How the Banks' Student Loan Gravy Train Finally Got Halted

With President Obama signing the Student Aid and Fiscal Responsibility Act into law (Congress included the bill in the landmark health insurance overhaul), it marks the end of decades of unnecessary subsidies to banks and will save taxpayers $61 billion over 10 years. That money is being reinvested into expanded student loan and education aid ($42 billion), deficit reduction ($10 billion) and health care reform ($9 billion).

The $42 billion to education increases Pell Grants, both the amount and the number of eligible borrowers ($36 billion); aids minority-serving institutions such as historically black colleges ($2.5 billion) and community colleges ($2 billion); eases student loan repayments ($1.5 billion); and increases funding for the College Access Challenge Grant program ($750 million). The House Education and Labor Committee has broken down the act's benefits state by state.

Now known as SAFRA, the act achieves these savings and investments by eliminating the Federal Family Education Loan Program (FFEL, pronounced "fell") and switching all student-loan originations to the Direct Loan program.

Eliminate the Middleman

By law, the terms and conditions of the loans in both programs are essentially the same, so why does changing programs save so much money? Well, the Direct Loan program has no middleman: The federal government loans money directly to students. In the FFEL program, the federal government paid private banks to play middleman, and the banks loaned the money to students.

But the banks didn't come cheap. The government paid three different kinds of subsidies for the privilege of their involvement. Ostensibly, these subsidies were "necessary" to lure private banks into the middleman role. However, the amount of the subsidies was far more closely related to Congress's budgetary needs and banks' lobbying clout than any analysis of what level of incentive would trigger banks' participation. Indeed, at times lenders managed to steer legislation and continue to exploit extraordinarily favorable terms.

What subsidies did the government pay? First, it guaranteed the banks an interest rate, making "Special Allowance Payments" on top of the interest the student borrower pays whenever the student's rate is below a benchmark rate, which it was most of the time in normal economic conditions. Second, the government guaranteed nearly all the principal and interest on the loan, so the banks were insulated from losses. Third, the government paid guaranty agencies for various administrative services. (Despite the agencies' names, the funds guaranteeing the private loans came from the federal government.)

In short, under FFEL, taxpayers guaranteed banks that student loans would be profitable and risk-free, and FFEL created a similarly risk-free, profitable role for guaranty agencies. The total extra cost to taxpayers for using FFEL instead of Direct Loans? About $11 per every $100 loaned.

How FFEL Came to Be

With the signing of SAFRA, that boondoggle ends. As Rich Williams, education advocate for the U.S. Public Interest Research Group, puts it: "This legislation finally ends sweetheart deals to banks and lenders, directing the money to help restore student aid programs for the tens of millions of students who rely on federal aid to achieve a college education."

Given how wasteful FFEL was, and how hard it was to eliminate, it's important to understand how we got here.

The original incarnation of the FFEL program was the guaranteed student loan program passed under President Johnson in 1965. At the time, federal budget rules accounted for Direct Loans and guaranteed loans differently, with the result that guaranteed loans -- ones with private bank middlemen guaranteed by the federal government -- looked much cheaper on the books. As a result, the policy preference was loan guarantees, not direct lending. Later, many people realized the accounting rules were irrational, and in 1990 President George H. W. Bush signed the Credit Reform Act, which made the government's accounting more sensible.

As soon as the two types of loans were on equal accounting footing, the additional costs inherent in the guaranty approach became obvious. Indeed, the logic of direct lending was so compelling that President Bush persuaded Congress to create a pilot direct-lending program. In 1993, President Clinton tried to eliminate FFEL in favor of direct lending, but he managed to achieve only a significant expansion of the direct-lending program. However, lenders fought back, not only on Capitol Hill with their army of lobbyists but also school by school, persuading colleges not to participate in the Direct Loan program.

To "persuade" schools to stay purely in FFEL, lenders initiated a variety of "questionable and even illegal practices" between themselves and some of the schools, such as paying "revenue sharing" kickbacks. Thanks to New York Attorney General Andrew Cuomo's investigation and prosecutions, those practices have been cleaned up, although not forgotten. To be clear, not all FFEL schools participated in the pay-to-play activities. Some were simply used to the program and preferred its model of lending. But the banks' tactics weren't isolated, and they were effective in maintaining FFEL's market share.

Inching Closer -- but Not Crossing the Finish Line

Over the years, Direct Loan champions -- such as former Senators Edward Kennedy (D-Mass.) and Paul Simon (D-Ill.), former Representative William D. Ford (D-Mich.) and Representative Tom Petri (R-Wis.) -- fought hard, too. But even with support from a slew of important allies -- including the National Direct Student Loan Coalition, the American Association of Collegiate Registrars and Admissions Officers, the U.S. Student Association, U.S. PIRG, The Institute for College Access and Success and the New America Foundation -- they were never able to pass legislation such as the "STAR" act to shrink or end FFEL and the subsidies. But after the Republican Congress committed the "Raid on Student Aid" and Cuomo cleaned up the pay-to-play scandal, Direct Loan advocates were able to persuade the new Democratic Congress to pass the 2007 College Cost Reduction and Access Act. That trimmed the subsidies and restored student aid, though it didn't come close to SAFRA's elimination of them.

When the credit markets froze, it became even clearer that FFEL was a hugely wasteful enterprise. Many student loan lenders no longer had access to sufficient capital -- or worried that they wouldn't have access to sufficient capital -- to make new loans, and started dropping out of the FFEL program. So the government quickly enacted a program that allowed the lenders to sell their loans to the government and then use the proceeds to make new loans.

In short, the government was not only paying a guaranteed interest rate and eliminating risk, but in many "private" loans it was now putting up the capital, too, making FFEL a subsidy-laden version of Direct Lending.By the end, $8.80 of every $10 spent in student lending activity was a federal tax dollar.

FFEL's Final Two Years

As private lenders withdrew from FFEL or tightened their lending standards during the credit crunch, schools started switching to Direct Loans. In 2008, direct lending loan volume increased 50%. President Obama came to office strongly advocating the end of FFEL, and Speaker Nancy Pelosi's (D-Calif.) House rapidly passed SAFRA. Although the student lending lobby fought fiercely, FFEL's days appeared numbered.

The lobby's most powerful "argument" in this time of high unemployment was the claim that eliminating FFEL would destroy thousands of jobs. But that assertion was hard to take seriously for two reasons. One, the Direct Loan program, which uses the student loan industry to service the loans, requires all servicing jobs to be located in the U.S. That requirement forced Sallie Mae to repatriate 3,400 jobs to service Direct Loan program loans. Second, since private companies service Direct Loans -- by competitively bidding for contracts -- they'll have plenty of work.

But again, despite the momentum to end FFEL, its demise no longer seemed certain because the bill got stuck in the Senate for a year. Democrats couldn't get it past a filibuster, because key party members such as Senator Ben Nelson opposed it. Nelson's state of Nebraska is home to the infamous Nelnet, one of the major student lending institutions.

So, Direct Loan's champions knew "reconciliation" (i.e. majority rule) was the only way to end FFEL. But only one reconciliation bill (of however many topics) is allowed per year, and the slot was being saved for health care. With the 2010 elections looming, FFEL had a path to survival: delay Senate action until a new, possibly less hostile Congress was elected.

Democratic leaders had to decide if including the student loan provisions in the health care reconciliation bill made sense. Thanks to the tireless efforts of Senator Tom Harkin (D-Iowa), Representative George Miller (D-Calif.) and President Obama, in the end the Democrats decided it did. Ironically, because the bill was linked to health care insurance reform, long-time Direct Loan champion Representative Tom Petri (R-Wis.) end up voting against it.

Finally, 45 years after the subsidies started -- and 20 years after the rationalized federal accounting revealed the subsidies' true cost -- FFEL has ended.

Next Target: Oversight of Private Student Loans

Of course, eliminating the waste of tax dollars isn't that easy: Under the contracts governing approximately $500 billion in outstanding FFEL loans, taxpayers will continue paying subsidies, guarantees and guaranty fees until all the loans are consolidated into Direct Loans or are retired. But at least new subsidies are gone.

Although reformers can celebrate SAFRA's signing, far more work remains to be done. The next item on the regulatory agenda is ensuring that the proposed Consumer Finance Protection Agency has the power to regulate private "subprime" student loans. Education debt is a growing and massive burden on all students, and cleaning up these loan products (and their marketing) would ease the burden significantly.

Special thanks to Tom Butts, former director of Financial Aid at the University of Michigan, former Deputy Assistant Secretary for Student Aid in the Carter administration, retired head of the Washington Office of the University of Michigan, and currently volunteer adviser to the National Direct Student Loan Coalition, who provided a lot of helpful background for this piece.