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Corporate Welfare in Disguise
The student loan industry is raking in the profits

By Robert Shireman

Faced with unprecedented budget shortfalls, states across the nation are desperate for money to support affordable higher education. Searching for every scrap and morsel, 23 states have managed to leverage their small role in the federal guaranteed student loan program into a little extra cash, totaling a few hundred million dollars. Understandably, they appreciate the income. The agency heads and their lobbyists regularly travel to Washington to argue for the preservation of their roles in the system. Sometimes they are able to enlist their state's governor in the effort.

But states could get even more money out of the federal student loan system. Billions more. How? By eliminating the state role, streamlining the loan program, and passing along the federal budget savings to all states. To get there, governors will need to rise above the empire-building tendencies of their own agency chiefs, and make the case to congress that a reformed, market-based system is in the best interests of students and families.

Reform would be worth the leadership effort and the political maneuvering it would require from governors. Based on President Bush's 2005 budget figures, waste and inefficiency in the federal loan system cost $7.54 billion in this year alone. If, through student loan reforms, these funds were provided to states for need-based financial aid instead, states could more than double total state financial aid (based on the total in 2002-03, the most recent data available). Instead of some states netting a few hundred million dollars, students in all the states would benefit and the states would not have to be in the business of administering student loans.

A sample distribution would yield the annual assistance shown below (based on Pell Grant recipients in each state):

Arkansas-$90,759,793New Hampshire-$16,900,652
California-$896,268,564New Jersey-$174,682,859
Colorado-$91,689,973New Mexico-$65,132,275
Connecticut-$46,898,044New York-$622,446,265
Delaware-$12,601,300North Carolina-$201,321,916
District of Columbia-$12,567,455North Dakota-$22,343,744
Illinois-$275,232,087Puerto Rico-$378,742,713
Indiana-$134,741,270Rhode Island-$18,078,614
Iowa-$80,200,821South Carolina-$114,676,647
Kansas-$67,898,161South Dakota-$23,899,066
Minnesota-$106,090,292West Virginia-$53,982,919

These amounts are far larger than those earned by any state from its current "guarantor" role. California's agency, for example, hopes to earn maybe $30 million next year. But reform of the whole system could free up 30 times as much for California students-more than the state spends now on Cal Grants ($759 million in the 2004-05 budget), one of the best financial aid programs in the country.

The current state role
The federal government has two key responsibilities associated with guaranteed student loans. It has to pay the lender when the borrower defaults; that's what the guarantee means. But before making that payment, the government has to ensure that the lender actually made a reasonably diligent effort to collect on the loan. After all, when a loan is 98-100 percent guaranteed, there is little financial incentive to spend very much on collection.

When the federal guarantee system was created forty years ago, the idea was that state agencies and some nonprofit organizations would serve as co-guarantors, shouldering a portion of the default costs, and taking on the frontline responsibility for policing the guarantee. Risk-sharing soon failed, however, when not enough states and charities were willing to take on the risk. That should have taken the states out of the equation. Instead, congress just kept sweetening the deal.

Eventually, the federal government assumed 100 percent of the program costs (actually, more than 100 percent), and called on a network of state agencies (and a few specially designated nonprofit organizations such as USA Funds and the National Student Loan Program) to serve, essentially, as extensions of the federal government.

It's like a roommate who you thought was going to split the rent, but who now gets paid for living with you. Instead of reducing the federal costs as originally intended, state guarantee agencies turned out to add yet another layer of subsidy and complexity to the system. Making a tidy little profit off their role, they are reluctant to give it up.

Although its explanation makes for a potentially mind-numbing paragraph, the actual fee structure works like this: When a state guarantee agency puts its imprimatur on a federal student loan, the agency receives a .4 percent "loan processing and issuance fee," and an annual .1 percent "account maintenance fee," paid by the federal government. If a borrower's payments are late, the bank notifies the guarantee agency, which has an opportunity to encourage the borrower to make a payment. If successful, the agency receives a one percent "default aversion fee" from the Department of Education. If the borrower defaults, the agency reimburses the bank that originally issued the student a loan. If the agency succeeds in collecting payments on the defaulted loan, it gets to keep 28 percent. If the loan remains in default, the feds directly reimburse the agency 98 percent of what the agency paid the bank, with the remainder coming from the "federal reserve fund" controlled by the agency. If the agency doesn't have enough federal reserves, the feds cover the shortfall so that the banks get paid. The agency can also charge students a one percent "guarantee fee" in order to bolster its federal reserves, but since the Department of Education would cover any shortfall anyway, agencies often waive the fee.

Believe it or not, all of these excruciating details are in federal law, written by congress with the help of lobbyists. There is no real logic to the system. But 23 state agencies and a dozen free-floating nonprofit organizations think it's just nifty.

The rest of the program
If states and a few charities were the only ones profiting from the federal loan program, it would not be worth complaining about. It would be a transfer of public funds from one level of government to the other. But states actually receive only a small portion of the federal subsidy pie. The bulk of the inefficiency-an estimated $7.54 billion in 2005 alone, according to figures from President Bush's budget-is going to Sallie Mae and other lenders, who take virtually no risk (because of the federal backing) but rake in enormous profits.

Federal student loans had originally been provided directly, like other college aid, following a recommendation of the economist Milton Friedman in the 1950s. But when congress in 1965 wanted to expand on that start, irrational budget rules of the time got in the way: A guaranteed loan appeared to cost nothing, even though default payments and interest subsidies would be paid in the future. And a direct loan showed up in the budget as a total loss in the year it was made, even though most of it would be paid back with interest.

The budgetary treatment "distorted costs and did not recognize the economic reality of the transactions," according to the Government Accountability Office. Today, the federal government assesses the costs of loan programs comprehensively, producing "transparency regarding the government's total estimated subsidy costs," according to the GAO.

What do the comprehensive budget estimates show? The guarantee system, as it is currently designed, is massively inefficient compared to a direct loan program that began as a pilot in 1992, the brainchild of some of the economists in the first Bush Administration. But since no one makes a huge profit in the direct system, there is not a high-powered lobbying organization pushing to retire the outdated, poorly structured guarantee system.

All of the federal budget and accounting agencies have reached this same conclusion. For example, President Bush's Office of Management and Budget says the guarantee system has "unnecessary subsidies," and that the direct loan program's significantly lower costs "call into question the cost effectiveness of the (guarantee) program structure."

After studying the guaranteed loan program, Congressman Tom Petri (a Republican from Wisconsin) found that despite the initial impression that it represents a private-sector approach, it is in fact so flawed that "no fiscal conservative or free-market supporter could justify embracing it." Along with several Republican and Democratic colleagues, he introduced legislation to allow colleges that choose to participate in the direct loan program to share in the federal budget savings. The Congressional Budget Office analysis of the bill found that, with only a modest increase in the size of the direct loan program, $12.3 billion would be shifted from banks to students.

Defenders of the status quo
Despite the clear and unanimous pronouncements from the accountants, we are still stuck with the guarantee system that was produced under the distorted, irrational budget rules of 1965.

Protected from risk by U.S. taxpayers, Sallie Mae and other lenders are raking in profits. Originally created by congress 30 years ago, Sallie Mae's profits tripled between 2001 and 2003. In last year's Fortune 500, Sallie Mae ranked fourth by one measure of profitability, and 12th by the other measure. The company CEO, Albert Lord, pocketed a reported $41.8 million in compensation, according to the Washington Post.

High profits and large compensation packages are not inherently evil. Indeed, they are important rewards and signals in a free market system that relies on risk-taking to encourage innovation and entrepreneurialism. But the student loan industry is hardly a shining example of the free market at work. Indeed, it is not even close. In this industry, we the taxpayers take the risk, while the student loan companies take home the profits. The program is corporate welfare in disguise.

Some of the profits, of course, finance expensive and creative lobbying strategies. Terrified of the budget reports showing the massive waste, the student loan industry has borrowed a page from the tobacco industry's long-successful effort to paint the research on smoking as questionable. When the subject is loans, interest projections, and discount rates, it is not hard to convince the average numbers-shy Capitol Hill staffer that this is all open to interpretation. And given where the campaign money is coming from, it is a convenient position for a member of congress to take.

The state guarantee agencies essentially serve to provide members of congress with one more reason to go along with the distortions proffered by Sallie Mae and the banks. Local bankers visit to say that the guaranteed loan program is good. The college financial aid officer, on a visit to Washington subsidized by the bank, praises the bank's role in the system. And to top it off, they bring a letter from the governor, who expresses an appreciation for the funds raised through the state guarantee agency. Arguing with all those home-state lobbyists would take up a lot of time and effort. It's easier just to go along.

This ridiculous system will not endure for long, though, for the same reason that it has managed to survive: money. The federal deficit is quickly becoming the focus of Democrats on Capitol Hill, as well as the focus of conservative think tanks and citizen groups. They are on the prowl for waste and inefficiency, and the idiotic structure of the student loan program is impossible to miss.

At the same time, congress is undertaking a review of the federal Higher Education Act which includes the loan programs. The only way that they can invest in financial aid is to find a way to cut back. The loan program's inefficiencies are the perfect target. If those who want to invest in student aid do not capture the savings that would come from reform, then the deficit hawks will go after it.

Governors could lead the way toward cutting the waste in favor of financial aid. They can rise above the parochial interests of their own agencies and make the case that student loan reform would bring a system that involves far fewer government employees, greater use of market forces, and leaves more money for states to develop and expand financial aid programs that serve the low-income families in their own states.

It is hard to argue with the idea of doubling state financial aid without adding one dime to the deficit.

Robert Shireman is a visiting scholar at the UC Berkeley Center for Studies in Higher Education, and founder of the website

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National CrossTalk Winter 2005



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