9.5 Scandal Fallout in Kentucky

[This is the fifth in a Higher Ed Watch series "Revisiting the 9.5 Student Loan Scandal." The series takes a closer look at the origins of the scandal with the purpose of trying to resolve unanswered questions and dispel lingering myths surrounding it. Links to earlier parts of the series are available here, here, here, and here.]

Kentucky's state student loan agency has pulled the plug on a loan forgiveness program designed to encourage students to pursue careers as educators, leaving hundreds of newly minted teachers deeply indebted with loans they never expected to have to pay off.

According to a report in the Lexington Herald-Leader, many of the borrowers say they would have thought twice about pursuing such a low-paying career if they knew they weren't going to get the help that the Kentucky Higher Education Assistance Authority (KHEAA) had promised them.

"The loan forgiveness played a large role in me deciding to go into this field," Travis Gay, a special education teacher, told the newspaper. "I paid for my entire master's degree out of the program, books and all, and so did my wife. We were told, ‘It's something you can count on.' But then it was gone."

In an interview with the Herald-Leader, a spokesman for KHEAA put the blame on Congress, saying that federal funding for its "Best in Class" program had dried up over the last two years. But at Higher Ed Watch, we know that's just spin.

The real story revolves around the role the Kentucky agency played as one of the most aggressive participants -- behind only Nelnet and the Pennsylvania Higher Education Assistance Authority (PHEAA) -- in the risky and illegal 9.5 percent student loan scheme.

Beginning in 2002, a small group of lenders devised a strategy to improperly grow the volume of federal student loans that they claimed were eligible for the 9.5 guarantee available on loans financed through tax-exempt bonds issued before 1993. This was a goldmine 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. These lenders then repeated this process over and over again.

By engaging in these types of serial loan and bond manipulations, KHEAA grew the volume of loans it claimed eligible for the 9.5 percent subsidy rate from approximately $140 million in 2003 to nearly $1 billion in 2004, according to figures released by the Department of Education. The Kentucky agency made a killing on these loans, taking in $41 million in subsidy payments that year.

Like PHEAA and the Iowa Student Loan Liquidity Corporation, the Kentucky agency used some of the windfall profits it received to compete against other lenders -- such as Sallie Mae and the federal government's own Direct Loan program -- by offering more-generous student loan discounts to borrowers in the form of public service loan forgiveness programs, such as teaching and nursing.

But the good times for KHEAA came to an end in January 2007 when Education Secretary Margaret Spellings barred lenders that refused to submit to independent audits from receiving any further 9.5 payments. Most of the lenders that participated in the scheme agreed to submit to the audits, which were designed to separate out the lenders' legitimate and illegitimate 9.5 claims. The Kentucky agency declined the offer. A separate auditor, Strothman & Company PSC, wrote that KHEAA's management was unable to attest to the Department that the claims were legal.

Now that the 9.5 payments are gone, KHEAA can ill-afford to continue the loan forgiveness program. The new teachers who counted on the funds, and planned their whole careers teaching math, science, and special education around the program, are petitioning the Governor of Kentucky for assistance.

Here's hoping that the officials at the Kentucky agency come clean to borrowers, to the Governor, and to taxpayers in the state who may have to bail them out, as to what really happened.