A Federal Monopoly in Student Loans: What’s the Big Deal?

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Introduction and Background

What’s the big deal on who makes student loans—the government or the private sector?  Should colleges and universities care?

That is the debate before the Congress this fall with most in the higher education community having concluded that the government program—called Direct Loans—will soon be the single provider of federal student loans.  Many see it as a “big deal” because the Obama administration has promised its proposal will “save” a full $87 billion over ten years—most of which it will “reinvest” in a plethora of education initiatives, including increased student grants.

The attraction of producing huge budget savings in a time of mounting deficits is obvious.  But, like many things that seem too good to be true, there is more to this proposal than meets the eye.  Things like declining service quality, increased federal intrusion into institutional governance, and higher defaults, for example.

Superficially, at stake is the future of the program where the private sector makes loans but the government guarantees them—known as the Federal Family Education Loan program or “FFELP.”  This program has few friends following years of scandal (both real and artificial) and complaints from both the right and left that it costs too much while enriching loan providers with the government bearing all the risk.  All of this has caused many schools to say “good riddance” to FFEL but, curiously, about seven in ten, have until recently stuck with the program.

This anomaly begs a question:  Why?

Where are We Now?

But first, where are we now?   The answer is that the Obama administration is now fighting aggressively for the enactment of the Direct Loan program. It both “wants the savings” to fund major parts of its education agenda and, simply put, “wants a win.”   Should its health care reform proposal be defeated or substantially watered down, student loans could become the single largest domestic policy triumph of the new administration.

That’s no small deal and it should surprise nobody that Congress is well on its way to enacting the proposal.  Under it, student loans would be made with Treasury funds and serviced by contractors managed by the U.S. Department of Education.

From a student perspective, the administration says, the program will be pretty much unchanged.   In fact, the administration suggests that its “single payer” approach (as you might have guessed, they don’t call it that) is simpler than the FFEL program.

A compelling case?  Why would a university not support the President’s proposal?  Basically there are three reasons.

Three Reasons for University Opposition

Reason 1

First, there is the issue of service.  Funding for the administration of the Direct Loan program is subject to annual appropriations.  It is highly unlikely to be upgraded absent any option for borrowers to go elsewhere.  In fact, because funding for administration will compete directly for funding with Pell Grants and other student aid, some have suggested that existing service quality on Direct Loans will start a gradual movement towards mediocrity or worse as soon as the legislation is enacted.

Importantly, the issue of service quality is not a matter of how easy the life of a financial aid administrator or borrower can be made.  Rather it can be the difference between a borrower paying back her loan or defaulting on it.  To paraphrase a credit card commercial, the default is priceless—it is impossible to put a price tag on the harm done to a borrower who defaults.

At the heart of the service quality concern is the elimination of the FFEL guaranty agencies.  These entities perform a variety of services in support of FFEL borrowers, the most important of which is attempting to help borrowers who find themselves in delinquency avoid default.  Services consist of counseling borrowers through the complex array of repayment options available to them.

Under the President’s proposal default aversion services are to be “built into” the contracts with loan servicers—in essence paying entities that have already failed to prevent a borrower from going into delinquency to try again.  FFEL guaranty agencies, in contrast, are a “fresh set of eyes and ears” on an account and are more likely to find opportunities for default aversion that the loan servicer will miss.

Reason 2

The second reason is the issue of federal intrusion into institutional governance.  “He that pays the piper calls the tune.”  The piper will be the government.  The tune will be anything to reduce or control the cost of student aid.

Please note that this concern is not yet prominent in the public debate.  Some schools, however, appear to be keenly aware of it.  As they see it, once a single payer is responsible for all student loans, the only way to cut federal costs associated with the program without increasing costs to borrowers is to improve student outcomes (a good thing) or to impose cost controls on schools.

As is the case with predictions for bureaucracies interfering with quality health care  should a “public option” be created, nobody really knows what the long-term consequences for institutional independence will be for the enactment of a federal monopoly for student loans.  Logic, however, suggests that budgetary pressures on student aid will increase dramatically as the federal debt grows and higher education costs continue to rise at a rate far eclipsing the normal consumer price index.

“Higher Education Cost Containment” could take a variety of forms.  To name just a few, greater federal intervention in who gets admitted and how the admissions process is carried out.  The stated goal would be to reduce the recruitment of students with a greater likelihood of not being able to repay their loans.  Also possible is the elimination of eligibility for student aid of programs that “don’t make economic sense.” Before nodding in agreement, think about the market for medieval historians.  Also possible are federal guidelines for what services and programs may be offered to students.  To paraphrase Richard Vedder, why should federal student aid dollars fund a “country club” environment on campus?

Faced with public scrutiny on “the value proposition,” many colleges may be characterized as abusing students or as “wasteful.” Many schools will survive this vilification, but for some struggling independent colleges, the bad PR will hurt student recruitment at a time when costs pressures are already undermining their competitiveness.

Reason 3

A third issue is reliability.  In FFEL, reliability has been a function of redundancy.  If one lender quit or provided unsatisfactory service, there were ten others waiting to work with the borrower and school.  In a Direct Loan monopoly, this redundancy is eliminated.  If the Direct Loan program fails, loans simply won’t be available.

How likely is that to happen?  If the past is prologue, the answer would have to be “likely” because the Direct Loan program has already been subject once to a catastrophic collapse.  It happened in 1997 when the demand for Direct Consolidation Loans exceeded the capacity of the Department’s contractor.  The “melt-down” resulted in the need for the enactment of “bail out” legislation allowing borrowers to go to private sector lenders for loans.

In addition to this “ancient history” one can also look to events today in the United Kingdom.   Every day new horror stories are emerging on delayed loans and poor service resulting from what is viewed (at least across the pond) as an ill-timed decision to turn student loans over to a single government payer.

Conclusion

One last thought:  Charging the Department of Education to be a bank is a mistake.  It is unlikely to have the  “band width” to competently run a $100 billion a year loan program and to execute  it’s more important functions of leading reform in elementary and secondary education, securing the educational rights of students with disabilities, promoting literacy, and, yes, overseeing the quality of higher education through its role in recognizing accrediting bodies.

These are legitimate questions that will be shrugged off by some but which raise questions about whether the government should be providing services that can be provided better in the private sector.  Put another way, if Congress sought to control the cost of higher education by creating a “public option” or worse yet, “federalizing” all institutions of higher education as a means of directly influencing both efficiency and quality, the academy’s outcry would be deafening.

Admittedly, a specific proposal to impose new, intrusive regulation over schools has yet to surface.  The possibility, however, is more than pure speculation.  The Department has already proposed limiting eligibility for certain occupational training on the basis of its assessment of the “value proposition” inherent in the student enrolling in the program and paying for it with loans. Also notable is the inclusion in SAFRA (The Student Aid and Fiscal Responsibility Act) of provisions directly funding provides community colleges (and not to other sectors).

Fifty years from now, the decisions being made today on student loans could be seen as a tipping point—a major step towards increasing federal intrusion into institutional governance.  The $87 billion in savings (a number, by the way, identified as overstated by over $30 billion by CBO’s own budget director) will be forgotten.

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John E. Dean, is principal in Washington Partners, LLC, a public affairs firm.