Student Loan Subsidies Questioned

Students who need help paying college tuition bills this fall can get a federally subsidized loan that charges 3.37% interest -- not a bad deal.

The deal can be even better for lenders. The government guarantees some of them a 9.5% interest rate for the student loans they issue, no matter what rates the lenders themselves are charging. The difference, and therefore the federal subsidy, can be 6 percentage points.

“Taxpayers are being ripped off,” said Luke Swarthout, higher education associate with the U.S. Public Interest Research Group. “It is clear that no one is safeguarding the rules that are governing the student loan playing field.”

Education advocates have been attacking the system for years, to no avail. Their cause could be helped by a new report that says the number of loans covered by the 9.5% subsidy is growing at a rapid clip as some lenders aggressively exploit what critics call a loophole in the law.

The report by the Institute for College Access and Success Inc., a nonprofit education research organization, says there are $17.5 billion of the 9.5% loans outstanding, up from $12 billion at the end of 2002 and from $10 billion in 1998.

What makes the situation galling, the report says, is that Congress passed legislation in 1993 that was intended to phase out the 9.5% loans. Instead, the $17 billion in loans will cost taxpayers $6 billion in interest payments to lenders -- even more if the government doesn’t act quickly to end the program.

“This is an enormous waste of tax dollars that could have been put to better use,” said Robert Shireman, director of the Institute for College Access and Success and coauthor of the report.

The government guarantees a return on most every student loan issued in the country, and in most cases that guarantee results in little or no subsidy payment to the lender.

The 9.5% guarantee was created by a law passed in 1976 -- when U.S. interest rates were in the double digits -- to ensure that there would be enough college loan money for all eligible students. The law encouraged states to issue tax-exempt bonds to fund student loans.

Originally, the 9.5% loans could be issued only by nonprofit state agencies. Over the years, however, many of these were taken over by for-profit companies that then were able to take advantage of the guaranteed 9.5% rate.

Meanwhile, interest rates plummeted. Congress tried to repeal the 9.5% law in 1993 but included a grandfather clause: Loans financed with pre-1993 tax-exempt bonds would continue to get the 9.5% rate.

The government expected the loans to slowly dissipate; instead, they’ve grown. The reason, Shireman said, is that the Department of Education issued a directive aimed at clarifying the law that instead opened a gaping loophole.

The directive allows lenders to “recycle” new loans into old tax-exempt pools, Shireman said.

That process gives these newly issued loans the favorable subsidy, even if they remain in the tax-exempt pool for only a day, Department of Education officials confirmed. That allowed lenders to issue billions in new loans, and briefly cycle them through the tax-exempt pools. When the loans were pulled out of the pool, they still would be eligible for that favorable 9.5% subsidy.

Officials at several student loan companies said several efforts to close the loophole had been launched since the mid-1990s, only to quietly die.

The report by the Institute for College Access and Success urges the Department of Education to take steps immediately to close the loophole, which the report conceded may require emergency action by Congress. A delay of even six months could cost the government an additional $2.8 billion in interest payments to lenders, over the $6 billion that it’s already committed to spend.

Sally Stroup, assistant secretary for the office of post-secondary education at the department, said immediate action was out of the question because of the need to publish the proposed rule and await public comment, a process that can take two years.

Stroup said the Department of Education agreed that the rules should be changed but said the best way to accomplish that quickly was through federal legislation. She noted that a provision that would eliminate the 9.5% loans was included in the Higher Education Act Reauthorization bill, which is slowly wending its way through Congress. The bill isn’t expected to pass until 2005.

“We are taking a lot of criticism about not doing this on our own,” Stroup said. “But the way the process works normally takes two years anyway. We thought the Higher Education Act would be passed by then. Now they’re beating us up because that has not happened.”

Another option would be for Congress to pass urgency legislation, stripping this provision from the bigger bill to pass it quickly on its own, Shireman suggested. A spokeswoman for the House Education and Workforce Committee, which is working on the Higher Education Act, said that wasn’t likely to happen either.

“If you tried to strip this bill down piece by piece, you’d end up with thousands of provisions,” said Alexa Marrero, a committee spokeswoman. “All of the reforms in the bill are important. I’m not sure that there is any move to split off pieces when they are all ways to prioritize students and expand access.”

The biggest beneficiary of the 9.5% loan program is a Lincoln, Neb., lender called Nelnet Inc., according to the Institute for College Access and Success report. The company, which bought the nonprofit Nebraska Higher Education Loan Program in 1998, started recycling 9.5% loans in earnest last year, after asking the Department of Education to confirm that it was legal to recycle the loans, according to exhibits filed with the report.

The government ignored the letter for more than a year, during which time Nelnet billed for -- and was paid -- millions in subsidies, the report says. The company’s volume of 9.5% loans rocketed 818% during that period. Still, Nelnet said in financial statements to shareholders that it would defer recognizing these interest payments until it got affirmation from the Department of Education that its government subsidies would not be rescinded. That affirmation came in a brief letter issued in June.

Nelnet’s stock and earnings soared on the news. The stock went up 20% and the company paid its employees $20.7 million in bonuses, according to the report. Nelnet’s profit in the first six months of 2004 was $94 million, up from $17.9 million in the first half of 2003, primarily as the result of recognizing $79 million in government subsidy payments that had previously been deferred.

Don R. Bouc, Nelnet’s president until last July and now president emeritus of the company, has publicly endorsed legislation to close the loophole that made his company a fortune.

In a statement, the company explained its rationale: “While Nelnet has been the beneficiary of such earnings, the company was the first to propose a change in the provision, with the resulting savings used to expand available student aid.”

Company spokesman Ben Kiser declined to comment beyond the statement.