Back Room Deal on Student Loan Subsidies?

Last month Secretary of Education Margaret Spellings wrote to Sen. Edward Kennedy (D-MA) asking that Congress retroactively change the way the federal government sets lenders subsidies in the guaranteed student loan program. This request has received little attention from the press given its arcane nature.

At issue is the index the government uses to set subsidy payments to lenders. Currently, subsidy payments are indexed to commercial paper interest rates, but securitization markets prefer to operate on LIBOR, a different index. In her letter, Secretary Spellings says that "volatility in the financial markets" has caused a major mismatch between the two indexes that could "have a severe impact on lenders' ability to make loans." She urges Kennedy to change the index "as quickly as possible."

While we appreciate the Secretary's concerns, this is not a matter that should be rushed or handled through behind-the-scenes policy negotiation. What Spellings has proposed is unprecedented, could be costly to taxpayers, and again highlights the desperate need for long-term reforms in the Federal Family Education Loan (FFEL) program.

The Subsidy And Its History

The federal government provides an interest rate subsidy to private lenders making FFEL loans (and a guarantee against 97 percent of default losses). The subsidy ensures lenders are paid a quarterly short term market interest rate plus a somewhat arbitrary mark up (currently 1.79 percentage points) for the life of the loan. This "Special Allowance Payment" (SAP) has been a key part of the loan program for decades. It compensates lenders for the cost of capital used to make the loans and the costs that they incur servicing them.

For decades the quarterly SAP was based on the interest rate on 91-day Treasury bonds, plus 2.5 to 3.5 percentage points. But in the late 1990s lenders rightly argued that the SAP should be based on a market index for short term interest rates, not risk-free rates at which only the federal government borrows. Indeed, a market rate better aligns the federal subsidy to lenders' capital costs. But which market index should be used?

Lenders financing loans through securitization usually need to pay investors rates based on 1-month or 3-month LIBOR, making it an ideal index for the subsidy. During the deliberations, lenders acknowledged that LIBOR was the best choice but argued instead for a different market index. They told the Department of Education and the GAO that, "... the FFELP Group recommends that the Congress adopt the 90-day Commercial Paper (CP) rate plus 2.40% as the reference rate used to determine lender yield on FFELP loans."

Why not LIBOR?

At the time, temporarily switching the subsidy index from 91-day Treasury rates to CP on new loans showed $20 million in savings from 2000 to 2003, while LIBOR was projected to increase costs. Thus, lenders backed the index that appeared to generate savings since it was more likely to be adopted. In 1999 Congress enacted the CP change for new loans made through 2003, and then in 2002 made the rate permanent at a considerable cost to taxpayers.

Credit Crunch

Since 2000 lenders have been borrowing at LIBOR rates to finance loans that pay slightly lower CP rates. The arrangement worked because LIBOR and CP rates were roughly the same over that time period, but there was always a small chance that the rates could diverge enough to make the financing source problematic.

And that is exactly what has happened.

Credit market disruptions have thrown the two interest rate indices into fits. In October, LIBOR spiked some 2.00 percentage points above CP (compared to an average 0.12 percentage points), and though it has settled lower recently, the spread is still well above historical averages.

Unprecedented, Costly... And All Behind the Scenes

In response to the market disruptions, Secretary Spellings and the lending industry want to temporarily change the CP index to LIBOR for existing guaranteed loans. That means outstanding loans made in past years would suddenly start paying a different subsidy rate to lenders. The move would be unprecedented. Subsidy rate changes have always been done prospectively - that is, they have applied to newly issued loans, not loans made earlier. What's more, the change could cost taxpayers hundreds of millions of dollars each financial quarter in higher subsidies to lenders.

For these reasons, Congress and the Secretary must have an open debate on the index change, rather than negotiate through private correspondence and backroom deals with student loan companies. At a minimum, a Congressional hearing should be held before any action is taken. Important policy changes are too often slipped into larger must-pass legislation without thorough vetting... and are subsequently made permanent by the same process. The LIBOR change is ripe for such pell-mell policy making.

Long Term Reform Needed

The index issue and proposed changes are a dangerous symptom of the guaranteed student loan program disease. To get private lenders to make loans under the program, Congress must adequately compensate them. Yet Congress is not skilled at setting a payment rate that is neither too high nor too low, or that encourages the optimal number of lenders to make loans to all students. Worse yet, Congressional subsidy setting is subject to dangerous amounts of influence by student loan company lobbyists. This is particularly true when the issues are steeped in financial complexity, such as yield spreads between commercial paper and LIBOR, or interest rate swaps and asset backed securities.

The index issue should serve as an important reminder to Congress and the incoming Obama administration that they must adopt a system for setting lender subsidies that does not rely on continuous, ad-hoc legislative tinkering and loan industry lobbying. An auction where lenders bid for loan volume or subsidy payments is the best way to avert loan subsidy inefficiencies, crises, 200-page study group reports and lobbying bonanzas.

Read the latest post on this issue here.