Exclusive: Some Ed Dept. Officials Encouraged Lenders to Overcharge the Government

[This is the sixth 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, here, and here.]

For years, we have known that nonprofit student loan companies engaged in an illegal scheme to gain windfall profits at the government's and taxpayers' expense. But these lenders did not act alone. Higher Ed Watch has learned that they received assistance and encouragement from several officials at a key office within the Department of Education.

In January 2007, then-Education Secretary Margaret Spellings put a stop to what has become known as the 9.5 scandal, in which nonprofit lenders were improperly growing 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 at a time when the borrower interest rate hovered around 3.5 percent.

But between the fall of 2005 and the end of the summer of 2006, the Financial Partners division of the Education Department's Federal Student Aid (FSA) office wrote a series of program review reports in which they signed off on these companies' billing practices and, in some cases, showed the lenders how they could take greater advantage of these inflated subsidies.

The timing of these reviews is curious, to say the least. They were conducted at a time when federal lawmakers had repeatedly taken action in 2004 and again in early 2006 to try to shut these payments off. The Department's Inspector General (IG) had also begun its own investigations into lenders, like Nelnet, that had been the most active in engaging in serial loan and bond manipulations to grow the volume of federal loans they claimed eligible for the 9.5 subsidy rate.

A One-Time Only Offer in Kentucky

One lender that the Financial Partners division had chosen to review was the Kentucky Higher Education Student Loan Corporation (KHESLC), the state's nonprofit student loan agency. Between 2003 and 2004, the Kentucky company became one of the most aggressive participants in the 9.5 student loan scheme, increasing the volume of loans it claimed eligible for the special rate from $140 million to nearly $1 billion over that period of time.

Still, a May 2006 Financial Partners program review report, which Higher Ed Watch obtained from the Education Department through a Freedom of Information Act (FOIA) request, concluded that the corporation had, in fact, "underbilled" the Department. The reviewer provided a spreadsheet of loans that he said were eligible for the 9.5 payments, and he invited the agency to determine the additional amount of subsidy payments it was owed on these loans and others like it. He made clear that this was a one-time only offer -- warning that a decision not to claim these payments, which had to be provided in writing to his office, could not be reversed. "This declaration is permanent and KHESLC may not decide later to recover this special allowance," the report stated. [Efforts by the Kentucky agency to receive these payments were later rejected by the Department.]

In a written statement to Higher Ed Watch, KHESLC officials cited this program review as evidence that the 9.5 percent claims it had made were legitimate. "USDE auditors reviewed KHESLC's practices and determined they were proper," the statement said.

Trying to Put to Rest "Lingering Doubts"

The Kentucky agency's experience was not an isolated case. Just ask officials at CollegeInvest, a nonprofit lender in Colorado. According to financial statements the company released late last year, a May 2006 program review initiated by the Financial Partners division found that CollegeInvest had undercharged the government nearly $14 million on 9.5 loans. Ironically, the company's own state-contracted auditor had determined three years earlier that federal law did not permit the claims and advised CollegeInvest to return 9.5 payments to the Department, which it did.

Meanwhile, in a November 2006 letter to the Education Secretary (see Exhibit 99.1 in this document), lawyers representing Nelnet pointed to three separate program reviews of lenders conducted by the Department between 2005 and 2006 that they said "should put to rest" any "lingering doubts" about the loan company's 9.5 claims. The lawyers didn't identify the lenders, so it's unclear whether they are referring to the audits of KHESLC and CollegeInvest. But they specifically cited at least one other case from June 2006 in which a lender was told that it had "underbilled" the Department.

The Department's Inspector General came to a very different conclusion in September 2006 when he declared that the lenders' scheme to aggressively grow the volume of loans they claimed eligible for 9.5 subsidy payments was "not in compliance with the HEA [the Higher Education Act], regulations, and other guidance issued by the Department." The following January, Spellings concurred with that opinion and required the lenders to undergo special independent audits to determine the legality of any future claims.

Serious Concerns Raised About FSA's Program Reviews

Recently, the Inspector General's office raised grave concerns about the program reviews that were initiated by the Financial Partners division over the past several years. In a report released late last month, the Inspector General concluded that reviews that came out of the division during this period of time cannot be relied upon, as they were conducted by regional staff without adequate time or training to undertake the reviews properly. What's more, the office said, the division did not consult with the Department's Office of General Counsel before issuing reports that dealt with "sensitive" or "political" issues to ensure that their findings were consistent with the Higher Education Act and Department regulations.

In this report, and one he issued in 2006, the Inspector General faulted FSA's oversight of the student loan industry, saying that its leaders emphasized partnership over compliance in dealing with lenders, guarantee agencies, and servicers. In his latest report, he particularly raised alarms about reviews that were conducted while Matteo Fontana was in charge of the Financial Partners division, including the division's 9.5 reviews. (The 2005-06 9.5 reviews fall into this category.) The Inspector General notes that "potential conflicts of interest existed with the former General Manager of Financial Partner Services," due to his ownership of stock in loan companies he was in charge of overseeing (a fact that Higher Ed Watch first uncovered in April 2007). The inspector general recommended that the Department "evaluate decisions" Fontana made during his leadership of the division to determine if any "were inappropriate," and if so, "to take corrective action as necessary, and assess the impact on the FFEL program."

The 9.5 program reviews certainly raise the question of whether officials in the Financial Partners division were trying to provide the non-profit lenders with cover in the event that policymakers chose to heed the IG's recommendation -- which he first offered in 2005 --and tried to get them to return the excess subsidy payments they had already received.

If that was their intent, they have generally succeeded so far. While Spellings' January 2007 ruling put a stop to the overpayments, she did allow lenders to keep the subsidies they had already received. Later, in explaining her decision, she said that the Department had "significant legal exposure" because it "had some responsibility with respect to that confusion" over the rules governing the 9.5 subsidy rates.

And, as we see from the Kentucky loan agency, lenders continue to point to these reviews to say they never did anything wrong.