Tuesday, May 01, 2007

The Case for Subsidized Loans

The Washington Post prints a long letter from my favorite student-loan industry mouthpiece, Kevin Bruns of America's Student Loan Providers, in response to the excellent April 23 editorial "Lender's Paradise." He's often found sending me gently scolding emails and I think once or twice in the comments section on this blog. Hi Kevin!

Kevin provides a 3 point argument for maintaining the status quo on FFEL.
In order from most valid to least:
1) "The private sector has been responsible for major technological and service innovations in the federal student loan program. "
This is true. It's hard to get federal bureaucracies to invest in the latest technology. However, this is exactly where competitively bid servicing contracts come in.
2) "Since 1965 Congress has understood that it's unreasonable to expect well-run financial institutions to lend at below-market interest rates to individuals with no credit histories, income, collateral or cosigners...Without the subsidies, we would not have a low-cost, private-sector-based program. "
That was true in 1965. But now major financial institutions will lend money to your dog at a zero percent introductory rate, and private student loans, which require none of the above and have no federal subsidies, are the fastest-growing sector of the student loan business. Clearly, they can and they will.
Also, this whole "involving the private sector is always better regardless of bloat, cronyism, or just plain incompetence" line smacks of W's first term. I thought we were all disgusted with that by now. Remember what a fine job Halliburton did rebuilding Iraq?
Which leads us directly to the worst point,
3) "because loan providers compete with one another, borrowers typically save thousands of dollars. In fact, federally guaranteed loans are the lowest-cost student loans available."
In fact, the vast majority of loan providers do NOT compete on price. (MyRichUncle is a notable exception.) They charge the federal maximum. That's because they didn't have to discount--they just "induced" schools to put them on the preferred lender list, and business followed. Now that there's more noise about the fact that you do have the right to shop around, all of a sudden there are some discounts on offer, as the Austin American-Statesman reports:

"Student lender Nelnet Inc. said borrowers who take out new Stafford loans after July 1 will be able to get a rate cut of 1 percentage point if they sign up to have their payments automatically debited from their bank accounts, up from the current 0.25 percent discount.
Citigroup Inc.'s student lending unit said it will automatically drop its rate 1 percentage point once students start repaying their loans, typically after graduation."

Real competition is great for students, and reducing subsidies will create real competition.


Anonymous said...

Anya, I am honored to be given such gracious recognition, although I bristled some at your nickname for me. Although, I guess, we're all mouthpieces in some way or another, right?

Let me address your points in the order you made them.

1) The ideal, you would at least partly agree, would be a loan program that attains the highest levels of both technological and service innovation and price competition. It's doubtful a system based entirely on the government contracting out loan servicing, which I think is what you're suggesting, would have attained the level of innovation students now enjoy. Would the Postal Service be the equal of Federal Express today had it contracted out all of its overnight delivery services? Ultimate responsibility for keeping customers satisfied would still have rested with a less dynamic, less nimble agency.

2) The argument for lender subsidies remains, and the terms in the private loan market make our case. Donald Trump's dog might be able to get a private student loan at zero percent, but not your typical student from a low- or middle-income family (some don't qualify at all). Private loans typically carry higher interest rates and higher fees and are subject to loan underwriting requirements, such as a good credit history, cosigner, etc.

The argument that the private sector is always better is a straw man. It's not. There are some things the government, with all of its limitations, does better, just as there are some things that the private sector, with its limitations, does better.

One thing that FFELP does better than the Direct Loan program is offer borrowers a choice of lenders.

3. Two points I'd like to make:

First, the cost of a student loan to a borrower involves at least two elements: the interest rate and the upfront fees, both set by Congress. If a lender offers a discount on the upfront fees (in other words, pays it for the borrower), the lender is competing on price, even if it charges the maximum rate. Many loan providers, if not most, pay some of the upfront fees. (MRU I believe charges upfront fees of 2 percent or more.)

Second, many lenders, if not most, offer to knock a quarter or a half a percent or more off the interest rate for paying electronically or having a good payment record. That may not look like price competition to you, but it is.

The price competition on interest rates which you cite underscores the consumer benefits of a program that offers students a choice.

Anonymous said...

Before direct lending, the levels of technological innovation, service innovation, systems standardization, and price competition in FFEL were quite low. This was discussed in many venues, including WSJ/Smart Money in the early 1990s. Who's to say whether things would not return to 1994 when direct lending is gone?

As far as price competition, no one can come up with any examples before the existence of DL, except perhaps an occasional ontime repayment benefit that Sallie admitted to the Treasury less than 19% of borrowers would ever achieve.

The threat to charge borrowers different interest rates based on race and other socioeconomic status criteria is a scare tactic. Every time an auction study comes around, lenders try to scare the schools by using that red herring. At most, the special allowance would float with the market, but, as this is a social program, there is a long-term consensus that the borrowers should not have different terms, conditions and benefits. That said, what is the difference between discriminating against borrowers by SES and allowing borrowers to Shop Around for The Best Deal. As CBO has pointed out, if we are guaranteeing the borrower an interest rate of 6.8 percent, we are quietly telling the Stanford student who would get 4 percent rate in the free market that she has to pay 6.8 percent so that the trade school borrower who would pay 12 percent in the free market can get the equal benefit of the 6.8 percent interest rate. If we are saying this is a social program, then it is not the same as getting a car loan -- choice of lenders should not be in the Top 100 list of priorities one cares about in a welfare program, unless we are truly going to get more comfortable with openly allowing lenders to establish different sticker prices based on school and borrower risk.

DL was not the only factor in emergence of FFEL borrower benefits in the late 1990s. It was partly related to unanticipated side effects from the changes to the guaranty agency financing system in the 1998 higher ed amendments.

If choice is a new feature of the student loan programs that the taxpayer must now shoulder, then be open about it. The taxpayer will be interested to hear that some lenders have chosen to redistribute some of her hard-earned money to reduce the fees for certain lucky borrowers. To the Beltway inside player that may sound like a great deal, but to the average taxpayer that sounds like a solid argument that subsidies are way too high and should be reduced, with the proceeds from said reductions used for a program-wide benefit that all FFEL borrowers could qualify for, cutting out the exertion and the so-called Shopping Around by students and FAAs. If that is too complex, then just use the money to accelerate the phase-out of origination fees. And loan limits haven't kept up with inflation, so maybe some of the money should be used to increase loan limits.

Most people believe they can beat the market. This is why only a minority of investors choose index funds. In the case of the student loan programs, they are using taxpayer funds to indulge this aim. Shouldn't we be concerned that one student got one deal while the one next door Shopped Around for a better deal? Is this now the top priority of a loan program originally set up to improve access to postsecondary education?