How O’Malley Would Let Private Lenders Back Into Federal Student Loans

This post originally appeared on Forbes.

President Obama won a major victory by kicking banks out of the federal student loan program in 2010. It was no-brainer good policy. Now Governor Martin O'Malley is proposing to let the same banks into the program through the back door. And expensive colleges are likely to pick up a little cash as part of the deal.

O'Malley wants to let people with private student loans convert them to federal student loans. The plan is a little light on details (there’s only one sentence on his campaign webpage) but we can assume it works like this. You have a private student loan. You file an application with the U.S. Department of Education to “refinance” your private loan into a federal loan. The federal government pays off your lender and issues you a new loan with the same balance. This loan now has a lower interest rate and you can repay it through income-based repayment or any other repayment plan the government offers.

Here is why expensive colleges will like the plan. It makes the limits lawmakers placed on the amount undergraduates can borrow each year in federal loans moot. The federal loan program doesn’t let undergraduates borrow an unlimited amount of money for a variety of good reasons (Parent PLUS loans notwithstanding). But under Governor O’Malley’s plan students would max out federal loans and then take out even more private loans. Then they would promptly convert the private loans to federal student loans. That would allow them to enroll in income-based repayment and make progress toward having their erstwhile private student loan forgiven at the expense of taxpayers. Few policies would drive tuition up more.

Private lenders are big winners, too. Private lenders do not make loans to anyone at any school. They underwrite, trying to gauge who is likely to repay, who is a good bet, etc. But under Governor O’Malley’s plan they can safely get out of the underwriting business and make loans to everyone. If a borrower gets behind on payments the lender can inform him of the wonderful benefits of refinancing his loan into the federal loan program. Heck, they might even pay him to convert his loan to a federal one. The federal student loan program can provide him no-questions-asked forbearance or loan forgiveness through income-based repayment.

In finance lingo, O’Malley is giving private lenders a free put option on every loan they make -- taxpayers bear 100 percent of the risk on each and every loan. Make a bad loan; put it to the government at face value. In fact, that's a lot like how the federal loan program used to work when banks made loans with full government guarantees.

Governor O’Malley may be the only progressive who wants taxpayers guaranteeing student loans again. Sadly, some Republican candidates might actually get behind this idea."