Federal Reserve Chairman Ben Bernanke says the government’s biggest student loan program, the Federal Family Education Loan (FFEL) program, is poorly designed. His suggested solution sounds a lot like an endorsement for an auction. In a letter to Sen. Chris Dodd (D-CT) on Federal Reserve action to help student lenders weather credit market turmoil, Bernanke notes that the structure of the FFEL program is problematic.
Bernanke writes:
The other side of the profitability equation--the reimbursement spread paid to lenders under this program--is under the control of the Congress and the executive branch. In particular, Congress may well wish to revisit the question of whether setting a fixed spread over the commercial paper rate is the best approach. You may decide that a more market-sensitive approach--flexible enough to provide a wider spread during times of market stress and a narrower one during normal times--could provide a more robust structure.
Here is what’s behind Bernanke’s assessment of the FFEL program and his suggestion for a "more market sensitive approach."
Two Parts to the FFEL Profit Equation
Turmoil in the credit markets has markedly increased the cost of capital for FFEL lenders, capital that they use to make student loans. Even though the loans are virtually risk free (they are guaranteed and subsidized by the federal government) the credit markets currently are demanding a hefty premium for capital compared to what was charged in the past. But while financing costs for student loan providers are problematic, they are only one side of the equation when it comes to the profitability of a FFEL loan. The other side is the subsidy paid by the federal government.
The federal government guarantees lenders an interest rate on all FFEL loans that is equal to a variable short-term market interest rate (three month commercial paper) plus a premium of 1.79 percentage points. Right now that rate equals about 4.5 percent, but fluctuates each quarter based on commercial paper interest rates. More information on this subsidy is available here.
In the past, the interest rate subsidy was sufficient to induce FFEL lenders to make loans. The cost of raising capital was low enough that the guaranteed interest rate paid on the loan produced a spread. For example, in the past a lender could borrow at 5.5 percent to make a loan, and then collect a guaranteed 7.5 percent rate by the federal government. The 2.0 percentage point spread was enough to cover the lender’s costs of origination, marketing, and leave a nice profit after taxes.
Today, however, the lenders’ cost of raising money has reduced the spread, and some lenders say it has eliminated it. As a result, lenders say that they may not make loans this fall.
FFEL Design is Risky and Wasteful
No one should be surprised. Congress has designed the FFEL program in a way that makes it susceptible to such disruptions. The guaranteed interest rate paid on the loans is arbitrary, made up by Members of Congress, and fixed in law. Some years that rate is too generous, heaping windfall profits on lenders and wasting taxpayer money. Other years, it may not be high enough to induce any lender to make loans.
What’s the solution? Well right now lenders and Members of Congress are coming up with all sorts of schemes to allow lenders to raise funds at lower, taxpayer-subsidized rates, which is intended to increase the spread lenders earn on a FFEL loan.
Use an Auction a la Ben Bernanke
Why not take Bernanke’s approach instead? Let a market set the guaranteed interest rate that the federal government pays lenders. If financing costs spike, as they have now, then the subsidy paid to lenders would adjust accordingly, ensuring a profitable spread. In less volatile years, the rate could adjust lower to ensure taxpayers weren’t paying more than they needed to fund the FFEL program.
To read more, please visit www.HigherEdWatch.org