Student Loan Program May Break the Bank
By Sue Kirchhoff, CQ Staff Writer
Congress is caught in a political dilemma that could become a financial
crunch -- whether to proceed with a cut in student loan interest rates or
back off under pressure from bankers threatening to pull out of the college
The quandary comes at a time when lawmakers had hoped to be unveiling
new initiatives to slow the rising cost of college. Instead, they are faced
with the unhappy prospect of having to roll back a 1993 law that would
lower interest rates on federally backed student loans, beginning July
If Congress does not alter the law, commercial banks, which account for
70 percent of the college loan market, say they will cut back on lending,
possibly upending the higher education finance market and leaving students
who depend on loans without access to college funds.
Student groups, however, insist Congress must make lower interest rates
a top priority this year as it considers reauthorizing the Higher Education
Act, which governs tens of billions of dollars in annual grants and
The predicament is a textbook example of how unforeseen economic
developments can derail policy objectives years after they are made. Two
unexpected changes are now colliding five years after Congress planned the
interest rate change.
One is the failure of President Clinton's direct government lending
program to capture a majority of the student aid market. The other is a
major change in interest rates, with short-term interest rates rising and
long-term rates falling, that bankers say have rendered the planned formula
"There's no question there's a problem . . . and it's everybody's
problem," said Senate Labor and Human Resources Committee Chairman James M.
Direct Lending Gone Awry
The controversy has its roots in
the 1993 fight over the Clinton administration's push to scrap commercial,
guaranteed student loans in favor of direct government lending. The direct
loans were designed to cut out banks, secondary markets and guaranty
agencies. Government lending was expected to save billions of dollars by
eliminating subsidies to private-sector lenders.
Congress refused to move entirely to direct lending by the government,
worried that the Education Department could not administer such a massive
program. Instead the 1993 budget-reconciliation law (PL 103-66) allowed the
government to gradually phase in the program over five years.
The legislation assumed that direct loans could account for at least 60
percent of new student loans. The Clinton administration had hoped the
government would eventually take over all student lending.
In the same law, Congress enacted a change in the formula the federal
government uses when it sets student loan interest rates.
For nearly 20 years, student loan interest rates have been based on the
91-day Treasury-bill rate. The current formula is the 91-day rate, plus 2.5
percent while the borrower is in school and 3.1 percent during repayment.
The new formula would set rates at the 10-year Treasury bond rate plus 1
percent. Overall, interest to students would still be capped at 8.25
The new formula could cut interest rates to students by more than a
full percentage point.
While that may be good news for students, bankers say it would decrease
the returns they receive on those loans to the point where the $25
billion-a-year commercial student loan market would be unprofitable for
them. The new formula, they said, would also create unpredictability
because banks would have to pay higher short-term interest rates to attract
deposits but would be forced to lend at long-term rates that are often
"The way the formula is configured . . . does not provide sufficient
returns to lenders to entice them to stay in the program," said Scott
Miller, director of government relations for the Sallie Mae, which purchases
student loans from banks.
Lenders say the decision to link student
loan rates, which run a standard 10 years, to the 10-year bond rate was
made to address bookkeeping problems that arose from having them linked to
the 91-day T-bills. They point out that if the new formula had been used in
1993 and 1994, interest rates would have increased.
Democrats say the change was always intended to reduce interest rates
to students, based on projections that the gap between interest rates on
long- and short-term Treasury obligations would change.
"The information they [banks] are throwing out is an effort to confuse
and deceive," said a White House official who is working on the issue but
who asked not to be identified. "It's clear that it was intended as a
But even administration officials skeptical about the bankers' claims
admit that the changes in interest rates over the past five years are
greater than expected, causing a problem.
The Treasury Department is analyzing the situation. Administration
officials say they expect the department will recommend that Congress move
away from 10-year notes.
According to Sallie Mae officials, when the law was written in 1993,
interest on 10-year Treasury notes was 5.78 percent. Adding 1 percentage
point would have resulted in a student interest rate of 6.78 percent. At
the same time, the 91-day Treasury bill rate of 3.11 percent plus 3.1
percent would have produced a 6.21 percent rate.
Using Jan. 7 data, Sallie Mae officials said the 10-year rate was 5.55
percent. Adding 1 percentage point produced an interest rate of 6.55
percent. That compares with the current formula using the 91-day T-bill
carrying a 5.25 percent rate and the 3.1 percent add-on, for a 8.35 percent
interest rate. However, student rates are capped at 8.25 percent.
A recent report by the Congressional Research Service said that the new
formula increased the odds that the loan program would be unprofitable for
banks and could be "sufficient to remove some of them from the program."
At the same time, direct loans have captured only 30 percent of the
student aid market. Administration officials say the government would not
be able to pick up the slack if commercial banks back out. Already,
congressional critics point out, the Department of Education is having a
hard time managing the current direct loan volume, and Congress in 1997 was
forced to approve special legislation making it easier for students to
consolidate loans taken out under the direct lending program.
Lining up against the bankers are students
and colleges who would benefit, at least initially, from a cut in interest
rates under the new system.
They say they are willing to alter the formula to guarantee banks a
slightly larger return -- but insist the bottom line must be a reduction in
"We won't condone a bank fix that does so at the expense of the
interest rate reduction," said Becky Timmons, director of congressional
relations for the American Council on Education, representing colleges and
The battle comes against the backdrop of growing student reliance on
loans to finance college education. The College Board, which tracks higher
education trends, said in a September 1997 report that student loans now
account for 60 percent of federal aid, compared with 40 percent in
The Education Department estimates that students and their families
will take out nearly $32 billion in new loans for college in fiscal
"This is one of the top priorities for students," said Erica
Adelsheimer, legislative director of the U.S. Student Association. "We are
taking on overwhelming debt and the debt levels continue to rise with no
end in sight."
She estimated the new interest rate formula could mean $1,000 in
savings to the average student who takes on $14,000 in college debt.
Bankers respond that while students may profit now, historic data shows
that the relationship between long- and short-term rates is unpredictable.
They warn that students in the future could end up paying higher rates
under the proposed formula.
"For people to suggest that students are going to be benefiting from
this is absolutely a mistake," said Bill Hansen, executive director of the
Education Finance Council, which represents not-for-profit organizations
that purchase student loans from banks.
The issue has been simmering for months but is reaching a crisis point,
with colleges and lenders saying they need a decision by this spring when
they must put together aid packages for students for the 1998-99 school
Congress Tries To Respond
"I'm not convinced, I'm
open-minded," said Rep. Dale E. Kildee, D-Mich. "I want to make sure I take
care of the legitimate needs of lenders, if there are needs, but also the
needs of borrowers."
House and Senate lawmakers have been talking to banks, student groups
and colleges for months to determine the depth of the problem and find a
possible solution. Some suggested the sketchy outlines of a possible
Rep. Howard P. "Buck" McKeon, R-Calif., chairman of the House Education
and the Workforce Subcommittee on Postsecondary Education, Training and
Life-Long Learning, said he was open to finding an alternative that would
ensure a higher return to banks.
"I'm not coming from a love for banks, I'm talking about a concern for
students," McKeon said. "If [banks] stop making loans, that's bad for
To make an expected increase in interest rates palatable to students,
McKeon and other lawmakers hoped to reduce a 4 percent federal fee now
levied on students when they take out loans. The fiscal 1999 White House
budget also calls for reducing such fees, at a cost of about $1.4
billion over five years.
Congress had expected to have money to pay for such a reduction. That
is because the Congressional Budget Office had estimated that blocking the
July 1 interest rate change would save about $1.3 billion over five
The savings would occur because if the government keeps the formula,
based on short-term Treasury bills, it would collect higher interest for
the government's direct loan program.
However, CBO's most recent budget baseline, released last month,
changed the forecast for student aid spending. The new baseline assumes
that the government will have to make special payments, required by law, to
compensate banks for making loans at the capped rate of 8.25 percent even
though commercial interest rates may exceed that.
Partly because short-term interest rates are more volatile, under its
new methodology CBO now estimates that blocking the 1993 formula change
would cost $2 billion over five years.
The turnabout leaves lawmakers suddenly without the money needed to
soften the blow for students. They must either persuade congressional
budget committees not to include the projections in the fiscal 1999 budget
resolution or find spending cuts elsewhere.
The Clinton administration has begun to cautiously weigh in on the
issue. Acting Deputy Secretary of Education Marshall S. Smith said Feb. 2
that he wanted to resolve the matter by April.
Treasury Secretary Robert E. Rubin told the Senate Budget Committee
that he hoped to have a final report in "a month or two."
"I trust you and I don't want to hear later on that somebody held that
report up," said committee Chairman Pete V. Domenici, R-N.M. "There's going
to be nothing left for those who are not direct loan people."
© 1998 Congressional Quarterly Inc. All rights reserved.