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!