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Sweeping change for the better in student loans

ASK THIS | March 29, 2009

Obama’s proposed overhaul of the student financial aid system would pump in more funding and still result in savings to taxpayers. Naturally, therefore, it is generating controversy and misinformation. (Second of two articles.)

By Pedro de la Torre III

In his 2010 budget, President Obama proposed a sweeping overhaul of the student financial aid system. Some of the major changes include tying the Pell Grant to one percent above inflation, reforming and expanding the low-cost Perkins Loan Program, and creating state-federal partnerships to improve college access and completion rates for high risk students.

While most of these policies enjoy a significant level of support, much controversy and misinformation has arisen around one of the ways that these reforms would be funded. The president’s budget proposes originating all future federal student loans through the Department of Education as part of the William D. Ford Federal Direct Loan Program (DLP). This change would effectively end the now dominant Federal Family Education Loan Program (FFELP), in which the federal government provides loan guarantees and subsidies to private student loan companies. Both programs are now used to provide the same loans to students.

With special interest groups, such as the Consumer Bankers Association, taking a keen interest in protecting subsidies to banks, reporters should arm themselves with the questions and facts that will keep them from being spun. Here are a few of the important questions you should be asking:

Q. Is the Federal Direct Loan Program really more reliable for students and less expensive for taxpayers?

A. Yes, Congress has known for some time that the DLP cost less per dollar lent than the FFELP, and, despite the cuts that Congress made to subsidies for student loan companies in 2007, it is still cheaper. The Congressional Budget Office recently found that this proposal would save taxpayers $100 billion over ten years – more than double President Obama’s original estimates.

Some lenders have attempted to claim that Congressional Budget Office’s assessment of President Bush’s 2008 budget showed that the DLP had become more expensive than the FFELP, but these numbers do not account for a process called “dumping.” In industry slang, “dumping” loans means that a guarantee agency will convince borrowers who have defaulted on their loans and are unlikely to resume payments to consolidate their FFELP loan into the DLP. This means that the DLP has had a higher lifetime default rate (and associated costs), but only because of unscrupulous practices in the student loan industry. A recent report by the Department of Education found that the DLP actually has a lower cohort default rate—the proportion of those who default within two years of leaving school—than the FFELP.

The Federal Family Education Loan Program is also less reliable for students, especially during difficult economic times. Its lenders are likely to avoid schools where students tend to have higher default rates, making it less useful to many of the students who need the most help. More recently, instability in the FFELP meant that lenders have turned to Congress to pass emergency legislation that will, essentially, use government funds to provide the capital to make new loans. Some lenders have also had to turn to the Term Asset-Backed Securities Loan Facility program.

Finally, amid reports of an imminent “student loan crisis,” some students with FFELP loans faced confusion as many loan companies ended or scaled back their participation in the program. This has left school financial aid offices scrambling, and many students with loans from several different companies. The system is broken, and the proof is that schools are “voting with their feet.” More than a quarter of FFELP schools have either switched to the DLP, or are considering a shift.

Q. Some lenders that participate in the FFELP have generous programs to help young people, like scholarships, financial literacy campaigns, and early education initiatives. If the FFELP is phased out, will this negatively impact charitable giving by student loan companies?

A. Some companies in the student loan industry do participate in worthy philanthropic efforts for young people, but most of them do so apart from their participation in the FFELP. In fact, the expansion of direct loans will provide additional loan servicing opportunities for Department of Education contractors. Sallie Mae, for example, already indicated that it will be aggressively pursuing this opportunity.

Many companies in all industries have and will continue to curtail their philanthropic efforts because of the economy, and the student loan industry will not be an exception. Additionally, Obama’s budget calls for an investment in state-federal partnerships aimed at improving access and completion rates for at-risk youth, and states will be able to use some of these funds to continue some of the programs currently run by FFELP lenders.

Q. The Consumer Bankers Association and others claim that expanding the Direct Loan program will increase the national debt. Is restructuring the financial aid system fiscally irresponsible?

A. As mentioned above, a switch to the DLP will save the government money, which will be reinvested into student aid. Switching to the DLP may increase the national debt on paper, since the government will be lending directly to students instead of guaranteeing loans made by private entities against default. Either way the federal government will have to pay for each defaulted federal student loan, and, unlike increasing the national debt for other purposes, providing loans directly to students should not result in tax increases or spending cuts in the future.

Since the money saved will be invested in expanding access to education, graduation rates, and making college more affordable, this reform will also help to grow the economy in the long run. A 2008 report found that on average, the government gets back, $7.46 for every dollar it spends on a college student.

Q. Is using only the direct loan program a “government take-over” of the student loan system?

A. Both the DLP and the FFELP are already government programs, administered by the Department of Education. Congress sets eligibility rules, maximum interest rates, subsidy rates, rules to help prevent conflicts of interest, rules about bankruptcy and default, minimum deferment and forbearance options, and more. As mentioned earlier, the government has also stepped in to provide private companies with the capital to make new loans. In fact, some have pointed out that one reason that the program doesn’t work is that subsidy rates are determined through a political process, subject to manipulation by special interests groups, and not a market or auction mechanism.

The only thing that the FFELP and the free market have in common is private companies. While many hold the view that the private sphere is always more efficient and competent than the government, the evidence shows that this is not always true. In this case, private companies are working within a broken federal frame work that is more expensive for taxpayers, less reliable for students, and more prone to special interest lobbying and corruption.

(Click here for a previous article, on plans for bettering educational attainment in the U.S.)

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