Making School Loans Worse
by John Berlau

The current federal student loan programs are a mishmash of subsidies and regulations that cause distortions, not the least of which is to raise the sticker price of tuition significantly more than it would be otherwise.

This doesn’t mean that it’s not possible for the student aid system to get worse — even much worse. To Sen. Ted Kennedy, D-Mass., who is once again chairman of the Senate Health, Education, Labor & Pensions, or HELP committee (a misnomer for a political body if there ever was one), the problem isn’t the fact of government interference, but the fact that private banks are still involved at all. He wants to make student loans a 100 percent government-run system, because he and others claim that this would save money by knocking out the middleman. So in his recently introduced Student Debt Relief Act of 2007, which is co-sponsored by fellow Democratic Sens. Barack Obama, Barbara Mikulski, Chuck Schumer, Dick Durbin, and independent Joseph Lieberman, the government would basically bribe schools with extra federal aid to paticipate only in the Direct Loan program, rather than have subsidized dealing with private banks.

But we only need to look at the history of this “direct” loan program to see that Kennedy’s plan would result in massive waste as well as burdensome red tape for students and parents trying to finance a college education.

When signed into law by President Bill Clinton in 1993, “direct lending” of student loans to college students was sold as a way to actually make money for the government by cutting out the “middleman,” Since the 1960s, the government has subsidized banks and other firms that lend to students to make student loans more affordable. Clinton and other advocates argued the government would spend less money and could even profit if it made the loans and collected the interest itself.

Direct lending’s defenders, such as Clinton’s former education aide Robert Shireman, point out that Congress and the Bush administration still score direct loan cost estimates as costing less than subsidized private loans. But the key word is cost estimates, and for the past decade the estimates have been wrong. On a cash flow basis, Congress’s General Accounting Office has found that the program has actually lost $10.7 billion for the government from 1995 to 2003. This is largely because the Department of Education loaned money to students at a lower rate of interest than it costs the government to borrow money to finance its spending.

In a report from 2005, Elizabeth Wright, a vice president of Citizens Against Government Waste, details some of the reasons why. If the government were to charge higher interest rates, it would defeat the purpose of providing affordable student loans. Private lenders, however, while protected by the government against default, take on the risks of interest rate risks themselves. They have charged around the same interest to students as the government, while bearing resposibility for the costs of that specific risk.

The bottom line is that in the ten-year time frame direct lending has been in existence, the costs of direct lending have been coming in higher than their estimates and have been increasing, while subsidized loans have cost the government less than their estimated costs. The White House budget for fiscal year 2006, the same one that estimates that direct lending will be cheaper, reports that direct lending has cost the government $7 billion more than intially predicted over the last decade, while subsidized loans have cost the government $5 billion less than they were estimated to.

Since there are different numbers of schools and students in the programs (and more in subsidized loans, both because it’s older and schools say they find it easier to work with), it’s difficult to compare costs. However, a study by American Student Loan Providers, an industry group, did find that costs as a percentage of outstanding loans were less for subsidized loans for every year the two programs were in existence except one (and that year was close to a tie). For 2004, the cost was over 3 percent for direct lending, and less than 1 percent for subsidized loans.

Direct lending has also failed in its promise to greatly reduce default rates. Clinton Administration officials actually predicted there would be no defaults with direct loans. Yet Department of Education statistics show a projected default rate above 15 percent for direct loans in 2005. The rate for subsidized loans, by contrast, was a slightly lower 13 percent.

One even more interesting aspect, direct lending really isn’t direct. It hires contractors to help collect the loans and build its computer systems, going against its stated promise of cutting out the “middleman.” The only middlemen its cuts out are the banks.

So, in a nutshell, critics have said that subsidized loans were wasteful because banks were on the hook for only part of the loan. To an extent, they’re correct. But longtime government waste experts such as Wright point out it will likely be even more wasteful when the government is on the hook for 100 percent of the loan.

There is also the issue of unnecessary red tape. As with many situations in dealing with the government directly, schools have found service from the government to be less than they desired. The reason schools, with both programs to choose from, have stayed with the banks is that the banks’ offer the private sector’s level of service. Some 600 schools have stopped participating in direct lending, and survey of schools cite poor service as the primary reason.

So if we were to make federal student loans totally government-run, we would also lose the innovation that private firms can show in servicing their customers even in situation that’s not the free-market ideal.

Expansion of tax-favored education savings accounts like 529s would be a great way to help students and parents with college costs. The tax benefits would go solely to parents and students, without encouraging tuition hikes at schools. So while we’re debating free market reforms for the existing student loan programs, free-market advocates must make sure that the program doesn’t take even more giant steps toward total government control.

John Berlau is director of the Center for Entrepreneurship at the Competitive Enterprise Institute. He is the author of Eco-Freaks: Environmentalism Is Hazardous to Your Health.