U.S. Won’t Bend Student Loan Rules; B of A Fears Big Losses

The parent company of Bank of America said Wednesday that the federal government has refused to relax regulations covering $1 billion worth of loans in the most expensive foul-up in the history of the student loan program.

The action essentially voids federal guarantees on the loans and leaves Bank of America and several other major banks vulnerable to losses estimated by the bank at $450 million to $650 million.

Those losses are likely to affect some of the world’s largest banks and may cause banks to reconsider their participation in the federal loan program, which provides about half of all financial aid to post-high school students in the United States.

Education officials expressed concern Wednesday that it will become more difficult for students nationwide to obtain financial aid. They said the impact is potentially most serious on students attending community colleges and vocational schools.

Processing Mistakes

“I’m very much concerned about the impact on the student loan program throughout the United States,” said Samuel M. Kipp III, executive director of the California Student Aid Commission, whose compromise plan was rejected by the federal government. “The impact can only be a profound reduction in access to post-secondary education.”

The concern stems from the U.S. Department of Education’s refusal to bend its rules and have taxpayers pick up the tab for massive processing mistakes by an Encino firm in handling $1 billion worth of student loans.

The refusal came despite intervention on behalf of the San Francisco-based bank by several California politicians, including Sen. Pete Wilson (R-Calif.), and concerns voiced by educators across the country.

In a letter to A. W. Clausen, BankAmerica chairman and chief executive, Education Secretary Lauro F. Cavazos said his responsibility to protect the taxpayers and the integrity of the federal student loan program meant that guidelines on the guarantees could not be altered.

The letter, dated Monday, followed a Jan. 31 meeting in Washington arranged by Wilson at which Clausen presented the bank’s case to Cavazos and other top department officials.

At issue are hundreds of loans to students, mostly at vocational schools, guaranteed originally by the federal government. About 40% of the loans were to students in California.

Bonds backing the loans were sold on the secondary market. Bank of America served as trustee for the bonds, which meant it has responsibility to assure that the bondholders are paid off and that the loans are serviced properly.

A consortium of big banks, including New York’s Citicorp and the world’s two largest banks, Japan’s Dai-Ichi Kangyo and Fuji Bank, provided letters of credit to back the bonds. The letters of credit require the banks to provide their own funds if collections on the loans are insufficient to pay the bondholders.

A chief cause of insufficient revenue is the failure to students to repay loans, and vocational schools have notoriously high default rates. But the lenders are normally protected because the federal government promises to provide funds for bad loans.

Computer Failure Blamed

However, federal regulations set out specific steps that must be followed in attempting to collect bad loans in order for the guarantee to remain in effect.

In this case, United Education & Software of Encino was hired to service the loans, including taking the required steps to seek repayment on delinquent loans. Last summer, a federal examination of United Education uncovered serious flaws in its compliance with the collection rules.

United Education and Bank of America blamed the problems on a massive computer failure at the firm. Bank of America ultimately bought out United Education and hired another company to process the loans.

But the Department of Education, after months of negotiations with the bank and California student loan officials, said the problems were so grave that its guarantees would not be honored.

The decision was conveyed to the bank on Jan. 30 and the next day Clausen met with Cavazos and others in Washington in an attempt to persuade them to change their ruling.

Funds to Cover Loans

Kenneth D. Whitehead, an assistant secretary of education who attended the meeting, said Clausen argued that the regulations were meant for routine errors and should not cover a massive computer failure. He also argued that the bank’s shareholders would be hurt if the department did not reverse its decision.

“The secretary carefully considered this and all the facts, but concluded that the integrity of the program and the interests of the taxpayers obliged him to maintain the regulations,” Whitehead said.

That means that the banks that issued the letters of credit will have to provide the funds to cover the loans without any federal repayment. Those banks have already indicated that they intend to try to recover any losses by suing Bank of America for what the other banks consider to be negligence in administering the program.

In a statement issued Wednesday, B of A said the estimated losses of $450 million to $650 million include loans that are never repaid, the costs of trying to collect delinquent loans and the bank’s legal costs.

The bank set aside about $80 million in the fourth quarter of last year to cover expected losses in the program and said Wednesday that an unspecified additional amount will be added to the reserves as a result of the government’s decision. The bank said its 1989 earnings should not be affected.

Bank of America said it believes that it has fulfilled its obligations as administrator of the program and will defend its actions in court. The bank said it expects lawsuits to drag out over several years.