Obama's Risky Plan: Government Takeover of the Student Loan Business

Under the current system, the federal government helps students secure loans to pay for higher education through a program called the Federal Family Education Loan (FFEL). Because student loans are historically high-risk for banks to offer, FFEL subsidizes the banks to offer those loans, acting in a role similar to a co-sponsor. If the student defaults, the government will pay the remaining debt.

In addition, to avoid being hurt by fluctuating interest rates, FFEL sets an interest rate that participating banks (called "guaranteed lenders") may charge. If market interest rates rise above that rate, FFEL will reimburse the lenders for that loss. At the same time, if market interest rates fall below the set rate, and the lenders make a profit, the lenders must pay the government back a significant portion of the difference. This is to avoid lenders from making "windfall profits." This program (more commonly known as a Stafford Loan) has existed in roughly the same form since 1965, encouraging banks to make loans they otherwise would have no interest in making, providing more students access to higher education. For the 2009-2010 fiscal year according to the Department of Education, more than 80 percent of student loans are provided through this program.

The other 20 percent of student loans, however, are provided through another program that provides loans directly to students. With the Ford Direct Loan Program (FDLP), created in 1993, the federal government cuts out the middle-man (the banks), and doles out the cash itself.

Under President Obama's plan, the government would scrap FFEL, and require that all new student loans be provided through FDLP -- in other words, private lenders would no longer be involved in the process, and the government would become the bank. It would be, ironically, a "public option."

The White House's argument has little to do with populist attacks on fat cats or evil Wall Street bankers, as one might think these days, but actually is a call for fiscal responsibility. By having all new student loans handled through the direct-loan system, the government argues (read this Wall Street Journal op-ed by Education Secretary Arne Duncan) it can save $87 billion:

Over the next decade, according to the Congressional Budget Office, the Education Department is slated to subsidize banks to the tune of $87 billion to enable them to make federal student loans. All of this money would be put to better use providing financial aid directly to millions of needy students who want a college education. The Education Department will be able to accommodate the new loans through an existing federal public-private partnership. Through that partnership, the federal government makes loans directly to students and uses companies that will provide better service to borrowers at a lower cost to taxpayers.

The argument, theoretically, is legitimate. If $87 billion is currently being spent to convince bankers to provide student loans, supporters contend, the government might as well just provide the loans itself, keep the profits and absorb the losses, and in the long-term save the $87 billion; it will collect more in interest payments from students than it it would otherwise to have to pay in fees to lenders. According to Duncan, $10 billion will go toward reducing the deficit, and the remaining sum will be put toward funding for Pell Grants. And, Duncan argues, as a result of the recent recession and the credit freeze, 80 percent of all new student loans are financed directly, so the transition would be a smooth one.

This writer is entirely supportive of across-the-board deficit reduction, so any proposal to save money should be considered. Upon close examination, however, this bill is not only unnecessary, but could do more harm than good.

There are several things to consider. Most importantly, the estimated savings need to be looked at with a healthy dose of skepticism. The National Review, in a July criticism of the plan, argued as much:

The government's cost structure is certain to change as it expands to fill the other 80 percent of the market. The government initially plans to contract out loan-servicing operations to private lenders, but Rep. Mark Souder, an Indiana Republican who sits on the Education Committee, says that could change. "AFSCME (the government employees' union) is going to want those servicing jobs," he says. That would lead to a big increase in the government's costs.

The Congressional Budget Office admitted even more room for accounting error, scaling down is estimated savings to $47 billion when calculating in the risk: students default on loans as the market fluctuates. It's easy to predict a savings now, but the forecast will be very tough to realize. Market performance is hard to factor in; with unexpected activity the predicted savings could drop. In addition, a new host of government jobs will need to be created to manage the new load of loans, most likely (at some point) filled by unions demanding expensive pension plans. The White House is trying to sell this bill as a pick-me-up for the budget deficit under the banner of saving money, when in reality the money saved from scrapping from FFEL will be little, and tacked on elsewhere to the federal budget anyway.

Aside from the savings, there isn't a valuation that students will be better off. As Dana Perino states, it's odd that the White House's big sell line for health-care reform has been that creating choice and competition is a boon for consumers, when in this plan they do just the opposite of that -- making the government not just a public option, but the only option. "It would not only eliminate all choice and competition in the student lending market," Perino writes, "but it also would risk tens of thousands of private-sector job losses -- the last thing we need with double-digit unemployment." The number of students choosing direct-loans through FDLP has steadily declined from 30 percent to 20 percent since its inception in 1993. Given a choice between the two, students have been choosing the FFEL route in larger numbers. It would seem that free choice and competition is working . . . decisively against direct-loans.

The liberal defense of this bill has been largely reduced to how the potential savings could be spent, and not of the actual impact on the student loan process itself. "Tens of billions of dollars will be cut from useless middleman processing and used instead to fund college educations for low-income students," the Atlantic Monthly commented. "A shot at upward mobility grows from the ashes of superfluous banking."

However, it seems that the potential upside (the $87 billion in potential savings) is outweighed by the potential downside. The government will run a monopoly on a vital resource for students seeking higher education, ignoring the choice of millions of students to seek their loans through private providers. The blow will be a harsh one to the credit sector of our economy that, if anything, needs to loosen up. And the potential savings may not even be realized.

America's Student Loan Providers, representing the student loan industry, has heavily lobbied against the proposal, and has offered its own plan. By requiring lenders to pay a fee to the government if a loan defaults, the overall number of defaults will (hopefully) lower, thereby saving the government money. This move, ASLP says, gives the lenders "skin in the game." Their proposal seems to be a decent compromise.

It is true that funding for higher education is in somewhat of a crisis, facing escalating tuition costs year after year, and some sort of reform is needed. But that reform effort needs to actually address the core of the issue (escalating costs) and not just shift funding dollars from one program to another. If SAFRA passes, we may be lulled into a false complacency, and continue to ignore this illusive problem.

Either way, as Forbes Magazine pointed out in its criticism of the bill, "this is hardly the destruction of capitalism." The student loan process is already heavily subsidized and has a unique level of government involvement, so the shift wouldn't signal a dawning of socialism in America -- and that's perhaps why it has gone under the radar. Students' lives will not be radically changed.

This scenario, however, calls to mind Calvin Coolidge, who once said, "Don't hurry to legislate. Give administration a chance to catch up with legislation." Instead of scrapping what we have and starting anew, let's look at what we have, and how we can make it cheaper. Otherwise, the casualty could be a program that has provided students with sky-high opportunities for nearly half a century.

As the National Review lamented, "(We'd go) from a simple loan-guarantee program to a 'public option' to a union-staffed, government run monopoly in 44 years." Casualty, indeed.