End Bank Loans to Students? If Government Takes Over, It Could Cost Billions

By Michael Fumento

Investor’s Business Daily, June 29, 1993
Copyright 1993 Investors Business Daily

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Supporters of the Clinton administration proposal to save money by replacing the current bank-based student loan program with direct loans from the government tout it as an example of "reinventing government."

But critics say that while the current system has real problems, this is one idea that should be denied a patent.

"Federalizing the program and giving direct loans doesn’t make sense," said former Office of Management and Budget Director James Miller, who is now chairman of Washington-based Citizens for a Sound Economy. "It’s a whole statist approach."

"This is a big step backward," added David Linowes, chairman of former President Reagan’s Commission on Privatization. "At the same time so many other countries are privatizing government operations, we’re doing this."

On Wednesday, for example, France’s Socialist government announced a massive privatization of its state-owned banks and other companies, reversing its long-standing policy of promoting government ownership.

"The banking industry is a fairly efficient operation," said Linowes, now a professor at the University of Illinois at Champaign-Urbana. "There is no reason this should be turned over to the federal government."

This year, outlays for post-secondary student loans will reach nearly $15 billion, an amount that is expected to increase to more than $23 billion by 1998.

Under the current system, the student applies at a college or university for aid, then the institution applies to a lender. When the lender approves the loan, it sends the paperwork to a government agency that underwrites a guarantee to pay it off in the event of a default.

The loan then goes back to the bank, which releases the money to the school. The school then gives the money to the student. The direct-lending system would streamline this tortuous process by letting the school determine the level of assistance, and the money would come straight from the Education Department.

By eliminating the middlemen — the banks that lend the money and the institutions like the Student Loan Marketing Association, Sallie Mae, that buy those loans on the secondary market — the administration says the government will save money, which it can then pass on to students in the form of lower interest rates.

The administration can point to two different government studies that project such savings, one by the Congressional Budget Office and the other by the Government Accounting Office.

GAO Assistant Director Jay Eglin told Investor’s Business Daily that both agencies now estimate slightly more than $4 billion in savings over the next four year. The administration, however, cites savings of $2 billion a year.

"I don’t know where they get that number. I’m missing something," said Eglin.

Further, the Congressional Research Service says even the CBO and GAO figures may be too high. According to the CRS, about half of the GAO savings and from 41% to 59% of the CBO savings aren’t savings at all, but a different way of accounting for liability on the books. That is, the government won’t have to spend billion to compensate lenders for defaults and prepayments; it will spend those same billions to compensate its own accounts.

The CRS found that the other half did represent real savings, but that they could be readily accomplished through a restructuring of existing program.

But a report by the accounting firm Ernst & Young found that, at best, direct lending would produce no savings, and at worst, it would cost taxpayers as much as $13 billion in the first five years of the program.

Administrative Burden

A study by KPMG Peat Marwick, another accounting firm, released earlier this month found that both the CBO and GAO studies assumed that under the direct-lending approach, much of the administrative burden currently borne by private lenders would be placed onto schools with no government compensation.

Lawrence Burt, director of financial aid at UCLA, said direct loans "will make my job much easier," but I’m not certain of any (college) business officer who’s enthusiastic about it" He did say that the student’s job would be made easier.

The American Banking Association is fighting Clinton’s proposal by warning of administrative nightmares.

"The direct-lending concept," said Donald Ogilvie, executive vice president of the ABA, "combines the efficiency of the Post Office with all the charm of the IRS. It will not deliver the level of access, service, and efficiency that the (system) currently provides"

Nevertheless, banks have a clear financial interest, since loans to students are among their more profitable ones. But parties without a financial interest such as Linowes are also convinced that the government cannot run the federal loan program nearly as efficiently as the banks do.

"When you examine government operations," said Linowes, "you find generally speaking there is not a follow-up to late payment notices. With a private business, there is regular follow-up, because they’re in a make or break situation. But government agencies just request more money in their appropriations."

Failure Rates

Miller agrees, citing a GAO report on the federal Small Business Administration and its three types of loans.

The GAO found that, while the SBA’s direct loans had a failure rate of almost 16% during the evaluation period, the loans that involved bank credit analysis had a 10.2% failure rate. Those administered fully by private lenders had a default rate of only 4.5%

The GAO said that the lower failure rate for loans administered fully by private lenders may have been in part because those loans were on average made more recently. Thus, they did not have as much time to fail.

But is still found that for loans of the same age, the failure rate of bank-administered loans was lower.

As in other government loan programs, Linowes said the SBA experience suggests government spending will rise — and, since the government is running a deficit, so will federal borrowing. The CBO report estimated that it would take 65-100 billion of additional borrowing to get the direct-loan program up and running.

Yet Linowes also criticizes the current system as too favorable to the banking industry. "We should not have such a guarantee" as we do now, he said. Instead, the government should "negotiate the loans with industry, let them estimate the cost of defaulting, and pay them the difference so they can be covered with (private) insurance," he said.

While student loans are profitable for direct lenders, no one has profited more than Sallie Mae, which holds $24 billion of the $66.4 billion of the government’s outstanding student loans.

Sallie Mae Criticism

Sallie Mae was recently criticized by Clinton, who noted to a group of students that between 1986 and 1991 the company’s costs "went down by 21% and its profits went up by 172%."

"This is a group that helps us get college loans," he said. "It should not be a big profit-making operation."

Sallie Mae responded basically by noting that the federal government set it up as a profit-making corporation. Congress established it in 1972 to ensure a secondary market for student loans.

After word got out about the Clinton proposal in February, Sallie Mae’s stock plunged, losing over 40% of its value. It has barely recovered any of that lost ground.

Sallie Mae has responded with a powerful lobbying and public relations campaign. Sen. Paul Simon, D.-IL, a supporter of direct lending, has accused Sallie Mae of setting up rump grass roots lobbying organizations. Its smaller competitor, the Student Loan Funding Corp., has admitted to doing so.

Even critics of Clinton’s direct-lending program say that Sallie Mae is doing awfully well — maybe too well. But they add that it’s the government’s fault.

"There are large barriers to entry (in the student loan business)," said John Works, an analyst with the New York investment firm of Keefe, Bruyette & Woods.

The processing requirements of banks that hold this paper are very strict," he said. "The requirements are so tight that if you miss one filing, the government can renege on its promise to repay. That drives out most of the competitors except the biggest ones with the resources to effectively manage the business."

User Fee Proposal

"It’s a funny program...with the biggest players benefiting the most," added Works. "But Sallie Mae does its business incredibly efficiently." Sallie Mae has cut its administrative costs in half since 1980.

But a major advantage for Sallie Mae is that, as a government-sponsored enterprise, it borrows funds at 20 to 30 basis points below the rate at which large commercial banks can borrow. To level the playing field, the CRS has suggested imposing a user fee on Sallie Mae’s borrowing.

"A 20- to 25-point basis surcharge...for every dollar Sallie Mae borrowed would set their borrowing cost very close to those of commercial lenders," the CRS said in a report.

Rep. Bart Gordon, D-TN, has introduced legislation that aims to save more than $4 billion over the next five years, largely by reducing the guarantee on defaulted loans. This would both cut lenders’ profit margins and increase their incentive to reduce student defaults. One major problem with Clinton’s direct-lending proposal, Works noted, is that "lending reform does nothing to address the issue of default losses. If they really wanted to tackle the thing, they should look at defaults."

Federal payments on defaulted loans rose from $117 million in fiscal year 1979 to $3.6 billion in fiscal 1991, an all-time high. They dropped to $2.9 billion last year, due to recent administrative reforms and the ending of the recession, analysts say.

Other Proposals

While the direct-lending proposal itself does not address defaults, two other proposals do. One is to have the Internal Revenue Service collect bad debts by withholding tax refunds. The other would allow students to make payments on a sliding scale, depending on their post-graduation salaries.

Yet, both of these could be done regardless of whether a direct-lending system was used or the current system was retained. Indeed, Miller says that when he was at OMB, he tried to get the IRS to withhold refunds of defaulters and the agency successfully resisted.

As to repayment based on income, a Department of Education pilot program at several universities proved to have real difficulties, according to some analysts.

Thomas Rutter, director of Student Financial Services at UCSD said that the Clinton proposal is "The exact same idea that was piloted and failed."

However, an Education Department spokesperson said that the department did not consider the pilot program failure.

Experimenting Suggested

Speaking of the direct-loan plan as a whole, Rutter added, "I would take current programs and tinker with them and put them back together. Then I would experiment with direct loans. Then I would see which worked better and if it were direct loans, switch over to them."

"Instead, the Clinton administration is moving full-speed ahead without a pilot and without test marketing," he said.

Ironically, a pilot direct-loan program is already in the works. Congress approved it last year, and the Department of Education is in the first states of setting it up. But the administration decided to not wait for the results.

"You wouldn’t see this in the business world," said Rutter, "That’s what happened with the Edsel."


Read Michael Fumento’s additional work on education, on economics and on the Clinton Administration.