Straight Talk on StudentLoans

The federal government provides student loans for college and graduate schoolin two ways: by guaranteeing bank loans and by lending directly to students.Approximately three-quarters of federal student loans are guaranteed and

one-quarter are direct. In the guaranteed loan program, a 40-year-old system, bankslend students money and profit from the interest payments while the governmentguarantees the loans against default and makes subsidy payments to the banks. In thedirect loan system, the alternative President William J. Clinton enacted in 1993,middlemen are cut out of the process. The government provides low-interest loansdirectly to students, using borrower interest payments to help cover the costs of theprogram.

By Robert Shireman

Policy BriefSeptember 2004

The difference between the two systems, inbudgetary terms, is substantial. In the decadesince the beginning of Clinton’s initiative, therehave been numerous audits and investigationsof both the direct and guaranteed student loanprograms, and in every case the auditors haveagreed: Direct lending is the more cost-effectiveapproach. In fact, it is much more cost effective.

The General Accounting Office (GAO), theCongressional Budget Office (CBO), and the Of-fice of Management and Budget (OMB) have allfound that switching completely to direct lend-ing would save billions of dollars a year. Follow-ing their lead, President George W. Bush’s latest

budget tells Congress that the guaranteed stu-dent loan program is structurally flawed, with“unnecessary subsidies” and “inefficiencies.” Thepresident’s budget concludes: “Significantly lowerDirect Loan subsidy rates call into question thecost effectiveness of the [guaranteed studentloan] program structure, including the appro-priate level of lender subsidies.”1

As analysts from across the political spec-trum have pointed out, the money that wouldbe saved by reforming the student loan programcould be used to help more students.2 Duringthe past few years, the money wasted on guar-anteed loans would have been enough to fully

Robert Shireman is senior fellow at the Aspen Institute and director of the Institute for College Accessand Success, sponsor of Student Loan Watch. He previously served as an education advisor at the

White House National Economic Council during the Clinton Administration. Shireman is launching ane-newsletter to monitor developments on student loan issues. To sign up, go to http://www.ticas.org/slw_support.htm. The author would like to thank James Kvaal, who provided valuable assistance in

the preparation of this policy briefing.

“One person with a belief is a social power equal toninety-nine who have only interests.”

—John Stuart Mill

The Progressive Policy InstituteThe Progressive Policy Institute is a catalyst for political change and renewal. Its mission is tomodernize progressive politics and governance for the 21st century. Moving beyond the left-rightdebates of the last century, PPI is a prolific source of the Third Way thinking that is reshapingpolitics both in the United States and around the world.

PPI invents new ways to advance enduring progressive principles: equal opportunity, mutualresponsibility, civic enterprise, public sector reform, national strength, and collective security. Its“progressive market strategy” embraces economic innovation, fiscal discipline, and open markets,while also equipping working families with new tools for success. Its signature policy blueprintsinclude national service, community policing, and a social compact that requires and rewardswork; new public schools based on accountability, choice, and customization; a networked govern-ment that uses information technology to break down bureaucratic barriers; pollution tradingmarkets and other steps toward a clean energy economy; a citizen-centered approach to universalhealth care and a progressive internationalism that commits America’s strength to the defense ofliberal democracy.

Rejecting tired dogmas, PPI brings a spirit of radical pragmatism and experimentation to thechallenge of restoring our collective problem-solving capacities—and thereby reviving public con-fidence in what progressive governance can accomplish.

The Progressive Policy Institute is a project of the Third Way Foundation.www.ppionline.org

fund the No Child Left Behind Act, or give everylow-income college student an extra $4,000 ingrant aid. In fact, each day, more than $15 millionis wasted that could help a deserving studentpay for college.

Congress should take action now, beforemore money is wasted. Lawmakers should in-sist that the student loan industry offer up asystem that is as cost-effective as direct lending.If the industry cannot deliver, Congress shouldcompletely replace the guarantee system withdirect lending and capture those savings for thebenefit of American families who are strugglingto afford higher education.

The Politics: Smoke Screensand Ghost Stories

Standing in the way of significant student loanreform have been some conservative House Re-

publicans who lean on a bogus depiction of theguaranteed loan program as a market-based sys-tem, which it is not. Instead, it is the worst typeof government program in which payments tobanks and middlemen are set on Capitol Hillrather than through a competitive process.

While detractors like to portray direct loansas more of a “government” program, bothguaranteed and direct loans use private-sectorcompanies to collect on the loans. (In fact, thedirect loan program uses some of the samecontractors as the banks.) The difference is thatin the guarantee program we pay the banks apolitically determined premium for havingprovided the capital—the same private-sectorcapital that the federal government can get atlower rates through highly efficient, market-basedTreasury auctions.

Defenders of guaranteed loans claim that di-rect loans only appear cheaper because of “ac-

WWW.PPIONLINE.ORG 3

Chart 1: Taxpayer Cost of Federal Student Loans

SOURCE: Based on subsidy rates in “Credit Supplement,” Budget of the U.S. Government, Office of Management andBudget, FY 2005, http://www.whitehouse.gov/omb/budget/fy2005/pdf/cr_supp.pdf and administrative costs providedby the U.S. Department of Education.

-2

0

2

4

6

8

10

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Bil

lion

s of

Dol

lars

If all DirectIf all Guaranteed

The numbers shown repre-sent the estimated tax-payer cost for the loansmade in each year, if theloans were either all director all guaranteed. Taxpay-ers can earn a net profitwhen interest paid by thestudents exceeds the cost ofmaking the loans (2002-2003).

counting procedures.” But the procedures thatthey object to are the same ones that, as GAOsays, “more accurately measure the government’scost of federal loan programs” and “permit bet-ter cost comparisons among and between creditprograms.”3 Critics of direct loans offer no al-ternative accounting methods, but instead tellstories of “hidden costs … that exist but don’tshow up on the federal government’s balancesheet.”4 These are ghost stories. But they havenonetheless succeeded in sowing confusion, lead-ing to inaction that allows continuation of thewasteful status quo.

Not all Republicans are fans of the guaran-tee program. One of the longest-serving Repub-licans on the education panel in the House isTom Petri (R-Wisc.). After studying the guaran-teed loan program, he found that despite theinitial impression that it represents a private-sector approach, it is in fact so flawed that “nofiscal conservative or free-market supportercould justify embracing it.”5 He says his colleagues

who support guaranteed loans have been sold abill of goods by the student loan industry.

Why Direct Student Loans Area Better Deal for Taxpayers

Whether the loans are direct or guaranteed,the amount students can borrow and the feesand interest rates they are charged are essen-tially the same. The rate at which students de-fault on their loan payments is also similar: 5.4percent in the guarantee program versus 5.2percent in the direct program. The major differ-ences are in how the loans reach students, andhow the providers and collectors are paid.

In the guaranteed loan program, the gov-ernment gives the student-paid interest incometo the lenders, but puts all of the risks on theshoulders of taxpayers. The risks include the costsof defaults and the costs associated with risinginterest rates. In the direct program, the gov-ernment still bears the risks but it is able to

PROGRESSIVE POLICY INSTITUTE4

cover some of the expenses with the interestpaid by borrowers. That is the biggest reasondirect student loans are cheaper.

The other major factor is the numerousmiddlemen who take mark-ups in the guaran-tee program. First among them are the banks.When we as taxpayers pay students’ interestwhile they are in school, we pay the bank itsborrowing costs plus a bonus. When a loan ismade directly by taxpayers through the govern-ment, the cost of the in-school subsidy to stu-dents is limited to Treasury’s borrowing costson the open market, with no bonus required.

There are other middlemen, too. When abank loan is fully backed by the government, thebank has little financial incentive to put resourcesinto aggressively collecting the payments, becausethe government will pay off any defaults. So, toensure that lenders do their collection job, thefederal government subsidizes 36 agencies acrossthe country to police the lenders—employingthousands of people at the expense of studentsand taxpayers. These agencies are not needed ina direct loan program, because the collection isdone through a performance-based competitivecontract.

After all of these costs are considered, a di-rect loan costs the government far less than thesame loan made through the guarantee program.Using figures from the most recent federal bud-get, Table 1 shows what the cost comparisonlooks like for one type of federal student loan.

Student loans are unique. This same analysiswould not apply to, say, home loans. With houses,private lenders play a critical role in determin-ing who is a credit-worthy borrower, and whatthe appropriate loan amount is for the asset be-ing purchased. The financial risk of a wrong deci-sion causes lenders to take seriously the job ofallocating loan capital efficiently. But in the fed-eral student loan program, the decisions aboutwho can borrow and where they can enroll withthe funds are made through a single process thatdelivers all federal financial aid, including aid fromthe U.S. Department of Education, the U.S. De-

partment of Defense, and other federal agen-cies. When private lenders are involved in thestudent loan program, they get paid but add noeconomic value to the process beyond the pro-vision of capital—a role the federal governmentplays quite efficiently.

A Brief History of StudentLoans

When Congress started guaranteeing stu-dent loans in 1965, it was an economist’s night-mare and a politician’s dream come true. ForCongress, placing the full faith and credit of theUnited States behind a bank loan appeared tohave no cost at all, because the defaults and in-terest subsidies would occur in later years andthus be someone else’s problem. Economistscried foul, concerned that financial commitmentswere being made without accounting for theultimate costs.

In 1990, the economists’ concerns wereaddressed. With President George H.W. Bush’ssignature on the Credit Reform Act, all gov-ernment loan programs—whether guaranteesof commercial loans, or loans made directlyfrom a federal agency—had to account fortheir full long-term expenses and income. Ev-ery federal loan program now has an esti-mated “subsidy cost”—put simply, the amountof money that needs to be set aside when theloan is made in order to cover the loan’s coststo the government during the life of the loan.The GAO explains that the old approach “dis-torted costs and did not recognize the eco-nomic reality of the transactions,” while thenew approach “provides transparency regard-ing the government’s total estimated subsidycosts rather than recognizing these costs spo-radically on a cash basis over several years aspayments are made and receipts are col-lected.”6 This more rational approach changedthe nature of policy discussions on CapitolHill. Student loans were among the first pro-grams to be affected.

WWW.PPIONLINE.ORG 5

Table 1: Taxpayer Cost for $10,000 in Subsidized Stafford Loans(net present value, same cost to students whether direct or guaranteed)

SOURCE: “Credit Supplement,” Budget of the U.S. Government, Office of Management and Budget,FY 2005, http://www.whitehouse.gov/omb/budget/fy2005/pdf.

foepyTnaoL seidisbuS evitartsinimdA

stsoC latoT

deetnarauG =

%73.61fostsocydisbuSseidisbustseretniloohcs-ni(

+seidisbustseretniknab+ycnegaytnaraug+stluafed

ybdiapseef-seidisbus)sredneldnasreworrob

+laredeF

stsocevitartsinimda%96.0fo

= 607,1$

tceriD =

-ni(%50.3fostsocydisbuS+seidisbustseretniloohcs+yrusaerTotdiaptseretnitseretnidnaseef-stluafed

)sreworrobybdiap

+

laredeFstsocevitartsinimda

sedulcni(%54.1fo&noitcellocnaol

)gnicivres

= 054$

Federal student loans had originally beendirect loans, following economist MiltonFriedman’s recommendation in the 1950s. Butin 1965, when Congress wanted to expandon that start, the irrational budget rules ofthe time got in the way: A guaranteed loanappeared to cost nothing, and a direct loanshowed up in the budget as a total loss in theyear it was made, even though most of it wouldbe paid back with interest. But now, after the1990 budget reforms, the equation haschanged.

Congress, prompted by a memo leakedfrom the Bush administration that indicateddirect loans would be less costly and simplerto administer than guaranteed loans, re-sponded by creating a pilot program of directstudent loans. The next year, as newly electedPresident Clinton focused on erasing the bud-get deficit, estimates showed that the directloan program would deliver the same loansto students at a much lower cost to taxpay-ers than guaranteed loans. So Clinton pro-posed replacing the guarantee program withthe new direct approach.

Student Loan ReformEfforts, 1993 to Present

Responding to President Clinton’s pro-posal in 1993, Congress went part of the waytoward replacing the guarantee program byphasing in direct lending first with colleges thatvolunteered to participate, and giving the Sec-retary of Education the power, if necessary,to require colleges to switch to direct loans,until at least 60 percent of the loans nation-wide were direct. While the law called for di-rect lending to replace guaranteed loans, itwas silent about what would happen beyondthe 60 percent mark, since that was outsideof the five-year window covered by the fed-eral budget.

When the Republicans took over Con-gress the next year, the new leadership tar-geted direct lending for elimination. But theydid not anticipate the enormous support thatthe new approach would have from collegesand universities. The reality was that manycollege officials disliked the guaranteed loansystem because it forced financial aid admin-

PROGRESSIVE POLICY INSTITUTE6

Chart 2: Percent of New Federal StudentLoans Made in the Direct Loan Program

SOURCE: Student loan volume as reported by the U.S. Departmentof Education.

0

5

10

15

20

25

30

35

40

94 95 96 97 98 99 00 01 02 03 04

Year

istrators to deal with what the GAO labeleda “complicated, cumbersome process,” dis-connected from other federal aid and in-volving thousands of middlemen. Collegeand university officials were cautiously op-timistic about a direct loan program thatwould operate in tandem with the otherfederal aid programs. So even with the elec-tion in 1994 of a Republican Congress hos-tile to direct loans, the program took offwith the enthusiastic participation of hun-dreds of colleges and universities.

Instead of eliminating the new program,the Republicans demanded that the Depart-ment of Education stop encouraging or re-quiring colleges to switch. The new mantrawas college choice: Universities wouldchoose to participate in one program orthe other. But the trick was that the banksand middlemen could use all of their moneyand people to coax and cajole, while theSecretary of Education had his hands tiedby the Republican Congress. Not surpris-ingly, campus participation in the DirectLoan Program dropped (see chart 2).

Multiple ways of delivering a government

benefit may be a good idea in some circum-stances. But in this case, duplication is costly,and not only financially. From a managementstandpoint, GAO argues that it is ineffec-tive for the government to run two loanprograms. In a series of reports on “high-risk” government programs, the auditorssaid the existence of two competing loanprograms leads to “a fragmented operatingenvironment in which two different groupsof students, schools, lenders, Departmentadministrators, and other entities partici-pate in two mostly similar programs.”8

College financial aid administrators likethe idea of two loan programs, because theyhave seen how the more streamlined directloan program has forced the industry to im-prove the operation of the complicatedguarantee system. For example, lenders andmiddlemen used to have separate forms,data formats, and processes, imposing hugeburdens on college staff members to keepit all straight. Because of direct lending, theindustry was forced to standardize and im-prove their systems for approving loans. Butthis competitive dynamic comes at an ex-

tremely high price. Would finan-cial aid administrators opt forkeeping the guarantee program ifthey saw it as standing in the wayof a $10 billion increase in finan-cial aid for low-income students?That is the real choice that Con-gress faces, and it should be aneasy choice to make. Studentsshould come first.

Federal Reserve ChairmanAlan Greenspan recently warnedthat the strength of the Americaneconomy depends on the educa-tion level of our people:

“[O]ur system of higher edu-cation bears an important respon-sibility for ensuring that our

WWW.PPIONLINE.ORG 7

Endnotes1 President Bush’s FY 2005 budget submission to Congress is unequivocal. It says there are “unnecessary subsidies” and that “significantlylower Direct Loan subsidy rates call into question the cost effectiveness of the FFEL program structure, including the appropriate levelof lender subsidies.” “Department of Education Part Assessments,” Budget of the U.S. Government, Office of Management and Budget,FY 2005, p. 34, http://www.whitehouse.gov/omb/budget/fy2005/pma/education.pdf. The actual subsidy rates for the two programs canbe found in the “Credit Supplement,” Budget of the U.S. Government, Office of Management and Budget, FY 2005, pp. 2 and 4,http://www.whitehouse.gov/omb/budget/fy2005/pdf/cr_supp.pdf. The GAO, the accounting arm of Congress, was the first to suggestdirect lending as a big money-saver with two reports in the early 1990s. More recent reports confirm those predictions. For example, ina March 2004 report, GAO found that consolidation loans in the direct loan program brought a “net gain to the government” of more than$1 billion in 2002-2003. In contrast, with the guarantee program, taxpayers suffered a net loss of more than $2.7 billion.(“Student LoanPrograms: Lower Interest Rates and Higher Loan Volume Have Increased Federal Consolidation Loan Costs,” Government AccountingOffice, March 17, 2004.) Meanwhile, in a 2003 presentation to congressional staff, CBO concluded that “under any apples-to-applescomparison the federal government will place a higher value on these assets [student loans] than would private sector investors.”Congressional staffers indicate that CBO’s current cost estimates continue to show direct lending as a significant money-saver. U.S.News& World Report investigative reporters reviewed federal data and concluded that “the FFEL plan costs the treasury far more than directloans, even after deducting administrative costs.” (Barnett, Megan, Julian E. Barnes and Danielle Knight, “Big Money on Campus: HowTaxpayers are Getting Scammed by Student Loans,” U.S. News & World Report, October 27, 2003.)2 “A Budget for America,” The Heritage Foundation, 2001.3 “Student Loan Programs: As Federal Costs of Loan Consolidation Rise, Other Options Should Be Considered,” Government AccountingOffice, October 2003.4 “Dear Colleague” letter from Rep. John Boehner, chairman, Education and the Workforce Committee, and Rep. Howard P. “Buck”McKeon, Chairman, 21st Century Competitiveness Subcommittee, May 20, 2004.5 Petri, Thomas E., “Putting Students First,” The New York Times, June 14, 2004.6 Calbom, Linda M., director, Financial Management and Assurance, Government Accounting Office, “Departments of Education:Student Loan Programs’ Subsidy Cost Estimates,” letter to Sens. Edward Kennedy, John Edwards, and Hillary Clinton, June 30, 2004.7 “High-Risk Series: Student Financial Aid,” General Accounting Office, February 1997.8 Remarks at the Boston College Finance Conference 2004, Boston, Mass., March 12, 2004.

workforce is prepared for the demandsof economic change.

“America’s reputation as the world’sleader in higher education is grounded inthe ability of these versatile institutionsto serve the practical needs of theeconomy by teaching and training and,more significantly, by unleashing the cre-ative thinking that moves our economyforward.”

Conclusion

As a nation, we cannot afford to wastethe potential of deserving young people.Congress should move all campuses to directlending—or to an equally efficient guaranteeapproach if one can be designed—and capturethose savings for the benefit of Americanfamilies who are struggling to afford highereducation.

Als

o fr

om t

he 2

1st

Cen

tury

Scho

ols

Pro

ject

at

PP

I:!

Aft

er-S

choo

l Pro

gram

s: Ex

pand

ing A

cces

s an

dEn

suri

ng Q

ualit

y by

Chr

isann

e L.

Gay

l

!O

pen

the

Pre

scho

ol D

oor,

Clo

se t

heP

repa

rati

on G

ap b

y Sa

ra M

ead

Now

on

PP

ION

LIN

E.o

rg:

!M

eeti

ng t

he O

ffsho

ring

Cha

lleng

e

Ro

bert

D. A

tkin

son

!U

nder

stan

ding

the

Offs

hori

ng C

halle

nge

Robe

rt D

. Atk

inso

n

Find

this

and

othe

r po

licy

repo

rts

atw

ww

. PP

ION

LIN

E.o

rg, t

he o

fficia

l web

site

of th

e Pr

ogre

ssive

Pol

icy In

stitu

te.

If y

ou w

ould

pre

fer

to r

ecei

ve f

utu

rere

por

ts v

ia e

ma

il, p

lea

se c

onta

ct t

he

PP

I P

ubl

ica

tion

s D

epa

rtm

ent

at

pu

bli

cati

ons@

dlc

pp

i.org

.