With End in Sight, Whistleblower Lawsuit Reveals Truths about the 9.5 Scandal

One way or another, the whistle-blower lawsuit filed by Jon Oberg, the U.S. Department of Education researcher who uncovered the 9.5 student loan scandal, against six student loan companies that participated in the scheme should be resolved shortly.

The parties are currently in the third-day of court-ordered settlement talks to resolve the lawsuit, which seeks the return of approximately $1 billion to the government in overpayments these lenders improperly received. If the negotiations break down, the case is scheduled to go to a jury trial in the U.S. District Court for the Eastern District of Virginia on Tuesday.

The defendant with the most to lose in the case is Nelnet, the Nebraska-based loan company that was the most aggressive participant in the scheme, reaping about $300 million in excess federal subsidy payments from the government. The other defendants are: Brazos Higher Education Services Corporation (Texas), Education Loans Inc. (South Dakota), Panhandle Plains Higher Education Authority (Texas), Sallie Mae, and Southwest Student Services Corporation (Arizona). Brazos and Oberg have tentatively reached a settlement, the terms of which are now under review by the Justice Department.

As we have repeatedly said, this case should finally resolve many of the unanswered questions surrounding the scandal -- a goal we have been pursuing at Higher Ed Watch over the last couple of years. After doing a careful review of court documents publicly available on PACER (Public Access to Court Electronic Records), here are some of the truths that we believe have been revealed:

• The lenders involved in the scheme defied the will of Congress

The roots of the 9.5 student loan case go back to the 1980s when Congress guaranteed non-profit lenders, which use tax-exempt bonds to finance their loans, a minimum rate of return of 9.5 percent on federal student loans made with these bonds. As interest rates on all other student loans fell in the 1990s, policymakers became concerned that these non-profit student loan providers were making a killing. So in 1993, Congress rescinded that policy, but grandfathered in loans made from the old bonds, expecting that the volume of 9.5 loans would decline as they were paid off and the bonds retired.

Instead, beginning in 2002, a small group of lenders engaged in a strategy to aggressively grow the volume of loans that they claimed were eligible for the 9.5 guarantee. This was a gold mine for lenders in the existing low interest rate environment (at the time, the borrower interest rate on regular loans hovered around 3.5 percent.) They accomplished this scheme by transferring loans that qualified for the 9.5 subsidy payment to other financing vehicles and recycling the proceeds into new loans that they claimed were then eligible for the subsidy. The lenders repeated this process over and over again.

“Defendants prided themselves on exploiting a supposed regulatory “loophole” through which they could eviscerate the express restriction Congress imposed on claiming 9.5% floor SAP ["Special Allowance Payments"] on loans made or purchased with any funds raised after October 1, 1993,” Oberg’s lawyers wrote in a recent brief in the case [subscription to PACER required to view document], adding, “They plunged ahead despite this ‘elephant in the room.”

Nelnet, for example, increased the amount of loans for which it sought the 9.5 percent rate from $370 million in 2002 to more than $3.5 billion by July 2004. Meanwhile, Panhandle Plains more than tripled the amount of loans it claimed eligible for the inflated rate between 2003 and 2004, from $148 million to over $500 million.

Despite the 1993 law, many of the loan company executives who were deposed in the case said that they didn’t think there were any limits on how much they could expand their 9.5 holdings, according to the brief. As a result of the “loophole,” some of these officials said they believed that they could make their entire loan portfolios eligible for the inflated subsidy rate.

• The justification the lenders used for their scheme was faulty

To justify their loan and bond manipulations, these loan companies cited sub-regulatory guidance the Education Department had offered in March 1996. As part of the “Questions and Answers” section of a “Dear Colleague” letter, a deputy assistant secretary at the Department declared that a student loan financed by a pre-1993 tax-exempt bond would remain eligible for the 9.5 percent subsidy rate even if a lender “refinanced” it with the “proceeds of a taxable obligation.”

In releasing this guidance, the Education Department was trying to prevent non-profit lenders from gaming the system so that they could gain windfall profits in a high interest rate environment. Department officials had found that in periods when the prevailing interest rate on student loans exceeded 9.5 percent, some non-profit lenders had transferred 9.5-eligible loans out of their pre-1993 tax exempt bonds and into taxable obligations in order to make the loans eligible for the higher subsidy payments. The Department determined that this activity was extremely costly to the government, served no public policy purpose; and needed to be stopped. In other words, this guidance was issued to protect taxpayer money – and not to provide lenders with an alternative method for scamming the government.

This was “a prophylactic rule designed to foreclose the very kind of SAP growth through self-contained, easily reversible loan transfers without business purpose in which Defendants engaged,” the brief states.

In addition, while the guidance allowed lenders to transfer loans out of their tax-exempt bonds and continue to bill the government for the 9.5 rate, it was silent on another key part of the lenders’ strategy -- which was to transfer new loans into the old tax-exempt bonds and have them qualify for the inflated rate. Some career officials at the Education Department raised alarms about this practice, noting that transferring loans out of the old bonds should have reduced the amount of funds available in these bonds and eventually led to their defeasance.

Taking new loans financed by taxable obligations and making them 9.5 eligible simply by “dipping” them in the old bonds “allowed Defendants to open a virtually unlimited taxpayer-funded 9.5% SAP spigot,” the brief states, adding that this practice “was not reasonable or lawful between 2002 and 2005 and is no more reasonable or lawful today.”

• The lenders' scheme served no broader public policy goal but was all about the money

Despite the vast sums of money the government spent filling the lenders’ ever-expanding 9.5 claims, absolutely no public purpose was served. Instead, the loan companies’ sole purpose was to gain windfall profits that they could use to try and improve their competitive position in the student loan marketplace.

According to the brief, many of the loan company executives acknowledged during their depositions that their primary goal was to increase their return on the loans so that they could get a financial advantage or at least keep up with competitors who had begun participating in the scheme before them.

 “Defendants’ motions paint Defendants as benefactors of students, their families and institutions of higher learning who proceeded in good faith as “colleagues” and “financial partners” to make legitimate SAP claims,” Oberg’s lawyers wrote. “In truth, Defendants were more Bernie Madoff than Mother Theresa – their universal goal was to grab every possible tax dollar.”

Higher Ed Watch will be off for the next two weeks for summer break. But when we get back, we will write about the resolution of the case, and other truths that have been revealed along the way. Stay tuned.

[Disclosure: Jason Delisle, the director of the Federal Education Budget Project in the New America Foundation's Education Policy Program, has agreed to serve as an expert witness on behalf of the relator Oberg in the case.]