallie Mae’s recently announced sale to two private financial services companies and two of the largest student loan banks (Bank of America and JPMorganChase) is another signal that market forces -- not public interest -- are driving the federally subsidized student loan business. While Sallie Mae holds 40 percent of total FFELP assets and services 10 million students and parents attending 5,600 colleges, new loan volume at growing value is originating not with banks, but with marketing companies that securitize their loans, selling them to American and foreign financial markets.
  • Time to payoff: With the boom in student loan consolidations, the time to payoff of student debt has lengthened from the nominal 10 years to 15 and 20 and 30 years, in some cases. The cost of college is exploding exponentially after graduation by extending interest-bearing loan payments so far into the future. With a possible average payback time easily approaching 15 years for most future borrowers, is it not time to look at other alternatives? British and European loan programs delay repayments further into work life. ”Student securities” plans based on percentage of earnings are being pioneered by the Robertson Educational Empowerment Foundation, allowing a match between future income and debt. These and other innovations should be explored that avoid mortgaging student futures -- drawing out loan payments and interest expense so far into their future

College presidents most often represent the aspirations of their institutions, faculty, and their clients, the students. The president may be the only policy actor to assure that student loans -- the essential, largest, and growing educational financial scheme of the 21st century -- meets the needs of both the academy and student

Student and family interests should coincided with institutional success. I think only the CEO sees that conjunction and must speak out to assure that government, lenders and the entire higher education community meets the financial needs of both colleges and students into the future.

The times are changing. And college chief executives need to reenergize the student loan debate, assuring that the outcome serves the whole student and his or her institutions.

Robert Maurer
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Robert Maurer, formerly President of New York’s student aid agency, the Higher Education Services Corporation, is a writer and consultant on college financial aid and instructional technologies.

Maggie ... Yer Doin' a Heck of a Job!

News of New York Attorney General Andrew Cuomo’s investigation of questionable student loan practices was initially met with dismissive contempt from most of the permanent players in the loan programs. The student loan industry lost precious crisis-management time to cognitive dissonance with the very idea of an enforcement agency that it didn’t control. The student aid profession and its leadership, meanwhile, went through a very public demonstration of the seven stages of grief with the vilification they suffered because of their years of coziness with lenders.

As public outrage at what was, until a few short weeks ago, perfectly respectable business-as-usual began to build, the players finally understood the Cuomo investigation for what it really was: a rout. Like ragtag remnants of a defeated army in retreat, they shed the insignia of their true identity to don the uniform of the winning side, no matter how ill-fitting and grotesque. Some of the most predatory lenders agreed to abide with the letter -- but of course not the spirit -- of the Cuomo code of conduct. Organizations that had long ago reduced their ethics to those of an impeccably honest auctioneer retreated from their prior moral stance of always letting the highest bidder win their support in contested policy debates.

Some aid organizations decided to deal with their addiction to loan industry money by going cold turkey. Others chose the associations’ equivalent of methadone treatment by refusing some lender money while accepting it in other forms. The postmodern moment was at hand when the Republican Congressional leaders -- whose previous 12-year tenure in majority will forever be remembered as the Gilded Age of loan industry rapacity -- indicated that they, too, would introduce legislation to restore integrity to the system they had done so much to create. They even joined the Democrats to pass emergency loan legislation, if only to quickly declare the endemic problems of the loan program resolved and to prevent more meaningful reform of the corporate welfare program they have set up for their political supporters in the loan industry. The point of this street theater of contrition, atonement and conversion, of course, is not real change, but a sufficiently convincing appearance of reform.

By the time Cuomo appeared before the House Education and Labor Committee for the Washington equivalent of his triumphant march, the chorus of special interests had practiced their new reformist tune enough at least to delude themselves and maybe even fool the inattentive passerby. But the careful staging suffered one fatal flaw: one of the lead actors had apparently slept through the rehearsal and was loudly and unabashedly singing off-key. Enter Margaret Spellings, stage left!

Far from striking an apologetic -- or at least conciliatory -- note for having so miserably failed to do her job while student loan corruption festered under the department’s nose, the secretary of education has chosen instead to sing an all too familiar tune of brazen defiance. On the very day of Cuomo’s testimony -- a day that, like others implicated in the scandal, she should have wisely spent away from the public eye -- she actually issued a remarkable press release to refute the reality that everyone else could by now discern.

The secretary’s statement, and her subsequent testimony Thursday before the House committee, combined outright ignorance of some of the facts already in evidence and denial of others. It also unapologetically rejected any personal responsibility for the debacle, citing the complexity of the job, which Spellings has apparently only grasped after Cuomo stepped into the vacuum created by her inattention. In fairness, the secretary’s testimony did manage to identify mistakes at her agency, but they all dated back to the period before 2001, when the administration effectively handed the loan programs to past and future employees of the student loan industry to run as they saw fit! As a rhetorical device, her Congressional appearance combined the tenuous grasp of facts, irritated denials, and vague promises that are the hallmarks of having been caught asleep on the clock. It is déjà vu, all over again: think Tommy Thompson and his ludicrous public comments as anthrax was being mailed around the country; the hapless Brownie as Katrina ravaged New Orleans; or Alberto Gonzalez as he explained to the Senate Judiciary Committee how he didn’t really run the Department of Justice.

Like so many other hopelessly under-qualified Bushies in high office, Spellings brought little by way of independent accomplishments hitherto expected of a cabinet appointee. Not only was she no Dick Riley or Lamar Alexander, her non-patronage résumé was actually even less impressive than that of her predecessor, Rod Paige! What she lacked in independent credibility for the job, however, she has made up with officious self-importance and a messianic belief that she is the right person in the right place in history to transform American higher education. Ironically, the euphemism Spellings has used repeatedly to describe this obsessive illusion of grandeur is, of all things, “accountability!”

In the Spellings lexicon, accountability is codeword for a prosecutorial assault on the traditional collegiate sector for alleged evils that range from lack of transparency, profligacy, inefficiency, and incompetence to political tendentiousness. There is no denying that, like every other human endeavor, American higher education partakes of all these qualities to some degree. And a thoughtful examination of the future of higher education would certainly not be a bad idea. But Spellings has approached the effort not only with dogmatism, but also with a Vaudevillian’s knack for committing every one of the sins for which she has taken higher education to task.

Her tenure in office has thus far consisted of a quixotic frolic to assert substantive federal control on colleges and universities through a variety of politically motivated and legally suspect maneuvers. Describing this detour from her legal responsibilities as overseer of the loan system in terms of sheer incompetence would, in a very real sense, be the more charitable explanation of the loan debacle. A more cynical mind could take the secretary’s pugilism on the collegiate front as a sideshow intended to distract attention from the wholesale looting of the treasury by the administration’s loan industry friends. But the authenticity of her performance at the hearing tends to favor the more charitable interpretation: I for one am now willing to accept that Spellings simply doesn’t get it. That she has been pursuing ill-advised policies for which she has no legal authority (like federalizing transfer of credit rules), while she failed to do what she has had ample authority and legal responsibility to do (like overseeing lenders and protecting the students and taxpayers), is apparently too complex a proposition for the secretary to be contemplating even now, after it has become clear that she has been playing the fiddle while Rome burned.

Whatever else it may bring about, the Cuomo investigation has demonstrated the emptiness of the secretary’s haughty pronouncements on accountability. What is already known of the department’s inaction -- if not outright complicity -- in the scandal amply demonstrates that accountability was the last thing this secretary demanded of the companies feeding at the federal trough on her watch. The disingenuous nature of the Spellings gospel of accountability becomes all the more apparent in light of her post facto reaction to the scandal. Her press releases and disavowal of authority and responsibility are ample enough proof that the thought that accountability applies to her as well has yet to cross the secretary’s mind.

And what’s the average borrower confronting this debacle to think? One apt thought may well be that you go to college with the Department of Education you have, not the one you ought to have. A heck of a job indeed!

Barmak Nassirian
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Barmak Nassirian is associate executive director of the American Association of Collegiate Registrars and Admissions Officers.

More Than Band-Aids

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
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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.

The Next Market Bubble: Student Loans?

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 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 Ed recently 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
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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.

Toward Federal Funding of Guaranteed Student Loans

Last week, the U.S. Department of Education announced its plan to purchase and temporarily fund student loans originated under the Federal Family Education Loan Program, the program in which the U.S. government guarantees and otherwise subsidizes student loans made by private lenders. This plan, based on wholly new statutory authority quickly granted by Congress only weeks earlier, has been criticized by some as a federal bailout of the private lenders.

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
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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.


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