Waste And Folly In Student Loans

Shortly after his inauguration in January President Obama announced a proposal to get rid of a 44-year-old program known as the Federal Family Education Loan (FFEL) program. In the FFEL system, the federal government guarantees loans to students from private banks and similar institutions under a variety of programs (the best known is the so-called “Stafford” loan) to help pay for the students’ education, whether at the undergraduate or postgraduate level. The idea behind FFEL, part of a massive piece of 1965 legislation designed to make higher education more attainable and affordable to larger numbers of Americans, is to encourage private lenders to extend credit for college to a cohort of society that would otherwise not qualify for loans that these days can total tens of thousands of dollars a year. In return for guaranteeing student loans against their borrowers’ default, the U.S. Education Department charges the lenders modest fees and sets maximum allowable interest rates.
Under Obama’s plan all students needing higher-education loans would instead obtain them through the William D. Ford Federal Direct Student Loan Program (Direct Loan for short), a Clinton administration creation of 1993 in which the U.S. Education Department itself lends money for post-secondary education. The only role that private banks and other institutions such as Sallie Mae (the formerly government-backed but, since 2004, completely private entity that currently originates about a fourth of all FFEL loans) would continue to play in student lending would be to service some of the loans under contract with the department.
The administration argues that eliminating private financial institutions as middlemen (until the administration embarked on its anti-bank stance Sallie Mae and other private entities accounted for 80 percent of the $92 billion federally subsidized loan market, and it continues to issue about 58 percent of those loans), would save the government $87 billion over the next 10 years in default payouts and interest subsidies to institutions that lend to students who demonstrate financial need. (For subsidized loans, the government pays the interest until the student leaves school; for unsubsidized loans, the interest accumulates, but the student is not obliged to make payments before leaving school, and there is also a variety of repayment and forgiveness plans geared to income levels after graduation.) Under Obama’s proposal the government would use part of the anticipated savings to put another $40 million into beefing up funding for Pell grants, yet another federal aid program for college students launched in 1973 and named (in 1980) after the recently deceased Democratic Sen. Claiborne Pell of Rhode Island. Under the Pell program, which costs the government $18 billion annually, about 7 million low-income college students (the ceiling family income is $40,000) receive outright grants from the government (the current annual maximum is $5,350), to help pay for their college educations.

The Bill And Its Opponents
In September the House of Representatives passed a bill (the Student Aid and Fiscal Responsibility Act of 2009, or SAFRA) that would forbid private lenders from making government-guaranteed loans after July 2010 and use inflation indexes to increase the maximum Pell grant amount to $6,900 over the next 10 years, raising annual Pell outlays to about $30 billion. (The House declined to pass another Obama administration proposal that would have turned the Pell program into a Social Security-style entitlement that would have included automatic grant increases at an estimated additional cost of $300 billion over 10 years.). Similar legislation has stalled in the Senate, but the U.S. Education department has forged ahead anyway, treating SAFRA as a fait accompli although it has yet to become law. Months before even the House acted, Education Department staffers were explaining to college financial officials In October Education Secretary Arne Duncan sent a letter to colleges nationwide urging them to get “Direct Loan-ready for the 2010-2011 academic year” so that their students would have “uninterrupted access” to loan money after the FFEL program was extinguished. Currently colleges can choose between Direct Loan and FFEL, but until Duncan’s letter went out, only 20 percent of them had opted for Direct Loan during the latter program’s 16-year history of operation.

The Education Department’s aggressive stance, coupled with bank-baiting populist rhetoric on Obama’s part (in a September speech the president accused “big banks” of using an “unwarranted subsidy” to rake in “easy money” via student lending), has provoked a counter-campaign by private lenders. Many banks, credit unions, and similar financial institutions, especially the smaller ones, have already left the student-lending market, battered not only by many colleges’ decision to abandon the FFEL program but by low yields. Since 2007 Congress has been requiring the Education Department to set ever lower maximum interest rates on federally guaranteed loans both subsidized and unsubsidized. As is the practice with many other types of loans such as home mortgages, banks typically sell student loans, after a year of “seasoning” via regular payments that presumably establish the borrower’s reliability, to larger financial entities, including Sallie Mae, generating capital with which to make more loans. Lower interest yields as mandated by Congress have translated into lower prices for student loans in those secondary markets, making the loans unprofitable for many lenders, which have thrown in the towel.
Those private lenders that remain in the market argue that there is a reason why institutions of higher learning overwhelming chose FFEL over Direct Loan until recent months and still seem to prefer FFEL despite the pressure from the Obama administration. Private-sector financial institutions, whose very business it is to process loans, determine creditworthiness, and keep track of borrowers and their payment schedules, say they do a better and more efficient job than federal bureaucrats. Many colleges apparently agree. Even before the House passed its FFEL ban in September, three dozen college administrators, led by the University of Notre Dame, signed a letter arguing for a longer transition period to Direct Loan. Furthermore, opponents of the House bill also argue the projected $87 billion in projected savings from switching to Direct Loan would be mostly illusory. The figure does not does not take into account the costs of administering a vastly expanded Direct Loan program, estimated at $7 billion over the decade, for example. Douglas Elmendorf, director of the Congressional Budget Office, pointed out in a letter to Republican members of Congress that the $87 billion savings figure derives from unrealistically rosy projections of likely student defaults under a vastly expanded Direct Loan program, and that the actual savings to be realized from the transition will be more like $47 billion. Finally, opponents argue that, with the elimination of private capital to fund student loans, the federal government would have to borrow nearly $1 trillion over the next 10 years to pay for an all-Direct Loan program, burdening a U.S. fiscal system already set to groan under multi-trillion-dollar projected debt loads arising from the Obama administration’s job-stimulus and healthcare-reform proposals.
Those are worthy arguments, but the administration’s arguments in favor of eliminating the FFEL program—trading in a Great Society program in which the federal government funnels loans to students for a Clinton-era program in which the federal government funnels loans to student—also have some worth. There is very little about FFEL that smacks of a free market that ought to be preserved. Rates of returns on federally guaranteed student loans may be low these days, but they are nonetheless rates of return—which is something, considering that the loans are virtually risk-free investments for the banks that make them. Furthermore, since 2007 the Education Department itself has been buying back student loans, essentially protecting lenders from the vagaries of the secondary market and ensuring them a pool of lending capital.
“I don’t like either of the programs [FFEL or Direct Loan],” says Andrew Gillen of the Center for College Affordability and Productivity, who argues that the government, instead of funneling money to lenders via covered interest payments and other subventions, ought to subsidize students’ loan payments directly if it wants to help them with their educations. On the other hand, says Gillen, “Direct Loan is highly susceptible to politicization on the budgeting level. In the short term, all that borrowing [the $1 trillion] ought to pay for itself in the interest rates the government charges the students as they pay back the loans. In the long term, it’s not realistic to expect high enough interest rates to prevail. There’s always going to be political pressure for lower interest rates, which means that taxpayers will be taking up the slack.”
What Are Loans Accomplishing?
The real problem, however—and it is a problem endemic to Pell grants as well as government-backed loan programs of any kind—is that it is difficult to measure exactly what the programs have accomplished and easy to enumerate a slew of unintended consequences traceable to making large sums of government cash readily available to young people. Federal aid to college students dates back to 1944, when President Roosevelt signed the first of a still-ongoing series of G.I. bills that give stipends to veterans of military service to enable them to pursue academic or vocational training. The original G.I. bill served a distinct and narrow purpose: to shield returning World War II veterans from the effects of an inevitable postwar recession and to compensate them for having given years of their lives to serving their country that might have been spent acquiring higher education and better civilian job prospects. It was not until President Johnson’s Higher Education Act of 1965, which created FFEL, that the notion of using government aid to support mass higher education as a good thing in itself became permanently entrenched in the public mind. A 2007 campaign speech by then-presidential candidate Barack Obama summed up a sentiment that still prevails in many quarters. Obama declared that “putting a college education within the reach of every American” was “the best investment we can make in our future.”
Forty-odd years of federal infusions of cash into higher education, via the FFEL program starting in the 1960s, Pell grants starting in the 1970s, and Direct Loan starting in the 1990s, have certainly increased the number of U.S. college students. In 1965, when Johnson signed FFEL into law, only 6 million Americans were enrolled in institutions of higher learning. By 2006, according to the Census Bureau, that number had soared to more than 17 million. Trouble is, the majority of those students never graduate. Only 54 percent of students enrolled in nonprofit four-year institutions collect a degree after six years (both the FFEL and Direct Loan programs are available to students enrolled only half-time, so there is little incentive for recipients to finish college quickly). Among those colleges on the bottom half of rungs of the admissions-selectivity ladder, the six-year graduation rate is only 45 percent. At community colleges, where an associate degree can typically be earned in two years, fewer than a third of students earn degrees of any kind even after spending six, seven or eight years in school, as is the norm (the three-year graduation rate at two-year colleges is only 6 percent). In a scathing article for the journal Democracy, Kevin Carey, policy director for the think tank Education Sector, observed that it is in exactly those low-performing schools that the vast majority of low-income Pell grant recipients are enrolled. There most of them waste time, fritter away taxpayer money, and do little to improve their future earning prospects. Carey, a self-described progressive who generally supports large-scale federal aid to students, pronounced the Pell program a “failure” and questioned whether the $40 million that Obama administration plans to sink into the Pell program by eliminating FFEL would accomplish much for disadvantaged grant recipients.
Furthermore, fueled by loan money flowing to students, colleges have vastly expanded their enrollments. The 1960s are famous as the decade when nearly every state in the Union embarked on campus building sprees that converted their small teachers’ colleges into giant facilities that were hastily renamed “universities.” (President Johnson signed the Higher Education Act of 1965 on the campus of his alma mater, the former Southwest Texas State Teachers College in San Marcos that subsequently blossomed into Texas State University.) Many of those enrollment-inflated institutions fall into that lower tier of academic selectivity that produces more dropouts than graduates, as Carey noted, and it is fair to question whether large numbers of their chronically low-performing students ought to be in college in the first place.
And Yet The Tuition Keeps Rising
Even more alarmingly, college tuition and other fees have skyrocketed over the decades. It is hard to believe that as recently as 1980 the cost of attending a private college was only about $5,600. Now it’s about $34,000, an increase of nearly 500 percent that has vastly outstripped inflation. Some 58 private colleges and universities–up from five last year–are charging more than $50,000 a year in tuition, fees, and room and board for the current school year. Obviously few middle-class students or their parents can afford those sticker prices, so again it’s not surprising to learn that two-thirds of college students these days graduate with average debts totaling more than $20,000 (debts for graduates of professional schools are far higher), and that all but the best-endowed elite universities would have trouble surviving without federal infusions of cash to their students. The loan and grant programs have generated a double dependency, with both students and colleges on the federal dole, so to speak.
The federal student loan programs have been constantly prone to moral hazards. In 1976, after FFEL had been in existence only 11 years, Congress felt compelled to crack down on then-prevalent phenomenon of students’ running up thousands of dollars in education loans and then filing for bankruptcy immediately after graduation so as to cancel those debts. Congress amended the bankruptcy code that year to make education loans non-dischargeable until five years after graduation. During the 1990s the lawmakers extended that period to seven years, and in a sweeping overhaul of federal bankruptcy law in 2005 Congress made it almost impossible to cancel student loans in bankruptcy court.
This last change to the bankruptcy law, while clearly aimed at encouraging young people to borrow more responsibly for their educations, actually triggered a housing bubble-style explosion of student lending by private banks during the mid-2000s in which standards of creditworthiness slid drastically. The expansion occurred not so much under FFEL, which sets limits on the amounts that students can borrow (typically about $13,000 a year at maximum for undergraduates in the Stafford program), but in a suddenly burgeoning and nearly entirely unregulated purely private loan sector that charges variable interest rates that can reach 20 percent (students must also start repaying the loans immediately or face heavy compound-interest charges). From 2003-04 to 2007-8 private student borrowing more than doubled, from $7.2 billion to $15 billion, according to the Institute for College Access and Success’s Project on Student Debt. It’s thanks to the purely private loans that you read about new holders of bachelor’s degrees staggering under education debt loads of $100,000 and $200,000. Private student lending dried up at the recession’s onset, but its brief flourishing was a reminder of the negative consequences of ballooning college tuitions.
Federal loans and grants have also transformed the for-profit education sector in ways that could be described as corrupting. Time was, before 1965, that commercial schools taught specific vocational skills—hair-styling or typing or practical nursing—and did not pretend to be “colleges” except in the loosest metaphorical sense. The writer Raymond Carver never got past high school, but he learned his craft in a class on short story-writing paid for by his mother at the now-defunct Palmer Institute of Authorship in Los Angeles during the 1950s.
That narrowly focused pay-as-you-go model, in which for-profit schools stood or fell on their graduates’ ability to find gainful work, has been superseded, thanks to federal money and its attached strings, by a degree-granting and highly government-dependent model whose educational outcomes are more dubious. The for-profits beat the community colleges at producing graduates (an industry self-study shows a 40 percent graduation rate), but lag behind all but the least selective nonprofit four-year schools in graduation percentages. Meanwhile, thanks to savvy working of the federal education-funding system by for-profit administrators, commercial colleges boast some of the largest numbers of Pell grant recipients in the nation. According to a study of the 2007-2008 school year by the College Board, nearly 100 percent of students at for-profit institutions had taken out education loans to pay tuition at levels approaching those charged by nonprofit colleges. About 60 percent of students at for-profits also owed money on private loans with their higher interest rates and less generous terms. For-profit schools also generate more loan defaults than their nonprofit equivalents.The Education Department recently revealed that 21 percent of borrowers of federal student loans who attend for-profit colleges default within three years of starting repayment, in contrast to nearly 12 percent (a figure that itself seems unduly high) among borrowers at non-profit institutions.
It is clear that easy federal cash has helped created a morass of bloated higher-education costs borne by debt-laden students and, ultimately, by U.S. taxpayers. Andrew Giillen of the Center for College Affordability and Productivity suggests some solutions: “I think that having a federally run program makes some sense, as long as the government is limited to determining need based eligibility and setting the loan limits. Get rid of lender subsidies, let interest rates vary, and let the government subsidize students interest payments directly if it wants to. For private loans, drop the non-dischargeability and let the market determine the terms of lending.”

[Ed. note – the preceding lines originally read – “I think that having a federally run program makes some sense, as long as the government is limited to determining eligibility and setting interest rates. Get rid of lender subsidies, let interest rates vary, and let the government subsidize students directly if it wants to. The problem with the private loans was that they happened because federal loan limits got mazed out. So drop the cumulative loan limit and let people borrow what you can pay back. Drop the non-dischargeability, but let lenders pursue borrowers to a limit of, say, $200,000 or $300,000.” They were altered at Gillen’s request]

Instead of getting rid of FFEL as President Obama and the House of Representatives would like, Gillen wants to see a reformed FFEL that would prod both lenders and borrowers to act more responsibly. That sounds sensible—but wouldn’t it have been nice if the federal government had never tried to intervene in higher education-financing in the first place?