America’s colleges and universities might not qualify as bailout material, but the nation should get ready for what amounts to massive federal government intrusion into higher education financing. Legislation signed March 30 by President Barack Obama practically seals the deal. And despite the administration’s claims to the contrary, taxpayers may find the transition exceedingly expensive. The measure, tacked onto the health care overhaul, requires that campuses using the prevailing system – federally-guaranteed private-sector lending – must move to federal direct lending. The U.S. Department of Education would serve as loan originator, though with a likelihood of contracting with banks to perform servicing.
Direct lending has been in place for more than 15 years. President Obama wanted to make it the only game in town — and he got what he wanted. Under the new law commercial banks, credit unions and other private-sector lenders still could make college loans, but from now on they will do so minus guarantees from Washington. With a typical ‘let’s-get-it-done’ coaxing emblematic of this administration, the law mandates that all colleges and universities switch by July 1. The legislation also relaxes loan repayment terms; provides massive funding for Pell Grants; and maintains high levels of aid to historically black institutions. All in all, it’s a massive expansion package for federal control over higher education.
The centerpiece of the law is the full move to direct lending. The president is trumpeting it as a victory for the American people and a blow to avaricious lenders and servicing operations. “For almost two decades,” Obama announced at the signing ceremony on the Alexandria campus of Northern Virginia Community College (where Vice-President Joe Biden’s wife, Jill, teaches English), “we’ve been trying to fix a sweetheart deal in federal law that essentially gave billions of dollars to banks. Those were billions of dollars that could have been spent helping more of our students attend and complete college.” Those “unnecessary middlemen,” as Obama described them, now would be virtually obsolete.
The White House estimates that elimination of government fees payable to private-sector intermediaries would save taxpayers $68 billion through 2020, a savings that presumably will pay for other programs. Yet experience suggests that the savings will not materialize. That’s another way of saying more taxes will be needed.
Before casting doubt on the new system, it’s essential to understand what it replaces. That would be the Federal Family Education Loan Program, or FFELP. Created by Congress in 1965 as part of the Higher Education Act, FFELP is an elaborate public-private partnership in which participating for-profit, nonprofit and state lenders underwrite and/or service loans to borrowers with a limited income or credit history. The program now serves in excess of six million participants, underwriting more than $55 billion a year in new loans, or more than 75 percent of the federal total. FFELP consists primarily of Stafford and PLUS components. Stafford loans, which run from 10 to 30 years, can be interest-subsidized or unsubsidized based on financial necessity. PLUS loans are available to parents of dependent undergraduate and graduate students, and cover the full cost of attendance minus outside aid. (The means-tested Perkins loan program may be part of either FFELP or direct lending).
Fueling much of the FFELP’s rapid growth over the last couple decades has been SLM Corp., better known as ‘Sallie Mae.’ Chartered by Congress in 1972 as a Government-Sponsored Enterprise called Student Loan Marketing Association, the Reston, Va.-based Fortune 500 Sallie Mae has an active loan portfolio of nearly $190 billion owed by around 10 million students and parents. Having phased in a full privatization plan during 1997-2004, Sallie Mae engages in a wide range of lending, servicing and counseling activities. It soon will have to scale them back.
Sallie Mae, unlike the residential mortgage industry’s roughly equivalent Fannie Mae and Freddie Mac (which thus far have received a combined more than $125 billion in federal bailout money), can be seen as the inverse of “too big to fail.” Call it “too big to succeed.” That is, Obama administration officials and allied Democrats in Congress, seeing a huge, solvent and privatized company, recognized they had an obstacle to a full conversion to direct lending. And so they decided to crowd it out of the picture. During the signing ceremony, the president singled out Sallie Mae as the prime culprit in an “army of lobbyists.” That the company had been named one of America’s “100 Best Corporate Citizens” at least five times by Corporate Responsibility Officer scored no points. And its contribution of the $250,000 legal maximum to George W. Bush’s second inauguration no doubt cost it a few.
Now that its services suddenly have become dispensable, Sallie Mae is figuring out how to downsize. Almost as soon as Obama signed the Health Care and Education Reconciliation Act, corporate management announced plans to lay off 2,500 employees from its 8,600-person work force at dozens of offices across the nation. This likely isn’t the only college loan-related employer who will distribute pink slips. Sen. Lamar Alexander, R-Tenn., who served as Education Secretary nearly 20 years ago under President George H. W. Bush, estimates 31,000 private-sector employees will lose their jobs. “The Obama administration’s motto is turning out to be: ‘If we can find it in the Yellow Pages, the government ought to try to do it,'” he said.
Supporters of direct lending argue that it is more efficient than the FFELP public-private partnership model, since it eliminates unnecessary layers of bureaucracy. Now there’s little question that the FFELP has had its share of problems. In 1991, U.S. Senate investigators concluded that the program is “plagued with fraud and abuse at every level.” Accusing the Department of Education of “gross mismanagement, ineptitude and neglect,” the Senate put cumulative losses during 1983-90 at $13 billion. In 1994, the Education Department (ED) admitted that waste, fraud and defaults in its higher education loan and grant programs amounted to at least $3 billion annually. And in May 2005, ED Inspector General John Higgins told a House committee that “the department’s student loan programs are large, complex and inherently risky…the loan programs rely upon over 6,000 postsecondary institutions [and] more than 3,000 lenders.”
Direct lending offers pretty much the same terms, benefits, interest rates and loan ceilings as its FFELP counterpart. And a sizable number of schools, such as Penn State University, already have made a transition to direct lending on their own. But would mandatory full conversion be an improvement? The evidence suggests not.
In 1993, Congress enacted and President Clinton signed into law the first-ever direct loan program. The main argument, then as now, was that cutting out middlemen would deliver more education for the dollar. Then-Education Secretary Richard Riley remarked:
So, who opposes direct lending? The financial middlemen who benefit from the old loan program, earning billions each year while assuming virtually no financial risk. That’s because the guaranteed loan system gives them a federal guarantee to replace their money if a borrower defaults, as well as hefty federal subsidies for participating in the guaranteed loan program. The bottom line is that the special interests’ profits are threatened, and their lobbyists have made clear to Congress that they expect to be protected. They do not want competition from a new system that works better.
Those words could have come straight from President Obama. Yet evidence indicates that direct lending, formally known as the William D. Ford Direct Loan Program, isn’t the bargain it’s cracked up to be. For one thing, the projected $68 billion in long-term savings is an exaggeration. Congressional Budget Office Director Douglas Elmendorf estimates the true figure at $40 billion. Writing in his blog this past March 15, he explained:
CBO estimates that replacing new guarantees of student loans with direct lending would yield savings in mandatory spending of about $68 billion over the 11 years through 2020. That figure represents the estimated savings in mandatory costs that would be shown in a CBO cost estimate for legislation under consideration by Congress. However, adjusting for the projected increase in annual discretionary administrative costs in the direct program, the net reduction in federal costs from the proposal would be about $62 billion. On a fair value basis, incorporating administrative costs and the cost of risk, CBO estimates that replacing new guarantees of student loans with direct lending would yield savings of about $40 billion over the 2010-2020 period. The primary reason for that $22 billion difference is that payments from the government to lenders are risky – they terminate when a borrower defaults on or prepays a loan.
On top of this, direct lending has exhibited higher default rates than FFELP loans. A paper prepared by Deborah Lucas (Northwestern University) and Damien Moore (Congressional Budget Office) for the National Bureau of Economic Research concluded that as of January 2006, the direct loan portfolio had incurred a composite 11 percent default rate, whereas the rate for guaranteed loans was only 8 percent. And the Government Accountability Office several years ago found that the direct lending program spent more than it collected in interest and fees in each year since 1997.
Additionally, direct lending severely diminishes consumer choice. The federal government, not the student or his family, chooses the lender because the government is the lender – private-sector competition is limited to auxiliary functions such as servicing. Bill Spiers, director financial aid at Tallahassee Community College explains: “One of the great benefits of the FFELP is the ability of the student, and where it is appropriate, their parent(s) to decide with whom they want to do business. Students in direct lending are not given this choice.”
Perhaps the most onerous consequence of a full conversion to direct lending is the possibility of financial aid used as political leverage. We all know the old saying about the Golden Rule: “He who has the gold makes the rules.” Well, it applies here. Nominally, these are ‘student loans.’ But in fact the federal government disburses them to institutions. When a student takes out a loan, he effectively is promising his respective college or university to pay back all debt with interest following completion of studies. Without recourse to switch back to the FFELP system, campus administrators may be at the mercy of the federal government. Peter Wood, president of the Princeton, N.J.-based National Association of Scholars, recently outlined the dilemma:
The federally subsidized student loan system surely stands in need of reform. But “Direct Lending” may well be a cure that is worse than the disease. The main problem is not financial but political. It will make American higher education extraordinarily vulnerable to political interference. Will Congress, presidential administrations, and the Department of Education resist the temptation to misuse their new power? Direct Lending will give the federal government decisive if not quite total control of higher education finance.
Then there is a paradox common to direct and indirect lending: tuition ‘cost-push.’ An individual loan defrays a student’s tuition, but loans as a whole raise it because participating institutions have fewer incentives to constrain costs. Taxpayers, after all, are liable for losses. “More and more Americans have sought a college education,” wrote Neal McCluskey and Chris Edwards in a Cato Institute paper last year, “which has pushed prices higher. Ordinarily, such upward pressure would be restrained by consumers’ willingness and ability to pay, but as government subsidies have helped absorb tuition increases, the public’s budget constraint has been lifted.”
The new legislation exacerbates this problem by loosening repayment requirements on direct loans. Students who meet income and other eligibility requirements and who borrow after July 1, 2014 would be allowed to cap their repayments at 10 percent above basic living requirements rather than the current 15 percent. Moreover, if borrowers remain on schedule in their payments, any debt remaining after 20 (instead of 25) years would be forgiven. Loan forgiveness would kick in after only 10 years if the student finds employment in a designated public service such as teaching, nursing or the military. It’s a backdoor way to expand government and raise tuition in one movement.
The switch to direct lending has major implications for a planned expansion of the Pell Grant program, the main source of federal aid to postsecondary students from low- and moderate-income families. Enacted in 1972 and named after its prime sponsor, Sen. Claiborne Pell, D-R.I., the program serves more than 10 percent of all college students, costing $16.3 billion in fiscal year 2009. That figure may seem quaint in the near future. Under the new law, the federal government would provide about $36 billion worth of new financing for Pell Grants over the next decade. The maximum annual grant would rise from $5,350 to $5,975 by 2017. If anything, these figures undershoot the mark. The CBO projects annual outlays to rise by $27 billion during fiscal years 2010-19 – in other words, to exceed $40 billion – thanks to Consumer Price Index indexing and increased participation. The Department of Education likewise projects Pell Grant spending to increase to $35.4 billion during fiscal 2009-13.
Other beneficiaries of the new law are the more than 100 ‘Historically Black Colleges and Universities’ (HBCUs) and their students. The new legislation provides $2.55 billion to black four-year institutions (e.g., Howard, Florida A&M) and another $2 billion to black two-year community colleges. That’s a hefty sum to maintain and promote racial separatism. That students at HBCUs typically exhibit high default rates makes this giveaway all the more inexcusable. President Obama puts it differently: “We’re not only doing this because these schools are a gateway to a better future to African-Americans; we’re doing it because their success is vital to a better future for all Americans.”
Americans are overextended to their creditors, and the new legislation will push the situation further into the danger zone. During 2000-09, total outstanding federal student loans more than quadrupled from $149 billion to $630 billion. President Obama says he wants to double higher education enrollment from 18 million to 36 million by the year 2020. If this comes to pass, can anyone deny the possibility that debt will explode even faster?
There are practical ways of getting around the high cost of a four-year college: attend a community college for the first two years; live at home and attend a commuter four-year school; choose an in-state public institution; apply for a partial or full scholarship; contribute to a ‘529’ state-sponsored prepaid tuition plan; contribute up to $2,000 annually to a tax-free Coverdell Education Savings Account; and enroll in college after accumulating full-time work force experience (or take evening courses during such experience). Yet the ultimate cost-reduction strategy is to avail ourselves of the notion that college is a basic right.
It’s understandable why an entitlement view is taking root. A special Census Bureau study early last decade, for example, concluded that adults with a four-year college degree receive substantially higher lifetime earnings than adults with only a high school diploma. Yet the blunt truth is this: College is not for everyone. The very term ‘higher education’ assumes a mastery of basic reading, math, history, science and other skills. It’s not ‘elitist’ to say that colleges and universities shouldn’t be providing remedial high school education. Yet so long as the line of applicants gets longer and the pot of federal aid gets larger, more institutions may find themselves filling that role. Taxpayers, less than cheerfully, will provide support.