Borrowed Trouble : Ineptitude Causes Biggest Mess Ever in Student Loan Program

Last spring, Joseph Pierz received 12 warnings in three months telling him in so many words that he was a deadbeat.

Letters sent to the McDonnell Douglas senior safety engineer warned him that he was “seriously delinquent” in paying off his 7-year-old, $3,000 student loan, even though he was not. A loan collector even telephoned Pierz’s aunt and uncle in New Jersey one Saturday morning asking where he could be found.

One letter the Lakewood resident received in May ordered him to pay his next installment the previous March.

“It got to the point where I didn’t want to look in my mailbox,” he said.

Pierz’s problem was caused by the improper “servicing” of his government-guaranteed student loan by an Encino company, United Education & Software. The company later acknowledged in a letter that Pierz had been making his $35.13-a-month payments and blamed the mistake on a computer software glitch.

At the time, United Education was the fastest-growing servicer of student loans in the nation, tracking more than $1 billion in loans for clients via computer and pestering delinquent borrowers with telephone calls and letters.

United Education’s servicing problems went far beyond Pierz’s account and faulty computer programs. Last summer, a review of its operation by the U.S. Department of Education and other agencies uncovered the biggest mess ever in the nation’s student-loan program, one that a federal report said “caused immeasurable hardship to hundreds of thousands of borrowers” such as Pierz. The fiasco may cost as much as $650 million to straighten out, according to one estimate.

One borrower’s $2,500 loan was listed as $25,000 for a year before the mistake was fixed, according to the federal report. Letters containing loan-payment checks were returned to borrowers unopened, the report said, and notices to pay sometimes were mailed to non-existent cities such as Radio City, N.Y., and Bacon, Ind.

Thousands of calls that United Education said it made to delinquent borrowers were not substantiated by telephone records, according to the report. Thousands of letters that United Education claimed were mailed were never sent. Hundreds of drawers were discovered with documents inside waiting to be filed, some of them three years old. In one warehouse, authorities said, 25 boxes were found containing 100,000 documents, much of it unopened mail.

“This is the worst problem we have had with (loan) servicing ever, by far,” said Dewey Newman, the U.S. Department of Education’s deputy assistant secretary for student financial assistance.

$1.1-Billion Portfolio

As the fiasco continues to unravel, the most puzzling question for federal and state student-loan officials is how United Education got so much business so fast when it later proved to be so inept.

In 1984, the company was a sleepy chain of vocational schools with a small unit that serviced $22 million in student loans. By early last year, it was servicing 700,000 student loans worth $1.1 billion from what it described in a report to the Securities and Exchange Commission as a $1-million, “state of the art” loan-service center in Costa Mesa.

“The operation was in total confusion and disarray. No way do you do a billion dollars of servicing with this bunch,” said an Education Department official--speaking under the condition that his name not be used--who has thoroughly examined United Education’s loan-service operation since last summer.

State and federal officials are troubled by the close ties found among a Sacramento trust company that is one of the most aggressive lenders to vocational-school students, a nonprofit corporation called the California Student Loan Finance Corp. in Los Angeles, which bought the loans with money raised by selling bonds, and United Education, which was hired to service them.

About $750 million in student loans--nearly 70% of the $1.1 billion worth that United Education was handling--were first made to students by First Independent Trust of Sacramento, according to interviews and documents.

Those loans were bought--immediately after they were made--by the nonprofit California Student Loan Finance in Los Angeles, which turned them over to United Education for servicing. What troubles state and federal officials further is that United Education’s chief executive, Aaron Cohen, is a close friend of the president of California Student Loan Finance, Jay Olins.

As the loans flowed from Sacramento to Los Angeles, the amount handled by United Education soared, growing on average by $40 million a month. Ultimately, state and federal officials believe, the system overheated.

“It was a meltdown,” said Fred Brill, staff services manager for the California Student Aid Commission, a state agency that administers federal student-loan programs.

Many Vocational Students

United Education executives argue that the computer software problem is to blame. In late 1987, the company installed a powerful IBM 38 computer and upgraded its software to keep up with its growing workload. The software, written by employees and consultants, turned out to be full of bugs, the company said.

“I trusted people to do a job, and they didn’t do it,” Cohen said.

United Education is no longer in the loan-service business, but the fallout from that operation continues to be felt.

Unlike Pierz, who used his student loan to earn a bachelor’s degree in business administration at the University of Southern California, most of the borrowers whose loans were serviced by United Education were former vocational school students.

Vocational students attend schools to learn such skills as fixing cars, taking shorthand and cutting hair. More than a third of vocational school student borrowers default on their loans, according to federal statistics.

Because of United Education’s servicing problems, most of the student borrowers who default will never be found or made to pay. Taxpayers normally would be stuck with the bill because the federal government promises lenders that it will make good on student loans that go bad. But U.S. Education Secretary Lauro F. Cavazos has vowed that taxpayers will not have to pay for United Education’s mistakes.

That leaves on the hook some of the world’s biggest banks--Citicorp and seven Japanese banks among them--with various roles in backing with letters of credit the bonds that were issued to buy the student loans. Also on the hook is Bank of America, which was trustee for those bonds. Last month, the bank estimated that it and the other banks could lose from $450 million to $650 million as a result of the fiasco.

The fiasco has strained relations between Bank of America and the Japanese banks--Mitsubishi Bank, Industrial Bank of Japan, Bank of Tokyo, Mitsubishi Trust and Banking, Fuji Bank, Dai-Ichi Kangyo Bank and Sanwa Bank. They are considering suing Bank of America for its role as trustee.

A spokesman for Dai-Ichi Kangyo said the bank sees “the entire responsibility resting with Bank of America” for failing to supervise United Education. Bank of America said it is was not to blame for the errors and that it has strong legal defenses.

It is ironic that so much money may be lost on what is a tiny business for the banks. Student-loan sources said banks supplying letters of credit probably make a fee of $300,000 to $400,000 for every $100-million bond issue.

Bank of America would not comment on what it makes as trustee for the bonds, but two federal sources said they understand that it may have been as little as $100,000 a year. The bank earns its money primarily by making sure that bondholders get their interest and principal payments. One high-ranking Education Department official described it as “shuffling papers.”

Increases in Defaults

Requiring the banks to shoulder the loss worries some lenders and educators. They argue that students, particularly low-income ones attending vocational schools, will find it hard to get loans because reluctant banks will not want to get involved now that they know the huge risks.

Citibank, the main unit of Citicorp, recently tightened its credit in a way that makes it more difficult for students at vocational schools to get loans. The move was a reaction in part to the United Education fiasco and to increases in defaults at some schools.

However, Education Department officials argue that government-guaranteed student loans are still good business for lenders. They accuse the program’s doom-sayers of exaggerating the fallout from the United Education fiasco to pressure federal officials into picking up a share of the cleanup costs.

Few have done more business in student loans than First Independent Trust, the Sacramento company. In the past 10 years, according to state Banking Department figures, the company has made more than $1 billion worth of government-guaranteed student loans, more than such California giants as Bank of America, Security Pacific and Wells Fargo.

In 1986, the number of student loans that First Independent made exploded because it began aggressively making them to students at vocational schools outside of California. In two years, it made more than $500 million in out-of-state student loans.

Deno Evangelista, chairman of First Independent Trust, said the company makes student loans because he believes strongly in education.

“I come from the coal mines of Pennsylvania. I know what it means to owe your soul to the company and that without an education you are in trouble,” he said.

But student loans are also good business for First Independent, which makes most of its money from loan-origination and other fees. Because the government guarantees the loans, it is normally a low-risk investment for the lender if it can find a buyer for the loan.

Student-loan officials are uncomfortable with the aggressive way First Independent has gone after student-loan business. Two years ago, Education Department officials criticized an arrangement by which First Independent supplied vocational schools with free computer equipment and software that linked the schools’ financial aid offices with First Independent offices.

Federal regulations considered the arrangements a gift that might influence financial aid offices to send students to First Independent to get their student loans. First Independent argued that the equipment was simply intended to provide a convenient link between the financial offices and its own system.

Education Department officials disagreed, saying the computers could be used for much broader work, such as bookkeeping, and told the company to start charging the schools fees.

Bonds Sold to Buy Items

The pipeline of loans led from First Independent to California Student Loan Finance, a nonprofit corporation founded in 1980 by cities and counties as a “secondary market” for student loans, mainly a place where lenders could sell loans of less than $3,000 made to students in vocational schools and community colleges in California. Without a place to sell the loans, lenders would be reluctant to make them.

The nonprofit corporation, which has bought nearly $2 billion in student loans since it was founded, raises money to buy the loans by selling bonds, mostly ones earning interest that is exempt from state and federal taxes. The investors are paid back as students pay off their loans. Large banks back the bonds with letters of credit, which assures investors that principal and interest payments will flow to them smoothly.

Under state rules, California Student Loan Finance cannot turn down an in-state student loan that a lender wants to sell it, but it can turn down an out-of-state loan. In 1986, the same year that First Independent began making huge amounts of out-of-state loans, California Student Loan Finance began buying them.

Olins, the president of the corporation, said buying more loans made sense because it would give the corporation clout to negotiate such things as lower fees for servicing and letters of credit. He added that First Independent was its best in-state supplier of loans as well and that he feared it might sell its loans to another buyer if the corporation refused to buy its out-of-state business.

Samuel Kipp III, executive director of the California Student Aid Commission, the state’s student-loan monitoring agency, said he was led to believe by Olins at that time that the corporation was going to buy out-of-state loans in a small way so it could use up some money raised in an old tax-exempt bond issue.

Instead, Kipp said, it bought more than $500 million in loans from First Independent that were made out of state. Kipp said he believes that a good share of that money was raised by selling tax-exempt bonds, although he has not determined how much yet. Olins said little money from tax-exempt bonds was used, probably $50 million to $75 million.

10-Year Agreement

Nearly all of the loans that First Independent made and sold to California Student Loan Finance were handed over for servicing to United Education. The nonprofit corporation virtually was United Education’s only customer, providing the company with 97% of the $1 billion in student loans it serviced, Securities and Exchange Commission documents show.

Early last year, before the loan-service problems surfaced, United Education and California Student Loan Finance signed a 10-year agreement in which United Education would receive more than $100 million to service the loans.

No one has alleged that any of the servicing agreements were illegal or violated procedures just because Cohen and Olins are close friends. Officials said student-loan regulations do not address such relationships.

But the close friendship between the two men bothers a number of federal and state student-loan officials because they think that the relationship may explain why United Education was getting so much business that many student-loan officials now believe it could not handle.

“They are best friends, and I think that’s pretty close. Had the volume not increased dramatically, there would have been no reason to change to a new computer and software,” Kipp said.

Newman, the Education Department deputy assistant secretary, said potential conflicts of interest such as the kind raised in the United Education case are of concern especially because so much taxpayer money is at risk if the loan-service company does a poor job.

“I’d rather have a bright white line between those parties where there is federal money involved,” Newman said.

Both Cohen and Olins acknowledged in separate interviews that they are close friends but denied that the big increase in business stemmed from their friendship.

Cohen said contracts were reviewed thoroughly by lawyers for both United Education and the corporation. Olins said he has always distanced himself from negotiations that involved United Education because of his friendship with Cohen. He said the main reason the corporation did business with United Education was that the company was willing to sign a long-term contract.

Stock Was Hot

Last November, United Education agreed to turn over the loan-service operation to Bank of America in exchange for being released from future claims by the banks involved. Education Department officials confirmed that the department’s inspector general is continuing to investigate the problems to determine whether anyone committed fraud by knowingly submitting faulty student-loan information to the government.

Despite the huge volume of loans that United Education handled, loan-servicing accounted for only about 10% of the company’s overall revenue of about $100 million a year, with the rest coming from its vocational schools.

Nonetheless, the company’s stock, one of the hottest over-the-counter issues in late 1987 and early 1988, has been hammered in the wake of the disclosures about its problems, falling to slightly more than $2 a share now from more than $16 a year ago. Three lawsuits have been filed by shareholders alleging that the company inflated its stock price by failing to disclose the problems soon enough. United Education denies the allegations.

One question that has been difficult to answer is why the servicing problems took so long to spot. Olins of California Student Loan Finance said it was “just beneath the surface” and was not easy to see.

Cohen said each time one problem was fixed in the computer software, it usually caused another. He blames himself for not discovering the problem sooner but said the Costa Mesa operation was 50 miles from his office in Encino and difficult for him to track closely. He said he fired executives who ran the center.

So far, the answers have not satisfied student-loan officials. With the problems as widespread as they were, they argue, someone should have known and told loan officials immediately.

“If they had been more forthcoming earlier, people could have come in and helped straighten it out and there would have been far less damage,” Kipp said.

Times staff writers James F. Peltz in Los Angeles and Karl Schoenberger in Tokyo contributed to this story.