CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

A

S T U D Y

MARCH 2010

Costs and

Policy Options for

Federal Student

Loan Programs

CBO

© JupiterImages Corp.
Pub. No. 4101
The Congress of the United States O Congressional Budget Office

A

STUDY

CBO

Costs and Policy Options for 

Federal Student Loan Programs

March 2010
CBO

Notes

Unless otherwise indicated, the years referred to in this study are federal fiscal years (which 

run from October 1 to September 30). In several instances, statistics are given for calendar 

years or for academic years (which run from July 1 to June 30). Federal laws and regulations 

governing higher education frequently refer to academic years.

Numbers in the text and tables may not add up to totals because of rounding.
Preface

CBO

The federal government helps students finance higher education through two major loan 

programs—one that guarantees loans made by private lenders and one that makes loans 

directly to borrowers. The two programs offer similar types of loans on similar terms to borrowers, but they differ significantly in how they are funded and administered. Those differences cause the guaranteed loan program to have a significantly higher rate of federal 

subsidies—as calculated for the federal budget under the rules of the Federal Credit Reform 

Act—than the direct loan program has. However, such subsidy-rate estimates do not include 

the costs to taxpayers that stem from the risks involved in making student loans, nor do they 

include federal administrative costs (which are recorded separately in the budget). Morecomprehensive, fair-value estimates, which include such costs, indicate higher subsidy rates 

for both programs, although direct loans continue to show a marked cost advantage over 

guaranteed loans.

This Congressional Budget Office (CBO) study—prepared at the request of the Ranking 

Member of the Senate Budget Committee—compares the budgetary and fair-value costs of 

the federal student loan programs. It also looks at several options for modifying those programs, including eliminating the guaranteed loan program after July 1, 2010, and expanding 

direct lending. In keeping with CBO’s mandate to provide objective and impartial analysis, 

this report makes no recommendations.

The study was written by Deborah Lucas, CBO’s Associate Director for Financial Analysis, 

and by Damien Moore of CBO’s Macroeconomic Analysis Division, under the direction of 

Robert Dennis and Kim Kowalewski. Deborah Kalcevic of CBO’s Budget Analysis Division 

produced some of the cost estimates, under the direction of Peter Fontaine and Sam Papenfuss. Justin Humphrey provided helpful comments on earlier drafts, as did Janice Eberly of the 

Kellogg School of Management at Northwestern University. (The assistance of an external 

participant implies no responsibility for the final product, which rests solely with CBO.)

Chris Howlett edited the manuscript. Maureen Costantino prepared the report for publication, with assistance from Jeanine Rees, and produced the cover. Monte Ruffin produced 

the printed copies, Linda Schimmel coordinated the print distribution, and Simone Thomas 

prepared the electronic versions for CBO’s Web site (www.cbo.gov).

Douglas W. Elmendorf

Director

March 2010

Contents

CBO

Summary vii

Overview of Federal Student Loan Programs 1

Types of Loans 1

Loan Terms 1

Loan Volume 2

Administration and Funding 3

Factors That Affect the Costs of Direct and Guaranteed Lending 4

Payments to Lenders 4

Comparison of Costs by Function 5

Budgetary Costs of the Student Loan Programs 8

Fair-Value Costs of the Student Loan Programs 8

Accounting for Costs Omitted from FCRA Subsidies 9

Fair-Value Subsidy Estimates 10

Sensitivity Analysis 11

Policy Options 13

Reducing the Federal Cost of the Guaranteed Loan Program 14

Restructuring Loans 15

Appendix: Assumptions and Analysis Underlying CBO’s Fair-Value 

Subsidy Estimates 19
VI COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS

CBO

Tables

1. New Direct and Guaranteed Student Loans, by Fiscal Year 3

2. Lending Functions in the Direct and Guaranteed Loan Programs 5

3. Projected Fair-Value and FCRA Subsidy Rates for Representative 

Loans and Borrowers, by Fiscal Year 10

4. Components of Estimated Subsidy Rates for Loans Made in Fiscal 

Year 2020 12

Box

S-1. Effects of the Financial Crisis viii
CBO

Summary

The federal government makes financing for higher 

education widely available through two programs: the 

Federal Family Education Loan (FFEL) program, which 

guarantees loans made by private lenders, and the William D. Ford Federal Direct Loan Program (FDLP), 

which makes loans directly to borrowers. The two programs are similar in many respects. By statute, they offer a 

similar variety of loans with comparable interest rates and 

repayment options for all qualifying borrowers. Those 

loan terms are usually more generous than what would be 

available from private sources. Schools, which choose 

which program to participate in, play an important role 

in administering the loan application process and in 

counseling students about the financing options available 

to them. In both programs, the federal government bears 

almost all of the losses when borrowers default. 

The FFEL program and the FDLP differ, however, in the 

ways in which they are administered and funded. In the 

guaranteed loan program, loans are administered by 

financial institutions—such as Sallie Mae, commercial 

banks, and nonprofit agencies—that act as FFEL lenders.1

 Those lenders usually raise the money to make loans 

in the private capital markets. By contrast, in the direct 

loan program, the Department of Education and its contractors manage most administrative functions, and loans 

are funded through the Treasury. 

Lending through the federal student loan programs has 

grown rapidly over time, with that growth accelerating in 

the past decade. Between 2000 and 2009, the volume of 

outstanding federal student loans more than quadrupled, 

from about $149 billion to about $630 billion. During 

that period, about three-quarters of the student loans 

made each year were originated in the guaranteed loan 

program. 

Private lenders in the guaranteed loan program faced a 

sharp increase in funding costs during the recent financial 

crisis, leading to concerns about the future availability 

of guaranteed loans. To ensure an uninterrupted flow of 

credit for students, lawmakers enacted legislation in 2008 

that gave the Department of Education temporary 

authority to buy newly originated loans from FFEL lenders. Through a combination of those purchases and direct 

loans, about 88 percent of the total dollar amount of federal student loans made in the 2008–2009 academic year 

was funded by the government (see Summary Box 1). 

Despite the new legislation, the guaranteed loan program’s share of origination volume fell to 69 percent in 

the 2008–2009 academic year. Since then, uncertainties 

about funding for the FFEL program and about possible 

legislation affecting it have led more schools to switch 

to the direct loan program. The Congressional Budget 

Office (CBO) projected in its March 2010 baseline that, 

under current law, the share of guaranteed student loans 

would continue to decline gradually for the next few 

years before leveling off at 40 percent starting in 2013. 

Budgetary Costs of Direct and 

Guaranteed Student Loans

Despite the many similarities between the FDLP and the 

FFEL program, the latter is significantly more costly for 

the federal budget. For example, CBO recently estimated 

that the President’s proposal to eliminate the FFEL program and replace it with additional direct lending would 

save the government a total of $62 billion between 2010 

1. Sallie Mae was originally a government-sponsored enterprise chartered by the Congress to provide liquidity to the secondary market 

for student loans (the market in which loans are bought and sold). 

It is now a private company that specializes in providing financial 

services to students, including FFEL and private student loans.
VIII COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS

CBO

Summary Box 1.

Effects of the Financial Crisis

In the wake of the financial crisis that began in 

August 2007, investors became wary of buying assetbacked securities—even those backed by obligations 

with a federal guarantee, such as guaranteed student 

loans.1

 Many lenders in the Federal Family Education 

Loan (FFEL) program that had relied heavily on the 

sale of asset-backed securities to finance new guaranteed loans faced much higher funding costs, which 

the fixed statutory payments from the Department 

of Education were insufficient to cover. Because the 

FFEL program provided nearly 75 percent of federal 

student loans at that time, the prospect that lenders 

would stop making new loans threatened to seriously 

disrupt the availability of credit for higher education.

Lawmakers responded by passing the Ensuring 

Continued Access to Student Loans Act of 2008 

(ECASLA).2

 That law authorized the Department of 

Education to provide funding to FFEL lenders, primarily by purchasing their loans but also by providing them with backup lines of credit. Between the 

initiatives in ECASLA and the direct student loan 

program, the federal government ended up financing 

about 88 percent (by dollar volume) of the federal 

student loans made in the 2008–2009 academic year. 

ECASLA’s effect on the federal budget has been to 

lower the cost of the student loan programs. Purchasing guaranteed loans allows the Department of Education to avoid some of the payments it would have 

made to FFEL lenders. Once the loans are purchased, 

payments from the government to FFEL lenders 

cease, and the loans are serviced and administered by 

the department’s contractors. Thus, the purchased 

loans have the same costs as direct student loans. 

Despite improvements in the financial markets 

last year, FFEL lenders continued to rely heavily on 

the enhanced federal support to obtain financing for 

student loans. Concerns about the availability of 

private capital led lawmakers to extend ECASLA to 

cover loans made for the 2009–2010 academic year.3

The federal government has also provided support to 

the private student loan market by allowing lenders 

to borrow from the Federal Reserve’s Term AssetBacked Securities Loan Facility (TALF).4

 Before the 

financial crisis, the private loan market was an important source of financing for higher education for 

some students (such as those who had exhausted the 

dollar limits on federal student loans or who did not 

qualify for federal loans). During the crisis, many 

lenders suspended or discontinued their private student loan programs because of the sharp increase in 

funding costs and worries about the deteriorating 

credit quality of borrowers. Although some activity 

has resumed in that market, the terms offered to 

borrowers on private student loans have remained 

stringent, and lenders have relied on federal backing 

through the TALF to obtain funding at affordable 

rates. 

1. Asset-backed securities are financial instruments whose interest and principal payments stem solely from the income generated by the assets that serve as collateral for the securities. 

Securities backed by student loans are created by bundling 

those loans together and selling investors claims to a portion 

of the loans’ cash flows. In the case of federally guaranteed 

student loans, the securities are structured so that federal payments for default claims on the loans are passed along to the 

holders of the securities.

2. Public Law 110-227.

3. The Department of Education reports that under the authority in ECASLA, it purchased roughly $50 billion in FFEL 

loans through the end of fiscal year 2009. The department 

estimates that it will buy another $62 billion in loans under 

the extended authority that ends on July 1, 2010, for total 

purchases of about $112 billion.

4. The Federal Reserve created the TALF in November 2008 to 

provide liquidity for certain types of asset-backed securities, 

including those backed by student loans. Issuers of assetbacked securities can borrow from the facility at interest rates 

set by the Federal Reserve, using asset-backed securities as 

collateral. The TALF is scheduled to stop operating later this 

year.
SUMMARY COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS IX

CBO

and 2020.2

 Although the federal cost per dollar of student 

loans originated varies from year to year and among different types of loans, a loan made in the FFEL program 

consistently shows a much higher budgetary cost than if 

it had been made in the direct loan program. 

The budgetary costs of the direct and guaranteed loan 

programs are recorded in the federal budget using the 

standard procedure specified in the Federal Credit 

Reform Act of 1990 (FCRA).3

 That law says that the 

costs of a federal loan or loan guarantee should be estimated in the year the loan is disbursed as the net present 

value of the federal government’s expected net cash flows 

over the life of the loan or guarantee. Those cash flows 

are discounted to their present value using the Treasury’s 

borrowing rates.4

Fair-Value Costs of Direct and 

Guaranteed Student Loans

Cost estimates made under FCRA do not provide a comprehensive measure of the cost to taxpayers of the federal 

student loan programs, for two main reasons. First, the 

FCRA methodology does not include the costs to taxpayers that stem from certain risks involved in lending—

risks that private investors would require compensation 

to bear. In particular, although the FCRA methodology 

accounts for average losses from defaults, it does not recognize a cost for the risk that losses from defaults will be 

higher during periods of market stress, when resources are 

scarce and hence most valuable. Such “market risk” is 

excluded from FCRA estimates because that methodology discounts expected future cash flows at Treasury 

borrowing rates rather than at higher interest rates that 

incorporate the price of risk.5

 Second, FCRA estimates do 

not include administrative expenses, which are recorded 

separately in the budget each year on a cash basis (that is, 

undiscounted). That treatment mixes together currentyear administrative costs for outstanding loans and for 

newly originated loans. 

In this study, CBO compares the costs of making a loan 

in the FDLP and guaranteeing a loan in the FFEL program, calculated as specified in FCRA and also at fair 

value—a broader measure that includes administrative 

costs and the cost of risk. The fair value of an asset or 

liability corresponds to its market value under normal 

market conditions (or, in the absence of such conditions, 

to an approximation of what the value would be under 

those conditions). In general, a fair-value subsidy occurs 

whenever the government accepts terms on the financing 

or services it provides that are less stringent than the 

terms that participants in private markets would require 

for taking on comparable obligations and risks. 

Taking into account the costs of risk and administration 

has the effect of significantly increasing the estimated cost 

of both the direct and guaranteed loan programs; it also 

narrows—but does not eliminate—the cost difference 

between the two programs. For instance, CBO recently 

estimated that whereas loans issued in the direct loan program between 2010 and 2020 would reduce the deficit 

by a total of $68 billion under FCRA accounting, those 

loans would increase the deficit by $52 billion on a fairvalue basis.6

 For loans issued in the FFEL program, the 

projected cost over that period increases from $22 billion 

under FCRA accounting to $105 billion on a fair-value 

basis. The savings from implementing the President’s 

proposal to replace FFEL loans with direct loans decline 

from a total of $62 billion over the 2010–2020 period 

under FCRA accounting to $40 billion on a fair-value 

2. Those savings stem from a $68 billion reduction in subsidy costs basis.

(which do not include the government’s administrative expenses), 

partly offset by a $6 billion increase in administrative expenses, 

which are funded separately in annual appropriation acts. See 

Congressional Budget Office, letter to the Honorable Judd Gregg

about the budgetary impact of the President’s proposal to alter 

federal student loan programs (March 15, 2010).

3. CBO’s method for estimating those costs is described in Congressional Budget Office, Subsidy Estimates for Guaranteed and Direct 

Student Loans (November 2005).

4. Net present value is a single number that expresses a flow of current and future income (or payments) in terms of an equivalent 

lump sum received (or paid) today. The present value depends on 

the rate of interest (the discount rate) used in the calculation. 

5. Student loans also entail prepayment risk: the risk that students 

will pay back loans more rapidly if future interest rates fall and 

more slowly if future rates rise, reducing the value of the government’s claims. That risk, however, is less important than market 

risk for student loans. Investors in securities backed by student 

loans also assign a price to other types of risk, such as liquidity risk 

(the risk that the securities may not be easy to sell quickly without 

having to offer a price concession). CBO takes into account all of 

those risks in its fair-value estimates. 

6. Congressional Budget Office, letter to the Honorable Judd Gregg

about the budgetary impact of the President’s proposal to alter 

federal student loan programs (March 15, 2010).
X COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS

CBO

To calculate fair-value subsidies, CBO generally used the 

same assumptions as for its FCRA estimates, except with 

regard to discount rates and administrative costs. In place 

of Treasury rates, CBO used discount rates that included 

an estimate of the risk premium (the additional return in 

excess of Treasury rates) that private investors would 

require to bear the risks of student loans. CBO estimated 

those discount rates on the basis of interest rates on private student loans and other data from the private student loan market.7

 The estimated discount rates also took 

into account differences between private and federal student loans (in the terms of the loans and the characteristics of borrowers); past and present market conditions; 

and the expectation that conditions in financial markets 

will improve in the next several years. In addition, CBO 

included the administrative costs incurred by federal 

agencies in its fair-value subsidy estimates, because a private entity would need to be compensated to bear those 

costs. 

Subsidy rates—the cost per dollar of loan originated—

vary from year to year with the composition of borrowers 

in each program and the mix of loan types. To present 

FCRA and fair-value estimates that are informative about 

the differences in the cost of lending under the two student loan programs, this study shows subsidy rates that 

are based on a representative loan (holding the characteristics of borrowers and the mix of loans fixed) made in 

the FFEL program in specified time periods. 

CBO’s calculations indicate that if subsidies were computed on a fair-value basis, student loans made in both 

the direct and guaranteed loan programs would impose 

costs on the federal government, and those costs would 

represent a significant share of the principal value of the 

loans issued. For instance, whereas on average over the 

2010–2020 period a representative loan issued in the 

direct loan program has a negative subsidy rate of 9 percent under FCRA (meaning that it reduces the deficit), 

the same loan has a positive subsidy rate of 12 percent 

on a fair-value basis. For the FFEL program, the average 

subsidy rate on a representative loan over that period is 

5 percent under FCRA and 20 percent on a fair-value 

basis. 

Thus, measuring costs on a fair-value basis narrows the 

difference between the costs of loans made in the guaranteed and direct lending programs, but it does not eliminate the gap. CBO estimates that if a representative 

guaranteed loan made during the 2010–2020 period was 

instead originated in the direct loan program, the savings 

in subsidy rates would be 8 percentage points (20 minus 

12) on a fair-value basis, compared with about 13 percentage points (5 minus -9, with rounding) under FCRA 

accounting.

Those estimates, which are based on the economic 

assumptions underlying CBO’s March 2010 baseline, are 

very sensitive to projections of interest rates and estimates 

of discount rates. However, the conclusions that fairvalue subsidy rates are positive for both programs and 

higher for the guaranteed loan program hold under a 

broad range of assumptions about interest rates, discount 

rates, and other market conditions.8

The higher costs in the guaranteed loan program (on 

both a FCRA and a fair-value basis) result mainly from 

the way in which the government compensates FFEL 

lenders. Payments to those lenders are fixed in legislation 

rather than set through a mechanism—such as a competitive bidding process—that ties reimbursement to actual 

costs incurred. In general, those statutory payments 

appear to exceed lenders’ basic administrative costs and 

their funding costs under normal market conditions 

(although during the financial crisis, the payments proved 

too low to cover the surge in lenders’ borrowing costs).9

Because FFEL lenders must compete to attract borrowers, 

any difference between the statutory payments they 

receive and their basic costs is mostly absorbed by increasing marketing efforts, enhancing the administrative services they provide, or offering other benefits to schools 

7. Many of the lenders that make guaranteed student loans also offer 

private student loans. Private loans are generally taken out by 

students at expensive undergraduate institutions or professional 

schools who have reached the dollar limit on federally guaranteed 

loans or by students who do not qualify for federal loans.

8. The conclusion that costs are higher for both programs on a fairvalue basis is a logical consequence of including costs that are 

excluded under FCRA; only the size of the effect depends on 

specific assumptions. The amount by which the FFEL program 

appears more expensive than direct lending is sensitive to the rate 

chosen to discount the government’s payments to FFEL lenders. 

With a sufficiently high—but unrealistic—discount rate, the 

FFEL program would appear to be less expensive than the direct 

loan program. 

9. The College Cost Reduction and Access Act of 2007 (Public Law 

110-84) reduced payment rates to FFEL lenders and guaranty 

agencies, which narrowed the difference in costs between the two 

programs. But in CBO’s estimation, a considerable cost difference 

remains.
SUMMARY COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS XI

CBO

and students. Thus, competition between lenders benefits 

schools and borrowers rather than lowering costs to the 

government. In addition, FFEL lenders fund their loans 

in the capital markets, which introduces additional costs 

and risks to the program that do not arise when loans are 

funded through the Treasury. 

Options for Changing Federal 

Student Loans

In recent years, many proposals have been made to modify the federal student loan programs. Some of those proposals focus on the cost disparity between the guaranteed 

and direct lending programs. For example, the President’s 

2011 budget calls for ending the FFEL program’s authority to guarantee new loans on July 1, 2010, and switching 

entirely to the direct lending program to realize the savings from that program’s lower costs. The House of Representatives recently passed legislation (H.R. 4872, the 

Health Care and Education Affordability Reconciliation 

Act of 2010) to carry out a similar change, and the Senate 

is currently considering that legislation.10

Policy options that could help bring the subsidy rate of 

the FFEL program closer to that of the direct loan program include having the government buy all student 

loans from FFEL lenders shortly after origination but 

allowing the lenders to retain their current administrative 

functions; cutting payments to those lenders; and auctioning off the right to lend under the program. Such 

cost-saving measures would probably cause FFEL lenders 

to reduce service levels, prompting more schools to 

switch to the direct loan program. 

Federal costs could be made more predictable—and the 

subsidies provided to different cohorts of students could 

be made more uniform—by indexing the interest rates on 

student loans to market interest rates. Under current law, 

subsidies vary considerably from year to year because the 

interest rates charged to borrowers are fixed by statute 

and unrelated to market interest rates. 

Other options to alter the student loan programs aim to 

address policy goals—such as improving the affordability 

and availability of student loans or reducing defaults—by 

modifying the terms offered to borrowers. For example, 

one way to help students would be to lower the interest 

rates charged on federal student loans. However, broadbased reductions in interest rates would entail significant 

costs to the government. For instance, reducing the 

scheduled interest rates charged to borrowers on new 

loans by 1 percentage point would increase the subsidy 

rate on guaranteed loans by 6 percentage points on a 

fair-value basis. 

Policymakers have also considered changes aimed at 

lessening the hardships that borrowers face in repaying 

federal student loans. Those proposed changes include 

expanding options that make repayment terms contingent on income, that eliminate a portion of an outstanding loan (forgiveness), or that allow a borrower to 

delay repayment (forbearance or deferment). Although 

more-lenient repayment terms may lower default rates, 

they increase costs to the federal government by lengthening the average time that loans are outstanding at subsidized interest rates. The costs of income-contingent 

repayment, or of loan forgiveness or forbearance, are 

generally higher on a fair-value basis than under FCRA 

accounting, because borrowers are more likely to take 

advantage of those opportunities in economic downturns, when the value of the forgone payments is greatest. 

10. On September 17, 2009, the House passed the Student Aid and 

Fiscal Responsibility Act of 2009 (H.R. 3221), which would also 

phase out the FFEL program.

CBO

Costs and Policy Options for 

Federal Student Loan Programs

The Department of Education oversees various programs to help students pay for the costs of postsecondary 

education. This Congressional Budget Office (CBO) 

study focuses on the two largest student loan programs 

created under the authority of the Higher Education Act 

of 1965 (as amended): 

B The Federal Family Education Loan (FFEL) program, 

which dates back to the mid-1960s, guarantees student loans made by private-sector lenders. 

B The William D. Ford Federal Direct Loan Program 

(FDLP), which began operating in 1994, makes loans 

directly to students or their parents. 

Overview of Federal Student 

Loan Programs

Both the guaranteed and direct loan programs have experienced rapid growth as increasing numbers of students 

have sought higher education and as the costs of school 

attendance have soared. The two programs offer virtually 

identical types of loans, which carry similar interest rates, 

repayment options, and other terms. However, significant 

differences exist in the way the programs are administered 

and funded, which have implications for their costs to the 

federal government. 

Types of Loans

The FDLP and the FFEL program offer many kinds of 

loans. Eligibility and some loan terms depend on a 

student’s course of study (for example, undergraduate, 

graduate, or medical); the identity of the borrower (student or parent); and whether the student qualifies for 

more favorable loan terms on the basis of need. 

Both programs offer so-called Stafford loans to undergraduate and graduate students. Those loans make up the 

bulk of federal student loans, accounting for more than 

80 percent of new loan volume each year (excluding consolidation loans). In a typical year, a little over half of 

Stafford loans (by volume) are “unsubsidized” and the 

rest are “subsidized.” Those labels refer to the terms of the 

loans, not to whether the federal government incurs subsidy costs for the programs. With subsidized Stafford 

loans—which are available depending on the income and 

assets of students and their parents—borrowers generally 

are not charged interest while they are in school and during certain other periods, and undergraduate borrowers 

are charged lower interest in some years. 

Besides Stafford loans, both the FDLP and the FFEL 

program offer so-called PLUS loans to parents of undergraduate students and to graduate and professional 

students who have reached their borrowing limits for 

Stafford loans. In addition, both programs offer consolidation loans, which allow most borrowers with more than 

one outstanding federal loan to refinance them into a 

single obligation.1

Loan Terms 

The terms offered to borrowers—interest rates, borrowing limits, fees, and repayment options—are set by statute and are almost identical under the direct and guaranteed loan programs. Since July 2006, new Stafford loans 

1. Consolidation loans offer extended repayment terms and a fixed 

interest rate equal to the weighted average of interest rates on the 

loans being consolidated (rounded up to the nearest eighth of a 

percentage point). For more about consolidation loans, see Congressional Budget Office, The Cost of the Consolidation Option for 

Student Loans (May 2006). For budgetary purposes, CBO treats a 

consolidation loan as an extension of the original loan rather than 

as a new loan. Thus, the subsidy estimates in this analysis, both 

budgetary and fair-value estimates, include the incremental costs 

of loan consolidation.
2 COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS

CBO

have carried a fixed interest rate.2

 (Loans originated earlier carry a variable rate that is indexed to the interest rate 

on three-month Treasury bills.) Setting a fixed interest 

rate that is not linked to a market rate has several effects: 

It causes the rate of federal subsidies provided to different 

cohorts of students to vary considerably, and it makes the 

budgetary costs of student loan programs more variable 

from year to year. 

Statutory restrictions limit the amount of money that can 

be borrowed—both annually and cumulatively—from 

the federal lending programs. The limits, which are identical under the two programs, depend on the type of loan, 

the course of study, and the costs of attending a given 

school.3

Although interest rates and borrowing limits are almost 

identical for direct and guaranteed loans, the fees that 

borrowers pay to take out a student loan vary slightly 

between the two programs.4

 For guaranteed loans, the 

government charges borrowers a fee equal to 1 percent of 

the loan amount when their loan is disbursed. That origination fee goes toward paying claims to FFEL lenders 

when borrowers default. The government also charges a 

1 percent origination fee on direct loans, but part of the 

fee is returned to students if they repay their loan on time 

(the rest is remitted to the Treasury). Thus, the average 

amount that students pay in origination fees is lower on 

direct loans.

When students complete or withdraw from a course of 

study, they typically receive a six-month grace period during which no loan payments are due, although interest 

continues to accrue on their loans. (With subsidized 

loans, no interest accrues during the grace period.) 

Stafford loans have flexible repayment plans that last up 

to 30 years; they also have deferment and forbearance 

provisions that allow borrowers to temporarily stop making payments because of financial hardship, a return to 

school, or other reasons.5

 For qualifying student borrowers, several repayment plans are available in which scheduled loan payments vary with the borrower’s income.6

Federal student loans are considered to be in default after 

270 days of missed payments—a much less stringent 

criterion than applies to private student loans and other 

consumer credit. However, student loans of any sort 

(direct, guaranteed, or private) are rarely forgiven in 

bankruptcy proceedings, and there is no statute of 

limitations on their collection.

Loan Volume 

The demand for federal student loans has risen rapidly in 

recent decades, aided by a series of legislative changes that 

expanded the federal programs and relaxed limits on the 

amounts borrowed.7

 Between 1990 and 2009, the total 

dollar volume of new loans originated each year grew at 

an average rate of roughly 9 percent. In the past five 

years alone, new originations increased by nearly threequarters: from $56 billion in 2005 to $97 billion in 2009 

(see Table 1). As a consequence, the total amount of federal student loans outstanding rose from $381 billion to 

2. That rate was initially set at 6.8 percent for both subsidized 

and unsubsidized Stafford loans. For subsidized loans to undergraduates, however, the rate follows a declining schedule: 6.0 percent in the 2008–2009 academic year, 5.6 percent in 2009–2010, 

4.5 percent in 2010–2011, and 3.4 percent in 2011–2012. After 

that, it reverts to 6.8 percent.

3. For example, as of July 1, 2008, the cumulative limits on outstanding Stafford loans are $31,000 for loans taken out as a 

dependent undergraduate and a total of $138,500 for loans taken 

out as an undergraduate or graduate student. Limits for medical 

students are higher.

4. A notable exception to the similarity of interest rates between the 

two programs is that the fixed rate for borrowers of PLUS loans 

made on or after July 1, 2006, is 7.9 percent for direct loans and 

8.5 percent for guaranteed loans.

5. During a deferment or forbearance period, payments are not 

required but interest still accrues. (In the case of subsidized Stafford loans, the government pays the interest during deferment.)

6. Three different plans exist: “income-based repayment,” “incomesensitive repayment,” and “income-contingent repayment,” all 

of which have slightly different rules. For instance, under incomebased repayment, monthly payments are capped at a percentage of 

the borrower’s discretionary income; the cap is based on the borrower’s income and family size. Single borrowers who earn less 

than $50,000, and married borrowers with two children who earn 

less than $100,000, have their monthly payments capped at less 

than 10 percent of their gross income. For a description of the various plans, see FinAid, “Income-Based Repayment,” available at 

www.finaid.org/loans/ibr.phtml. 

7. For example, the unsubsidized Stafford loan program, established 

in 1992, extended eligibility to higher-income borrowers by 

removing an income test, and the volume of those loans grew rapidly. Starting in 2006, the PLUS loan program increased the availability of federal loans to graduate students; that program has also 

grown quickly. Borrowing limits, both annual and cumulative, 

have been raised several times since 1995. On PLUS loans, for 

instance, changes allowed for borrowing up to the full cost of a 

student’s education.
COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS 3

CBO

Table 1.

New Direct and Guaranteed Student Loans, by Fiscal Year

Source: Congressional Budget Office based on data from the Department of Education.

Note: These numbers reflect net commitments, excluding consolidation loans.

$631 billion over that period. Approximately two-thirds 

of the growth in the FDLP and the FFEL program has 

resulted from a rise in the number of borrowers, and 

one-third has stemmed from larger loan balances per 

borrower during the 1995–2009 period. The increasing 

demand for student loans has coincided with extraordinary growth in the cost of higher education—which, 

since the 1980s, has reportedly risen at an annual rate 

that was 3 percentage points higher than the general 

increase in prices.8

Historically, the guaranteed loan program has been the 

main source of federal credit assistance for higher education. It accounted for an average of about 75 percent of 

the total dollar amount of federal student loans originated between 1998 and 2008. That program’s share fell 

from 81 percent in 2008 to 69 percent in 2009, as some 

schools switched to the direct loan program to avoid 

uncertainties about the availability of guaranteed student 

loans during the financial crisis (see Summary Box 1 on 

page viii). Furthermore, the government financed a large 

percentage of the guaranteed loans originated in 2009 

through loan purchases by the Department of Education. 

Since then, the number of schools participating in the 

FFEL program has continued to decline. CBO projects 

that under current law, guaranteed loans will account for 

55 percent of all new federal student loans in 2010 and 

smaller shares thereafter, leveling off at about 40 percent 

beginning in 2013.

Some students who have exhausted their eligibility or 

who do not qualify for federal loans turn to the private 

student loan market for financing. Private student loans 

are offered by many of the same lenders that participate 

in the FFEL program. But whereas the federal government determines eligibility and loan terms for federal 

direct and guaranteed student loans, and assumes the risk 

of default, lenders play those roles for private loans. Data 

on the size of the private student loan market are scarce, 

but one estimate put originations at about $22 billion in 

the 2007–2008 academic year—implying that the private 

market was about one-quarter the size (by dollar value) of 

the market for federal student lending in that period.9

The volume of the private student loan market appears to 

have fallen off sharply in the wake of the financial crisis.

Administration and Funding

The direct and guaranteed student loan programs differ 

in how they are administered and funded and in how the 

government pays for administration and funding. In the 

guaranteed loan program, the federal government guarantees loans that are administered and funded by FFEL 

lenders, including private financial institutions and nonprofit organizations. FFEL lenders are compensated for 

those activities on terms set by statute under the Higher 

Education Act. In the direct loan program, by contrast, 

the Department of Education makes loans directly to 

2005 2006 2007 2008 2009

Direct Loans 12.6 12.2 12.5 17.8 29.7

Guaranteed Loans 43.2 46.7 51.8 57.9 66.8 ____ ____ ____ ____ ____

Total 55.8 58.8 64.4 75.7 96.5

Direct Loans 3.0 2.8 2.7 3.7 6.1

Guaranteed Loans 10.3 10.8 11.6 12.7 14.5 ____ ____ ____ ____ ____

Total 13.3 13.7 14.3 16.5 20.6

Volume of New Loans (Billions of dollars)

Number of New Loans (Millions)

8. College Board, Trends in College Pricing, 2009 (Washington, 

D.C.: College Board, 2009).

9. Mark Kantrowitz, “Characteristics of Private Student Loan Borrowers Who Do Not Use Federal Education Loans” (published by 

FinAid.org, June 7, 2009), www.finaid.org/educators/

20090607private_vs_federal_loans.pdf.
4 COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS

CBO

qualifying borrowers and manages all aspects of the lending process. It hires private contractors, selected in a competitive bidding process, to perform some administrative 

functions, and it funds loans through the Treasury. 

Schools play an important role in both programs in 

administering the loan application process and counseling students about the financing options available to 

them. Schools also must decide which program to participate in. When choosing between the direct and guaranteed loan programs, schools consider such factors as 

which program provides better administrative and other 

services and which program seems more beneficial to 

their students. 

Factors That Affect the Costs of 

Direct and Guaranteed Lending

The FDLP and the FFEL program differ markedly in 

their costs to the federal government. The main reason is 

that payments to FFEL lenders are set legislatively at an 

average amount that is higher than the costs to the FDLP 

of administering and funding direct loans. Those additional payments to lenders accommodate the higher marketing and funding costs of the guaranteed loan program 

and the higher level of services that it offers to schools 

and students. 

Payments to Lenders

The way the government compensates lenders under the 

FFEL program is set by statute and is only weakly related 

to the actual costs that lenders incur. Lenders receive regular quarterly payments from the government—known as 

special allowance payments (SAP)—that are a percentage 

of the principal value of their outstanding guaranteed 

loans. That percentage equals the prevailing interest rate 

on high-quality three-month commercial paper plus an 

additional amount—called a spread—minus the interest 

rate that borrowers contractually pay on the loans.10 That 

arrangement effectively transfers to the government the 

interest payments that lenders receive from borrowers. In 

return, the commercial-paper rate plus a small portion of 

the spread is intended to cover lenders’ normal costs of 

acquiring the funds to make loans in the capital market.11

The rest of the spread goes toward covering administrative costs and other expenses incurred by lenders.12 The 

statutory amount of the spread varies by type of loan and 

type of lender. For example, payments to for-profit FFEL 

lenders include a spread of 1.79 percent on Stafford and 

PLUS loans and 1.19 percent on consolidation loans. 

Spreads paid to nonprofit lenders are 0.15 percentage 

points higher. 

Lenders also pay and receive a variety of other, relatively 

small, fees and payments that affect their total compensation. In addition, when borrowers default, the government pays FFEL lenders a fixed fraction—currently set at 

97 percent—of the principal and accrued interest owed 

(see the section on collection below).13

In deciding whether to offer guaranteed loans, lenders 

weigh the value of those various payments against the 

costs and risks associated with participating in the FFEL 

program. If statutory payments to lenders fall short of 

covering their costs—as happened during the financial 

crisis before additional federal support became available—lenders have the option to stop participating. But 

when payments to lenders exceed the basic cost of administering and funding loans, there is no mechanism for the 

government to recoup the excess. 

Competition among lenders means that a substantial portion of any excess payments will be used to attract and 

retain business, such as by spending more on marketing 

or improving services to students and schools. Those services include discounts to borrowers for on-time payment 

and support services to financial aid offices, such as software systems and educational materials.14 (To the extent 

that lenders are shielded from competition, some portion 

10. Commercial paper consists of unsecured promissory notes that 

large corporations or banks issue to raise money for short-term 

needs.

11. During the recent financial crisis, FFEL lenders’ funding costs 

increased well above the commercial-paper rate, and the fixed 

spread did not accommodate those increases.

12. The College Cost Reduction and Access Act of 2007 (Public Law 

110-84) reduced SAP spreads from previous levels. Although no 

major lender withdrew from the program in the following year, 

the level of benefits offered to borrowers declined. Lenders further 

cut services and benefits when the financial crisis increased their 

funding costs.

13. From the lender’s perspective, a default terminates the stream of 

special allowance payments and triggers claim payments from the 

government. Prepayments of loans similarly terminate the stream 

of spread payments and result in redemption of principal from the 

borrower.

14. The extent of such inducements is limited by the Higher Education Act, and enforcement has increased in recent years. 
COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS 5

CBO

Table 2.

Lending Functions in the Direct and Guaranteed Loan Programs

Source: Congressional Budget Office.

a. Under current law, the government’s share is set to decline to 93 percent beginning in 2013.

b. The Treasury Offset Program enables the Department of Education to collect from delinquent borrowers by having the Treasury withhold 

a portion of their federal transfer payments, such as tax refunds or Social Security benefits.

of any excess payments will be retained by lenders.)15 In 

the direct program, by contrast, the likelihood of excess 

administrative payments is diminished by the practice of 

hiring private contractors through a competitive bidding 

process.

Comparison of Costs by Function

Lending involves a number of basic functions: origination, servicing, collection on loans in default, risk 

assumption, and funding. Identifying the differences in 

how those functions are carried out between the two programs (summarized in Table 2) is helpful in understanding why cost differences arise. 

The comparisons below are based on the normal operations of both programs. Thus, they do not reflect the 

effects of the temporary provisions that lawmakers 

enacted in 2008 to ensure an uninterrupted supply of 

credit to students during the financial crisis (see Summary Box 1 on page viii).

Origination. Origination refers to all of the steps required 

to issue a loan, from application to final approval and 

disbursement of funds. Most loans in both the direct and 

guaranteed loan programs are originated through school 

financial aid offices, which many students rely on to 

obtain information and advice about loan products and 

lenders.16 In carrying out the origination function, 

schools use software and other support services provided 

either by the Department of Education (for schools in the 

direct loan program) or by FFEL lenders (for schools in 

the guaranteed loan program). Because FFEL lenders 

compete with one another to attract and retain business, 

they incur marketing and other expenses that are avoided 

with direct lending. Those higher origination expenses 

do not directly affect federal costs because they are not 

reimbursed, but they do affect whether a given amount of 

federal payments is sufficient to induce lenders to participate in the guaranteed loan program. 

Servicing. Servicing involves the administrative functions 

associated with billing and collecting interest and principal payments on loans that are in good standing. The 

government and FFEL lenders rely on many of the same 

private contractors to perform those functions, and the 

Department of Education uses a competitive auction 

process to select its contractors and determine payments 

Direct Loan Program Guaranteed Loan Program

Source of Funding Government 

(Through the Treasury)

Private capital markets 

(Through securitization and banks)

Assumption of Default Risk Government (100 percent) Government (97 percent)a

Lenders (3 percent)

Origination Government 

(Through schools)

Guaranteed lenders 

(Through schools)

Servicing Government 

(Partly through subcontractors)

Guaranteed lenders 

(Partly through subcontractors)

Collection Government subcontractors and Treasury 

Offset Programb

Guaranty agencies for three years, then government 

subcontractors and Treasury Offset Programb

15. For instance, schools encourage students to borrow from a list of 

“preferred lenders,” which thus have a competitive advantage over 

lenders not listed.

16. An exception is consolidation loans, which are often obtained 

independently of a financial aid office.
6 COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS

CBO

for them. Hence, servicing costs are similar under both 

programs.

Collection. When a loan made under either program goes 

into default, it is typically transferred from a regular servicer to a “special servicer” that focuses on collection and 

recovery. In the direct loan program, those special servicers are private contractors, which the Department of 

Education chooses through competitive bidding. As an 

incentive to increase recovery rates, compensation is 

structured so that contractors keep a share of the money 

they recover. 

In the FFEL program, guaranty agencies—state or private 

nonprofit entities that administer the federal guarantee 

and provide a variety of programs and services to schools 

and borrowers in their state—act as the special servicers. 

For loans that default, guaranty agencies pay FFEL lenders the insured amount of outstanding principal and 

interest, using funds supplied by the Department of 

Education. The guaranty agency then holds and seeks 

to collect on the delinquent loans for up to three years, 

keeping a share (that is fixed by law) of any collections.17

Although that compensation is not determined competitively, it is close to what contract special servicers in the 

direct loan program receive. 

Guaranteed loans that remain outstanding after three 

years of nonpayment are transferred to the Department 

of Education and effectively become direct loans. The 

department and its contractors continue to try to collect 

on the loans after the transfer and remit the net amounts 

collected to the Treasury. 

Risk Bearing. Since the criteria that determine eligibility 

for federal direct and guaranteed loans are identical, the 

two programs attract similar groups of borrowers.18 Thus, 

the risks arising from the behavior of borrowers are also 

similar. The most significant of those risks is the risk of 

default. The options for borrowers to prepay a loan at any 

time without penalty or to seek forbearance or deferral 

also create risks. 

Although the risks arising from defaults and prepayments, and the cost of those risks to society as a whole, 

are much the same for the two programs, the way they are 

allocated differs. In the direct loan program, the federal 

government—and hence taxpayers—retain all of the risk. 

In the guaranteed loan program, the federal government 

assumes most of the risk, but some of it is transferred to 

FFEL lenders (and to a lesser extent to the holders of 

securities backed by guaranteed student loans). The 

partial shifting of risk to FFEL lenders occurs primarily 

through the way they are compensated by the government, as well as through the 3 percent loss on loans that 

default.

Although FFEL lenders are protected by the federal guarantee from most of the losses from default,they bear risk 

because the government’s special allowance payments to 

them end if a loan is prepaid or goes into default; those 

payments are reduced if a loan is consolidated by the 

same lender. When default or prepayment rates are high, 

lenders may not recover the administrative costs associated with making guaranteed student loans. Thus, the 

structure of the special allowance payments exposes lenders to market risks, and lenders require higher compensation to participate in the FFEL program because of that 

risk exposure.19 The way in which guaranteed loans are 

funded also transfers a small amount of default and 

17. Currently, guaranty agencies receive 16 percent of the recovered 

amounts (or 8 percent if the recovery is achieved by consolidating 

the loan). The Department of Education and its contractors may 

also collect on delinquent guaranteed loans during that three-year 

period.

18. Despite the similarity of borrowers, some differences in default 

rates exist between the programs. Default rates on consolidation 

loans, for example, have been significantly higher in the direct 

loan program than in the guaranteed loan program. Borrowers can 

consolidate loans under either program, and FFEL lenders can 

choose whom they market consolidation loans to at an individual 

level; therefore, it appears that FFEL lenders have been able to 

avoid offering consolidation loans to borrowers who are close to 

default. In addition, guaranty agencies have a financial incentive 

to rehabilitate the loans of borrowers in default by consolidating 

them into the direct program. 

Default rates also vary somewhat between the two programs 

because the programs serve different schools, which attract different groups of students (in terms of backgrounds and economic 

prospects). Specifically, the FFEL program serves a larger proportion of higher-risk borrowers, as evidenced by its higher default 

rates. Although CBO takes such differences into account in projecting the cost of each program, they are not relevant for comparisons of the structural factors that determine the cost differences 

between the programs. Thus, CBO holds the mix of loans constant in the subsidy estimates in this analysis.

19. The Department of Education can decline to accept default 

claims for loans that have not been properly serviced, which gives 

rise to a small amount of performance risk for lenders. 
COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS 7

CBO

prepayment risk from lenders to the capital markets, 

although contracts are generally structured to minimize 

the exposure of investors in student-loan-backed securities to the default risk of the underlying loans. 

Furthermore, the funding mechanism for guaranteed 

loans creates some additional risks that are absent in the 

direct loan program. For instance, the possibility that a 

lender may not properly service loans—or, more generally, that other problems will interrupt the lender’s ability 

to make payments or cause it to forfeit the federal guarantee—is a source of risk whose costs are avoided by raising 

funds through the Treasury. Such risks are usually insignificant, but during the recent financial crisis, they probably contributed to the sharply higher funding costs for 

FFEL lenders. 

Financing. The capital markets provide the funding for 

student loans in both the direct and guaranteed loan programs, but through different mechanisms. In the direct 

loan program, the government funds loans by issuing 

Treasury securities. In the FFEL program, lenders fund 

loans either on their own balance sheets (with deposits 

or other borrowing) or, more often, by securitizing the 

loans—that is, by bundling them together to create 

student-loan-backed securities that are sold to private 

investors in exchange for a claim to part of the principal 

and interest payments generated by the underlying loans. 

Those securities generally carry a variable interest rate 

that equals the rate on commercial paper plus a fixed 

spread.20

Because the government reimburses FFEL lenders by 

formula and not according to their actual funding costs, 

those costs do not directly affect the government’s spending. Nevertheless, the government must pay FFEL lenders enough to cover their expenses in order for the program to continue, so the costs that lenders incur to obtain 

funding affect the extent to which the costs of the guaranteed loan program can be reduced.

Funding a student loan involves two types of costs: the 

administrative costs associated with obtaining funds and 

the rate of return that investors require to provide the 

funding. Securitizing student loans (or raising funds privately by other means) involves higher administrative 

costs than borrowing through the Treasury does. FFEL 

lenders that securitize loans incur administrative expenses 

such as fees to investment bankers to structure and market the securities, fees to the Securities and Exchange 

Commission, legal fees, and the ongoing costs of managing receipts and payments. The Treasury avoids some of 

those expenses, and because it issues a very large volume 

of securities, it benefits from administrative economies of 

scale in doing so.

The rate of return that investors require depends on the 

amount and types of risks associated with the claims they 

receive. FFEL lenders pay higher interest rates than the 

Treasury does to obtain funds—typically about half a percentage point more under normal economic conditions. 

(During the recent financial crisis, the rates that investors 

demanded to hold securities backed by guaranteed student loans peaked at more than 2 percentage points above 

the Treasury’s borrowing costs.) How much of that difference represents a true cost disadvantage for the FFEL 

program is hard to determine. For instance, if investors in 

those securities assumed some of the default risk from the 

underlying student loans, the higher rates could be fair 

compensation for protecting taxpayers from that risk. 

The government guarantee and the structure of studentloan-backed securities protect investors from almost all of 

the default risk on the underlying loans, so default risk 

does not seem to explain the higher cost of funds for 

FFEL lenders.21 Nevertheless, investors in those securities 

are exposed to counterparty risk—the possibility that a 

lender will encounter problems that interrupt its ability 

to make timely payments or that it will make a servicing 

error that forfeits the federal guarantee. Investors also 

bear liquidity risk—the risk that the securities may not 

be easy to sell quickly without having to offer a price 

concession. 

Several other characteristics of student-loan-backed securities also help explain why investors demand a higher 20. The mismatch between fixed-rate student loans funded with 

variable-rate debt does not expose FFEL lenders or investors to 

additional risk because the government effectively swaps fixed student loan payments from lenders for variable interest rate payments to lenders. Most of the variable interest rate payments from 

the government are passed on to holders of the student-loanbacked securities (the rest is kept by the lenders).

21. FFEL lenders often provide additional protection to investors by 

retaining a junior claim on a securitized loan pool that pays off 

only after other investors are repaid in full. Because the securities 

carry a variable rate, investors also face minimal prepayment risk. 
8 COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS

CBO

yield on them than on Treasury securities. For example, 

securities backed by student loans are less liquid, and they 

are subject to state and local taxes (which Treasury securities are exempt from). Inferring how much those differences contribute to truly higher costs for private funding 

is difficult. Some of the Treasury’s apparent advantages 

are transfers rather than gains, or they come at a cost to 

taxpayers. The exemption from state and local taxes has 

an offsetting cost to the localities that lose tax revenue. 

The greater liquidity of Treasury securities comes at least 

in part at a cost to taxpayers—liquidity is enhanced by 

the safety that stems from the federal power to transfer 

risk from investors to taxpayers. The scale of Treasury 

borrowing also contributes to liquidity, but the ability to 

borrow on so large a scale may also depend on the transfer of risk to taxpayers. 

Other characteristics that cause investors to demand a 

higher return on student-loan-backed securities probably 

reflect inefficiencies in funding government-guaranteed 

securities using securitization (or other private means). 

The complexity of student-loan-backed securities relative 

to Treasury securities makes them harder to value, and 

the costs that investors must incur to obtain information 

and expertise about them reduces their liquidity. Because 

the underlying student loans are guaranteed by the government, costs incurred to understand the securities and 

evaluate counterparty and other risks have little apparent 

value to society. Furthermore, the variation in funding 

costs that exists among FFEL lenders suggests that some 

lenders in the program are considerably less efficient than 

others and that, hence, their higher funding costs have no 

offsetting benefit to taxpayers.

To the extent that FFEL lenders pay more to fund their 

borrowing than can be attributed to a transfer of risk 

from taxpayers to the private sector, the FFEL program 

has a true cost disadvantage because of counterparty risk, 

liquidity risk, and securitization inefficiencies not present 

in the direct loan program. Lenders can profitably remain 

in the FFEL program only to the extent that special 

allowance payments compensate them for those 

additional costs.

Budgetary Costs of the Student 

Loan Programs 

CBO and the Office of Management and Budget calculate the budgetary costs of federal student loan programs 

on an accrual basis according to guidelines specified in 

the Federal Credit Reform Act of 1990 (FCRA). Under 

that law, the cost—known as a credit subsidy—of new 

federal loans and loan guarantees is recorded in the budget in the year the loans are disbursed. The credit subsidy 

is calculated as the net present value (as of the year of disbursement) of the government’s expected cash flows over 

the lifetime of a loan or guarantee, using interest rates on 

Treasury securities of comparable maturity to discount 

the estimated cash flows. Those subsidy estimates do not 

include the government’s expenses for operating the programs (including the costs of originating, servicing, and 

collecting on loans); such administrative expenses are 

shown elsewhere in the federal budget on a cash basis.

By that FCRA accounting, the guaranteed loan program 

has consistently appeared to be more costly per dollar of 

lending than the direct loan program. Indeed, FCRA 

subsidy rates—the subsidy cost per dollar of loan 

amount—have frequently been negative for the direct 

loan program, meaning that the loans were credited in 

the budget with creating savings for the government. 

FCRA subsidy rates for loans originated in the direct and 

guaranteed loan programs—and the difference between 

the two programs’ subsidy rates—vary over time with 

changing market conditions and program rules. Some of 

the variation occurs because the terms on loans offered to 

students and the government’s payments to lenders are 

fixed by statute, whereas the Treasury interest rates used 

to discount cash flows vary widely as market conditions 

change. In 2009, FCRA subsidy rates were negative for 

both programs because the fixed interest rate on new 

loans was much higher than rates on Treasury securities 

of similar maturity, which were at historically low levels. 

Fair-Value Costs of the Student 

Loan Programs

Although they are used for federal budgeting, FCRA subsidy estimates are not comprehensive measures of the 

costs of the federal student loan programs, for two main 

reasons: They do not take into account the cost of some 

of the risks that student loans impose on taxpayers, and 

they omit most administrative costs (which are recorded 

elsewhere in the budget).22 Because of the different structures of the direct and guaranteed loan programs, those 

22. The same limitations apply to subsidy estimates for other federal 

credit programs that are accounted for under FCRA.
COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS 9

CBO

omitted costs are greater, on balance, in the direct program, which leads to an overstatement of cost differences 

between the two programs. For those reasons, some analysts have asserted that the reported difference between 

the subsidy rates of the direct and guaranteed loan 

programs is not meaningful.23

Fair-value subsidy estimates, which include the cost of 

risk and administrative costs, provide a more comprehensive measure that allows the costs of the two programs to 

be compared on a level playing field.24 The fair value of 

an asset is the price that the asset would bring if it was 

sold in an orderly transaction between willing market 

participants on a specified measurement date.25 In general, the government furnishes a subsidy—on a fair-value 

basis—whenever it accepts terms on the financing it 

provides that are more favorable than the terms that participants in private markets would demand to take on 

comparable obligations and risks.26 The cost of credit 

subsidies is ultimately borne by taxpayers, because gains 

and losses on federal loans or loan guarantees ultimately 

must be covered through the tax system.

Measured on a fair-value basis, the government’s costs of 

making a loan in both the direct and guaranteed loan 

programs are higher than those costs as measured under 

FCRA, and subsidy rates are uniformly positive, meaning 

that each new dollar of lending under the programs costs 

the government money. In addition, the adjustments 

for risk and administrative costs lessen the difference 

between the two programs relative to FCRA estimates. 

Even with those adjustments, however, the average subsidy rate on a representative guaranteed loan remains 

higher than if the same loan was originated in the direct 

program.27 The main reason for the higher subsidy rate 

on guaranteed loans (both on a fair-value basis and under 

FCRA) is that the costs of administering the FFEL program, including payments to lenders and guaranty agencies, exceed the administrative costs associated with lending through the direct loan program. 

Accounting for Costs Omitted from FCRA Subsidies

CBO’s fair-value subsidy estimates employ many of the 

same assumptions and methods that are normally used to 

estimate costs under FCRA. The two main differences are 

that discount rates include a risk premium (the additional 

return that private investors would require to bear the 

risks of student loans), and federal administrative costs 

are fully allocated between the two programs.

Using Treasury interest rates to discount expected cash 

flows on risky loans generally produces higher estimated 

values for the loans than what private investors would 

willingly pay for them. Consequently, when the government offers loans to risky borrowers on fair-value terms, 

those loans appear to make money for the government 

(that is, they have negative subsidy rates as calculated 

under FCRA). Moreover, the greater the riskiness of those 

loans, the higher are the expected gains to the government under FCRA accounting. Similarly, FCRA 

accounting understates the fair-value cost to the government of federal loan guarantees, and that understatement 

is higher the greater the risk that is involved. To infer the 

effects of risk on the fair value of federal obligations for 

student loans, CBO relied mainly on data about the 

interest rates charged to borrowers in the private student 

loan market. CBO also considered patterns in the rates 

charged for other types of consumer credit.

Excluding administrative costs from FCRA subsidies 

understates the cost of both programs, but particularly of 

the direct program, in which all administrative functions 

are handled and paid for directly by the Department of 

Education. In the guaranteed loan program, by contrast, 

23. See, for example, Dennis Zimmerman and Barbara Miles, “Substituting Direct Government Lending for Guaranteed Student 

Loans: How Budget Rules Distorted Economic Decision Making,” National Tax Journal, vol. 47, no. 3 (December 1994), 

pp. 773–787; and Kevin Bruns, “The Hidden Costs of Direct 

Loans,” Chronicle of Higher Education, vol. 53, no. 42 (June 22, 

2007).

24. Although fair-value estimates are not used in budgeting for federal 

credit obligations, CBO values the government’s asset purchases 

under the Troubled Asset Relief Program on what is effectively a 

fair-value basis, using procedures similar to those specified in 

FCRA but adjusting for market risk as directed by the Emergency 

Economic Stabilization Act of 2008. 

25. See Financial Accounting Standards Board, Statement of Financial 

Accounting Standards No. 157: Fair Value Measurement (September 

2006), p. 2.

26. In general, an economic subsidy can exist even though a program 

has positive net income if the costs that are used to determine net 

income are not comprehensive. The conceptual issues surrounding estimates of economic subsidies for credit programs are 

described in Congressional Budget Office, Estimating the Value of 

Subsidies for Federal Loans and Loan Guarantees (August 2004). 

27. Unless otherwise noted, average subsidy rates are based on averages across all types of loans projected to be originated from 2010 

to 2020.
10 COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS

CBO

Table 3.

Projected Fair-Value and FCRA Subsidy Rates for Representative Loans and 

Borrowers, by Fiscal Year

(Percent)

Source: Congressional Budget Office.

Notes: Subsidy rates show the impact on the federal deficit of a dollar’s worth of lending under a given program. For example, a subsidy rate 

of 13 percent means that each dollar of lending increases the deficit by 13 cents.

The subsidy rates in this table are based on the mix of loan types and borrower characteristics projected for the Federal Family Education Loan (FFEL) program in each time period. Thus, the rates reported for the direct loan program represent the cost of making a typical FFEL loan in the direct loan program instead of in the FFEL program. The rates shown here for the direct loan program using the 

FCRA methodology do not correspond to CBO’s published estimates for the direct loan program.

a. Subsidy rates calculated according to the procedures specified in the Federal Credit Reform Act of 1990 (FCRA) are used for federal budget estimates. Those subsidy rates exclude administrative costs (including payments to Department of Education contractors, certain 

statutory payments for collection costs, and statutory payments to guaranty agencies).

the government payments that compensate FFEL lenders 

for administrative functions are included in FCRA subsidy rates (categorized as interest). To account fully and 

symmetrically for federal administrative costs in its fairvalue subsidy estimates, CBO allocated the various federal administrative costs between the two programs and 

between newly originated and outstanding loans on the 

basis of information from the Department of Education 

and private lenders. For each program, CBO discounted 

the lifetime administrative costs for each cohort of borrowers to the disbursement date and included the total in 

its estimates of fair-value subsidy costs.28 (For additional 

information about the discount rates and adjustment for 

administrative costs, see the appendix.) 

Fair-Value Subsidy Estimates

CBO’s estimates of subsidy rates for new federal student 

loans over the next decade are considerably higher on a 

fair-value basis than under FCRA accounting (see 

Table 3).29 Those subsidy rates are based on the characteristics of a representative FFEL loan—one that reflects 

average default and prepayment behavior by borrowers 

and the average mix of loan types under current law. The 

subsidy rates are also based on projections of interest rates 

and other market conditions from the economic outlook 

that underlies CBO’s March 2010 baseline budget projections. A number of factors account for the year-to-year 

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Direct Loan Program 13 13 11 7 9 11 12 13 13 13 13 12

Guaranteed Loan Program 16 21 20 18 19 20 20 20 20 20 20 20

Direct Loan Program -18 -14 -13 -12 -10 -7 -6 -4 -4 -4 -4 -9

Guaranteed Loan Program -11 1 4 4 6 7 8 8 8 8 8 5

FCRA Estimatesa 

Fair-Value Estimates 

(Using risk-adjusted discount rates and including administrative costs)

(Using Treasury discount rates and excluding administrative costs)

Average,

2010–

2020

28. One reason for excluding administrative costs from subsidy estimates is the difficulty of dividing total costs among individual 

loan cohorts. However, certain costs, such as for servicing and 

collection, are relatively easy to estimate, and there are standard 

approaches for allocating fixed costs among programs.

29. The results presented in this section differ from those in the 

Budget of the United States Government: Federal Credit Supplement, 

which is prepared by the Office of Management and Budget. That 

agency reports the costs of consolidation loans separately from the 

costs of the Stafford or PLUS loans being consolidated. CBO, by 

contrast, treats consolidation loans as extensions of the original 

loans, consistent with the principle of recognizing the value of a 

contractual right (in this case, the right to consolidate) at the time 

it is granted.
COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS 11

CBO

variation in subsidy rates, including rising interest rates 

and declining risk premiums. The upward trend in 

market interest rates accounts for the general pattern of 

higher subsidy rates over time. A slightly offsetting effect 

for the fair-value estimates is that the risk premium is 

projected to gradually fall to normal levels as conditions 

in financial markets improve, which decreases the relative 

cost of fair-value subsidies in later years.

Adjusting for risk and administrative costs narrows the 

gap in average subsidy rates on a representative loan 

between the two programs relative to FCRA estimates 

but does not eliminate it. On a fair-value basis, the average subsidy rate over the 2010–2020 period is 8 percentage points (20 minus 12) higher for a loan originated in 

the guaranteed loan program; under FCRA, it is about 

13 percentage points (5 minus -9, with rounding) higher. 

The gap is narrower on a fair-value basis because payments to FFEL lenders are less costly to the government 

when the risk of those payments is taken into account. 

Components of the subsidy rates can be illustrated using 

estimates for 2020 on a fair-value basis and on an alternative basis in which all cash flows are discounted using 

Treasury rates—similarly to FCRA estimates, but with 

the inclusion of administrative costs. The divergence in 

average subsidy rates is driven largely by the difference 

between the government’s payments to lenders in the 

guaranteed loan program and federal administrative costs 

in the direct loan program (see Table 4). The higher cost 

of payments to lenders in the FFEL program is only 

partly offset by the share of default losses retained by 

those lenders. The subsidy rates for the portion of cash 

flows associated with borrowers’ repayments are almost 

identical in the two programs, regardless of the discount 

rate used to value them.30 Payments to guaranty agencies 

that exceed the amount necessary to cover their costs of 

collecting on defaulted loans add to the cost of the FFEL 

program, but by an insignificant amount.

The student loan programs affect not only federal spending but also revenues from corporate income taxes. The 

different degrees of public and private involvement in the 

direct and guaranteed loan programs mean that more corporate tax revenues are generated under the guaranteed 

loan program. Those revenue effects are not included in 

CBO’s subsidy estimates (although they are accounted for 

elsewhere in the budget). A 2005 study by PricewaterhouseCoopers estimated that the corporate tax receipts 

produced by the FFEL program had a present value of 

1.5 cents per dollar of loans originated.31 That figure is 

probably smaller today because of recent reductions to 

lenders’ special allowance payments. Furthermore, the 

PricewaterhouseCoopers study did not include tax 

receipts from private-sector contractors for the direct loan 

program, which would further diminish the difference. 

Hence, incorporating the effect of taxes would offset only 

a small portion of the estimated cost difference between 

the two programs. 

Sensitivity Analysis

CBO’s fair-value subsidy estimates are highly sensitive to 

assumptions about a variety of uncertain factors, such as 

the effect of risk on discount rates and the allocation of 

federal administrative costs between programs. Nevertheless, under a wide range of assumptions, the guaranteed 

loan program is consistently more expensive than the 

direct program, and both programs’ subsidy rates are 

significantly positive on a fair-value basis.

Sensitivity to Risk Adjustment of Discount Rates. The 

rates used to discount cash flows on federal student loans, 

which CBO inferred primarily from interest rates charged 

on private student loans, involve considerable uncertainty, for several reasons. First, rates from a private market may not accurately represent the risk of federal loans 

(for instance, loan terms and characteristics of borrowers 

differ). Second, those rates can fluctuate considerably 

over time with market conditions. If the risk premium for 

student loan cash flows was 1 percentage point higher 

than that assumed in CBO’s base case, subsidy rates 

would increase by 6 percentage points for a typical loan 

made in the FFEL program, and by 8 points if the same 

loan was made in the direct program. (A reduction of 

1 percentage point in the risk premium would decrease 

subsidy rates by the same amounts.) In the case of direct 

loans, that effect is most easily understood as the higher 

discount rate reducing the value of future repayments. 

For guaranteed loans, greater market risk has the effect of 

30. A small difference arises because in the direct loan program the 

government pays for certain benefits to borrowers.

31. PricewaterhouseCoopers, National Economic Consulting Group, 

The Limitations of Budget Score-keeping in Comparing the Federal 

Student Loan Programs (Washington, D.C.: PricewaterhouseCoopers, March 3, 2005), available at www.studentloanfacts.org/

resources/. 
12 COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS

CBO

Table 4.

Components of Estimated Subsidy Rates for Loans Made in Fiscal Year 2020

(Percent)

Source: Congressional Budget Office.

Notes: All components of the subsidy are based on the mix of loan types projected for the Federal Family Education Loan (FFEL) program in 

2020. Thus, the subsidy rate reported for the direct loan program represents the cost of making a typical FFEL loan in the direct loan 

program instead of in the FFEL program.

n.a. = not applicable.

a. The subsidy rates shown in these columns do not follow the methodology specified in the Federal Credit Reform Act. Although cash flows 

are discounted at Treasury rates, as required under FCRA, they include various administrative costs and other payments that CBO would 

normally exclude to comply with FCRA requirements.

b. Includes collection costs and origination fees. The present value of loan payments for the direct loan program is different than for 

the guaranteed loan program because borrowers in the direct program pay lower interest rates on PLUS loans and may receive other 

discounts.

c. Excludes collection costs, which are included with loan payments.

d. Includes special allowance payments to lenders minus various statutory fees that lenders pay (and excluding lenders’ share of default 

losses, which is shown separately). Lenders may use those payments to offer benefits to borrowers and services to schools as well as to 

defray various costs of financing and administering loans.

e. Includes fees for loan processing and account maintenance. (Payments received for loan collection are included with loan payments.)

increasing the present value of payments made on 

guarantee claims for defaulted loans. 

Incorporating a risk premium into estimates also lowers 

the present value of some federal payments to lenders, 

which narrows the cost difference between the two 

programs. The rates that CBO used to discount those 

projected payments differ from the rates it used to discount loan cash flows, because the two streams of cash 

flows involve different amounts of risk and differ in the 

extent to which they depend on fixed versus variable 

interest rates. CBO’s imputation of the discount rate for 

payments to FFEL lenders depends in part on the interest 

rate spread over Treasury rates that those lenders pay to 

finance their guaranteed student loans. That spread has 

varied over time and among lenders, ranging from as little 

as 0.3 percentage points above the yield on Treasury securities for the most efficient lenders to more than 2 percentage points during the financial crisis. 

The appropriate discount rate for federal payments to 

FFEL lenders depends on how much of the spread over 

Treasury rates that lenders pay to fund their borrowing 

can be attributed to an offsetting savings to taxpayers 

from a transfer of risk to the private sector. The greater 

the transfer of risk, the higher the appropriate discount 

rate, but the amount of that risk transfer is highly uncertain. CBO discounted the variable-rate payments at a 

rate that was 0.3 percentage points higher than the comparable Treasury rate. Increasing that spread above the 

100.0 100.0 100.0 100.0

-89.5 -88.8 -103.5 -102.7

_____ _____ ______ ______

10.5 11.2 -3.5 -2.7

0.7 2.2 0.8 2.5

-1.3 n.a. -0.3 n.a.

9.4 n.a. 13.0 n.a.

0.9 n.a. 1.0 n.a. ____ ____ ____ ____

Total Subsidy 20.2 13.4 11.0 -0.2

Subsidy Computed with

Treasury Discount Ratesa

Program Program 

Direct Loan 

Fair-Value Subsidy

Guaranteed Loan Direct Loan 

Program Program 

Guaranteed Loan 

Payments to Lendersd

Payments to Guaranty Agenciese

Loan Disbursement

Present Value of Loan Paymentsb

Loan Subsidy

Federal Administrative Costsc

Lenders' Share of Default Losses
COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS 13

CBO

Treasury rate to 0.6 percentage points decreases the subsidy rate on FFEL loans by about 2 percentage points.

Sensitivity to Administrative Costs. For its fair-value calculations, CBO divided unallocated cash administrative 

costs between the two programs according to their relative dollar amounts of loans outstanding. That approach 

may overstate the administrative costs of the guaranteed 

loan program if most administrative functions are performed by FFEL lenders. An alternative approach, which 

provides the most favorable case with regard to the cost of 

the guaranteed loan program, is to assume that all of the 

unallocated administrative costs reported by the Department of Education are used for expenses of the direct 

loan program. With that change in assumptions, the difference between the average cost of the two programs falls 

from about 8 percentage points to 5.5 percentage points.

Policy Options

Policymakers have considered a variety of modifications 

to the federal student loan programs—some aimed at 

reducing the costs of the programs to the government and 

others intended to change the loan terms available to borrowers. In evaluating options to modify those programs, 

it is useful to consider the various ways in which federally 

backed credit for education can improve social welfare, as 

well as the potential drawbacks of such credit.

The benefits to students from federal loans may exceed 

the fair-value cost to the government of providing them if 

the private market for student loans operates imperfectly. 

For example, private lenders cannot profitably lend to all 

borrowers if they cannot effectively evaluate differences in 

the risk of default. Because their ability to evaluate that 

risk is limited, in a purely private market some borrowers 

would wind up being denied credit.32 However, some evidence suggests that federal policy has been effective at 

easing such constraints for most students.33 Thus, when 

considering new policies to relieve financial constraints, it 

may be most cost-effective to focus on constraints faced 

by subsets of the population that still have limited access 

to what they perceive as affordable credit (or other means 

of financing an education). It may also be cost-effective to 

examine policies in which the government adjusts repayment terms to accommodate borrowers’ risky or lowpaying career choices or to help borrowers during periods 

of financial distress. Such policies can provide valuable 

insurance that would not be feasible for borrowers to 

obtain privately because of the losses it would entail for 

private lenders.

The benefits of subsidizing education may also outweigh 

the costs when education produces benefits for society in 

addition to the private benefits enjoyed by the student. 

Students may fail to take those social benefits into 

account when making choices about their education, 

which provides a case for government subsidization. A 

number of studies offer evidence of such social benefits.34

Others, however, suggest that social benefits have proved 

difficult to identify and quantify and that the case for further subsidizing higher education may be weaker than the 

case for the current level of subsidies.35

An unintended consequence of making subsidized credit 

available is that it may cause some people to overinvest in 

higher education. Such overinvestment could take the 

form of students’ choosing formal higher education in 

place of cheaper on-the-job training or instead of entering the labor force sooner. Students may also be harmed 

by easy access to credit if they underestimate the burden 

of paying off their loans later on. In addition, there are 

32. Although the government is unlikely to have an advantage over 

the private sector in evaluating risk, it can alleviate borrowing constraints by lending to people who would be denied credit by private lenders (thereby providing a subsidy to those borrowers).

33. For example, one study concludes that fewer than 8 percent of 

student loan borrowers are constrained; see Pedro Carneiro and 

James J. Heckman, “The Evidence on Credit Constraints in Postsecondary Schooling,” Economic Journal, Royal Economic Society, 

vol. 112, no. 482 (October 2002), pp. 705–734. 

34. See Enrico Moretti, “Estimating the Social Return to Higher Education: Evidence from Longitudinal and Repeated Cross-Sectional 

Data,” Journal of Econometrics, vol. 121, no. 1–2 (July–August 

2004), pp. 175–212. In that analysis, Moretti concluded that 

college education creates positive spillovers in productivity and 

wages. See also Eric Hanushek and Ludger Woessmann, Do Better 

Schools Lead to More Growth? Cognitive Skills, Economic Outcomes, 

and Causation, Working Paper No. 14633 (Cambridge, Mass.: 

National Bureau of Economic Research, January 2009). In that 

analysis, the authors found empirical evidence of a causal relationship between educational attainment and growth rates among 

countries. For a discussion of the relationship between postsecondary education and social mobility, see Robert Haveman 

and Timothy Smeeding, “The Role of Higher Education in Social 

Mobility,” Future of Children: Opportunity in America, vol. 16, 

no. 2 (Fall 2006), pp. 125–150.

35. See James J. Heckman and Peter J. Klenow, “Human Capital Policy,” in Michael Boskin, ed., Policies to Promote Capital Formation

(Stanford, Calif.: Hoover Institution, 1998). 
14 COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS

CBO

probably some borrowers for whom the availability of 

federal student loans does not alter their educational 

attainment. In the case of those borrowers, a federal 

credit subsidy is simply a transfer payment to them from 

taxpayers as a group.36

Reducing the Federal Cost of the Guaranteed 

Loan Program

Policy options that have been discussed for lowering the 

federal cost of the FFEL program include replacing it 

entirely with direct lending, funding all federal student 

loans through the Treasury but continuing to have private 

lenders perform administrative functions, cutting government payments to lenders, reducing the guarantee percentage on loans, and auctioning off the right to lend 

under the program. 

Replace Guaranteed Lending with Direct Lending. The 

President’s 2011 budget proposed eliminating the FFEL 

program after July 1, 2010, and replacing it with an 

expansion of the direct loan program.37 CBO recently 

estimated that under FCRA accounting, that proposal 

would reduce mandatory spending by a total of $68 billion over the 11 years from 2010 through 2020.38 At the 

same time, however, discretionary spending for administrative costs in the direct loan program would increase, so 

the net budgetary savings over the 2010–2020 period 

would amount to about $62 billion. The savings on a 

fair-value basis (taking into account the cost of market 

risk and the present value of future administrative costs) 

were estimated at about $40 billion for that period. The 

cost reduction results primarily from eliminating federal 

payments to FFEL lenders that exceed the administrative 

costs associated with loans in the direct program. The 

savings are smaller on a fair-value basis because that measure, which takes into account the risk associated with 

those payments, assigns them a lower cost to the government and thus finds a smaller benefit from eliminating 

them.

Finance Guaranteed Loans Through the Treasury. An 

option that would avoid the higher funding costs of the 

FFEL program and prevent disruptions in the supply of 

credit would be to fund all federal student loans through 

the Treasury. Under that approach, the Treasury would 

buy the loans made by FFEL lenders, but the infrastructure of the FFEL program would be retained for other 

administrative functions. At the same time, payments 

from the government to lenders could be reduced by the 

amount of the savings from lower funding costs. To realize similar savings from that change as from eliminating 

new guaranteed lending entirely, however, compensation 

for administrative services under the FFEL program, 

including services performed by guaranty agencies, would 

have to be set on a competitive basis rather than by statute, as in current law.

Switching to financing all federal student loans through 

the Treasury would increase the amount of federal debt 

outstanding, but that increase would be offset by a 

decrease in federally guaranteed private debt. Because 

federal obligations would essentially be unchanged, and 

because federal debt would increase by only a small percentage, CBO expects that the effect on the government’s 

borrowing costs would be negligible. However, the 

increase in the size of the federal debt would affect its 

relation to the statutory debt ceiling.

Reduce Payments to Lenders or the Percentage of the 

Federal Guarantee. CBO’s analysis suggests that a major 

reason for the higher cost of the FFEL program is the fact 

that, under normal conditions in financial markets, statutory compensation to lenders exceeds estimated administrative costs in the direct loan program.39 Lowering 

lenders’ spread over the interest rate on three-month 

commercial paper by, for instance, 0.4 percentage points 

from current levels would reduce the fair-value subsidy 

rate on guaranteed loans by 3 percentage points. 

Another way to reduce the cost of the FFEL program 

would be to lower the guarantee percentage. Currently, 

the government guarantees 97 percent of a loan’s outstanding principal and interest for most lenders; that figure is scheduled to fall to 95 percent in 2013. Lowering 

the guarantee to 90 percent would reduce the fair-value 

36. Because transfer payments must be paid for with taxes that distort 

people’s incentives to work and invest, such subsidies have social 

costs as well.

37. The House of Representatives recently passed legislation (H.R. 

4872, the Health Care and Education Affordability Reconciliation Act of 2010) that would implement that proposal, and the 

Senate is considering the legislation.

38. Congressional Budget Office, letter to the Honorable Judd Gregg

about the budgetary impact of the President’s proposal to alter 

federal student loan programs (March 15, 2010).

39. The abnormally high funding costs for FFEL lenders in the current market environment have absorbed those excess payments, 

but CBO expects that making guaranteed loans will again become 

profitable for lenders as market conditions improve.
COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS 15

CBO

subsidy rate on guaranteed loans by 2 percentage points. 

Cutting the guarantee percentage could have the effect of 

narrowing the set of potential investors willing to buy 

student loans—because riskier loans require more expertise to evaluate—thereby increasing the funding costs of 

FFEL lenders and the compensation necessary to induce 

them to participate in the program.

Reducing special allowance payments or the guarantee 

percentage could have other consequences as well. Such 

cuts might leave some lenders with too little cash coming 

in to recover their funding and administrative costs, even 

under normal market conditions. Some lenders would 

probably leave the program and be replaced by lower-cost 

lenders or by the direct loan program. Lenders would also 

be likely to reduce the benefits and services they offer to 

borrowers. Moreover, FFEL lenders might find it unprofitable to serve borrowers or schools whose loans have 

higher risks and are more costly to finance and administer, which could force those schools into the direct loan 

program. Cutting payments to or protections for lenders 

would also increase the probability that emergency interventions would be needed in the event of future market 

disruptions. Those effects are hard to quantify—because 

of the difficulty in assessing costs across the diverse range 

of schools, borrowers, and lenders in the guaranteed loan 

program—and CBO did not attempt to do so.

Add Competitive Auctions. Auctioning off the rights to 

originate or hold guaranteed student loans has been proposed as a market-based alternative to cutting lenders’ 

payments or the guarantee percentage. In a well-designed 

auction, the winning bids would reflect the cost of funding and administering loans for the most efficient lenders, 

eliminating the excess profits that arise when compensation is fixed in legislation.40 To explore this possibility, the 

College Cost Reduction and Access Act of 2007 mandated a pilot auction program for PLUS loans. But the 

initial attempt to implement it failed to attract any bidders, and the program was postponed for two years. 

Several factors may limit the ability of auctions (or any 

similar mechanism) to substantially reduce the difference 

in subsidy rates between the two loan programs. Historically, private lenders have offered better service at greater 

cost than the direct program does. Lenders may bid less 

aggressively if they expect that they will need to maintain 

higher service levels to attract borrowers—particularly if 

winning an auction does not guarantee exclusive access to 

a pool of borrowers. Similarly, lenders’ administrative 

costs include marketing expenses, which winning bidders 

will continue to incur if the auction does not guarantee 

them a certain volume of lending, and which they will 

therefore factor into their bids. Furthermore, to the 

extent that FFEL lenders have higher financing costs, the 

bid price will continue to incorporate those higher costs. 

Collusive bidding is also a concern, especially in an 

industry dominated by a few large participants.

Restructuring Loans

The Congress has periodically changed the interest rates 

and other terms on federal student loans to meet goals 

such as increasing the affordability and availability of 

credit for students or preventing defaults. The structure 

of student loans also affects the level and volatility of federal program costs (as measured on both a fair-value and a 

FCRA basis).

Interest Rates. Policy options for modifying the interest 

rates charged to borrowers include raising or lowering the 

current fixed rates; indexing those fixed rates to a market 

interest rate; or changing from fixed rates to variable 

rates, with an upper limit, or cap, on the variable rates. 

In the past, the direct and guaranteed loan programs have 

switched several times between charging a fixed interest 

rate set in statute and charging a variable rate (tied to a 

market index) with a cap. Since July 2006, loans made 

under either program have carried fixed interest rates. 

Since 1998, borrowers have been able to consolidate their 

Stafford and PLUS loans into a single loan with a fixed 

interest rate equal to a weighted average of the interest 

rates on the underlying loans. For borrowers with 

variable-rate loans, the right to consolidate is a valuable 

option—in many cases it allows borrowers to lock in 

fixed interest rates that are well below the alternatives 

available in private markets. Taking into account 

historical variation in interest rates (and using discount 

rates adjusted for risk), CBO concluded that the right 

to consolidate variable-rate loans added approximately 

2 percentage points to the subsidy rates for direct and 

guaranteed student loans.41

40. For an assessment of the options and issues involved in designing 

an auction program, see Department of Education and General 

Accounting Office, Alternative Market Mechanisms for the Student 

Loan Program, GAO-02-84SP (December 18, 2001).

41. Congressional Budget Office, The Cost of the Consolidation Option 

for Student Loans. 
16 COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS

CBO

The federal costs of the student loan programs are very 

sensitive to the interest rates on the loans. For instance, 

each decrease of 1 percentage point in the interest rate 

charged to borrowers increases the fair-value subsidy rate 

by approximately 7 percentage points. The increase is 

slightly higher for FCRA subsidy rates (because discounting at a lower rate makes reductions in interest payments 

that occur in the future more costly to the government in 

present-value terms).

Fixing by statute the rate charged to borrowers has the 

effect of adding considerable volatility to the cost of the 

federal student loan programs over time, whether measured under FCRA accounting rules or on a fair-value 

basis. Under the assumptions of a fixed 6.8 percent rate 

on Stafford loans and future interest rate levels and volatility consistent with experience, the fair-value subsidy 

rate on a loan issued in 2014 would have a 10 percent 

probability of being at least 6 percentage points more 

than currently projected purely because of variation in 

future interest rates. Setting interest rates by statute also 

causes the subsidies that different cohorts of borrowers 

receive to differ considerably; the greatest benefits go to 

students who happen to attend college when market 

interest rates are well above the statutory rate on student 

loans.42 Conversely, when market interest rates are low, 

students receive relatively little federal subsidy. 

One way to avoid large fluctuations in the subsidy cost of 

federal student loans over time would be to index interest 

rates to a market rate. In the case of fixed-rate loans, the 

yield on long-term Treasury securities could provide an 

appropriate index; for variable-rate loans, the yield on 

short-term Treasury bills could provide such a base.43 A 

concern about indexing is that it exposes students to the 

possibility of being charged high interest rates. However, 

high interest rates tend to occur during periods of high 

expected inflation, when future income is also likely 

(though not certain) to grow at a faster-than-average rate. 

An alternative approach that would make subsidies less 

volatile than under current law, but that would protect 

students from unusually high interest rates, would be to 

index interest rates and also put a cap on them. Such a 

cap exists now for variable-rate student loans that were 

made before the switch to fixed rates in July 2006. 

Repayment Terms. The repayment terms offered to 

borrowers affect the costs of the student loan programs 

because they can influence the probability and severity of 

defaults as well as the length of time that subsidized loans 

remain outstanding. Repayment terms also have a significant impact on the welfare of borrowers—for instance, by 

affecting how much flexibility they have in their future 

career choices. Options for modifying those terms 

include changing the current forbearance and deferment 

policies and introducing additional loan-forgiveness policies that would be contingent on a borrower’s income or 

career. 

In the past, student loans had the highest rates of default 

of any federal credit program. High default rates are not 

surprising given that most student borrowers have few 

assets after graduating and student loans are unsecured. 

Default rates and losses from defaults have fallen dramatically over time, however, because of various factors specific to the loan programs as well as other legal and economic developments. Changes to the bankruptcy code 

generally prevented federal student loans from being discharged, or erased, during bankruptcy proceedings (with 

some exceptions). In addition, use by FFEL lenders of the 

default-averting provisions of federal student loans—such 

as forbearance and deferment, which allow borrowers to 

temporarily stop making payments—has become more 

common.44 And individual schools and lenders have 

increased their oversight of loan performance. In particular, the Department of Education excludes schools and 

lenders from participating in the student loan programs if 

they exceed specified thresholds for two-year default rates 

on individual cohorts of loans.

42. Offering similar subsidy rates to all cohorts may be perceived as 

fair. However, policymakers might want to offer different subsidies to different cohorts for various reasons. For instance, cohorts 

that graduate when the labor market is weak tend to experience 

persistently poorer employment prospects, which may justify a 

higher subsidy for those groups. There is considerable variation in 

the amount of time between when a borrower takes out a loan and 

when repayment begins, and market conditions may change in the 

interim. Thus, the variation in subsidy rates over time caused by 

fixing interest rates by statute is unlikely to efficiently help borrowers who graduate during recessions.

43. A return to variable-rate lending would transfer to students the 

interest rate risk that is now borne by the government.

44. Private lenders also offer forbearance on nonguaranteed student 

loans because doing so for a borrower who faces a short-term 

liquidity problem can be less costly to a lender than trying to 

collect on the same loan in default. Nevertheless, the use of forbearance on student loans is less pervasive in the private market 

than in the federal programs.
COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS 17

CBO

Some of the decline in default rates may also have 

resulted from the strong performance of the overall economy and the growth in demand for college graduates over 

the past several decades. However, in the aftermath of the 

recent deep recession, with the unemployment rate 

remaining high, default rates may be above their recent 

levels for at least the next few years. 

Although forbearance and deferment policies avoid some 

defaults, they also entail significant costs for the government because they lengthen the average repayment 

period of a loan at below-market interest rates. Under 

current law, forbearance for as long as three years is available to borrowers who can show evidence of financial 

hardship.45 In addition, borrowers in both programs can 

defer repaying existing loans by starting a new course of 

study. And students have a six-month grace period after 

they leave school before they must begin repayment. Data 

suggest that a typical borrower spends about three years 

in grace and deferment. 

The recovery rate on defaulted loans—the present value 

of the cash flows recovered for each dollar of loans in 

default (net of the costs of collection)—also affects the 

cost to the government from borrowers’ defaults. The 

Department of Education has strong collection mechanisms available that bolster its recoveries. The inability of 

borrowers to have their student loans discharged in bankruptcy proceedings extends the period over which delinquent loans can be collected to the entire lifetime of the 

borrower.46 Besides using private loan-collection agencies, 

the department can garnish the wages of delinquent borrowers and use the Treasury Offset Program to collect a 

portion of federal transfer payments (such as tax refunds 

or Social Security benefits) that they receive. 

The department can charge the full cost of collecting on a 

defaulted loan to the borrower, which theoretically means 

that 100 percent of the outstanding principal and interest 

on the loan is collectible. In practice, however, recovery 

rates are lower than that because some borrowers never 

repay in full (such as those who evade collection, remain 

in a perpetual state of poverty, become disabled, or die) 

and because the department has discretion to negotiate 

settlement terms and waive collection costs. From a fairvalue perspective, even if 100 percent of the outstanding 

principal and interest, plus collection costs, were recovered by rehabilitating or consolidating a loan, the private 

sector would value that recovery at less than 100 percent. 

The reason is that the collection process extends the time 

that the loan is outstanding and earning an interest rate 

less than market rates.

Strong collection mechanisms reduce the costs of default 

to the federal government, but they may harm the very 

populations that student loans are intended to help. 

Delinquencies on student loans are reported to the 

national credit bureaus, which reduces those borrowers’ 

ability to obtain further credit, jobs, and housing, especially if they fail to complete their course of study. That 

situation has led some policymakers and analysts to advocate broadening the existing provisions for loan forgiveness and income-contingent repayment, which currently 

play only a minor role in the student loan programs. 

Greater loan forgiveness and more reliance on incomecontingent repayment have also been proposed as options 

to reduce the debt burden on certain groups of students. 

The idea is that borrowers who have less ability to pay 

because of a personal misfortune or choice of career (such 

as the military, public service, or teaching) should be 

allowed to pay less for their education than borrowers 

with greater resources. In a carefully designed program, 

some of the costs of subsidizing borrowers who ultimately 

are less able to repay their loans may be covered by charging higher fees or interest rates to borrowers who can 

repay—much as insurance programs do. Such insurance 

provisions would be unique to federally provided credit 

because the ability to cross-subsidize borrowers depends 

on having market power: In a competitive private market, 

if a single small lender tried to charge a high-income 

borrower an above-market rate, the borrower would repay 

the loan with money borrowed at a lower rate from 

another lender. The federal government can avoid that 

problem by setting rates that are lower than market rates, 

including for high-income borrowers.

45. Some deferments also are available on a hardship basis.

46. For other types of unsecured loans, state-level statutes of limitations typically prevent loans from being collected beyond a certain 

window of time (generally 3 to 10 years).

CBO

Appendix: 

Assumptions and Analysis Underlying 

CBO’s Fair-Value Subsidy Estimates

The Congressional Budget Office’s (CBO’s) fairvalue estimates of the cost of student loan programs 

depend on the same cash flows assumed for the estimates 

that follow the accounting procedures specified in the 

Federal Credit Reform Act of 1990 (FCRA). However, to 

calculate the fair-value estimates, CBO used additional 

information and assumptions in order to allocate federal 

administrative costs between the direct and guaranteed 

loan programs and among different loan cohorts as well 

as to derive discount rates adjusted for risk. This appendix describes the information and assumptions that CBO 

used.

Administrative Costs

The federal costs that CBO classifies as administrative 

are recorded in the budget on a cash basis, as required by 

FCRA, for both student loan programs.1

 In the Federal 

Family Education Loan (FFEL) program, the Department of Education directly bears some of the administrative costs of guaranteed loans (such as the costs of collecting on loans that have been in default for more than three 

years and of supporting schools’ financial aid offices); 

those costs are recorded together with the total administrative costs for the direct loan program. At the same 

time, some of the department’s payments to FFEL lenders (which cover administrative costs such as loan servicing) are classified in the budget as part of mandatory 

interest payments, and the present value of those costs for 

each loan cohort is included in FCRA subsidy estimates.2

As a result of that accounting, the administrative costs 

that appear in the budget on a cash basis are a mixture of 

costs from old and new student loans and from the FFEL 

and direct loan programs. To estimate the lifetime federal 

administrative costs attributable to newly originated 

loans in each program for its fair-value estimates, CBO 

relied primarily on data from the Department of Education. Detailed information on administrative costs was 

limited; CBO used data from the 2006 program year to 

impute the normal allocation of federal administrative 

costs, by activity, between the two programs. Because the 

factors that determine administrative costs and the proportion coming from each program are likely to be similar from year to year (under normal market conditions), 

that approach is unlikely to create a bias in estimates for 

future years, in CBO’s judgment. The sensitivity analysis 

discussed earlier in this study also shows that the resulting 

estimates are not very sensitive to assumptions about the 

allocation of federal administrative costs. 

In 2006, the annual appropriation to the Department of 

Education for the direct and guaranteed loan programs 

totaled approximately $800 million. In information 

given to CBO at that time, the department reported allocating about $200 million of the appropriation to servicing contracts in the direct loan program, $30 million to 

origination contracts in the direct loan program, and 

$200 million to recovery contracts in both programs. In 

its base-case analysis, CBO assumed that approximately 

1. Some of the programs’ administrative costs are mandatory, and 

others are discretionary. The mandatory portion involves items in 

the guaranteed loan program, such as fees to guaranty agencies, 

that are required by law to be paid.

2. Those payments also cover benefits to schools and borrowers that 

might not be considered basic administrative costs. In addition, 

the Office of Management and Budget’s FCRA subsidy estimates 

include federal payments to guaranty agencies for collection costs 

and fees, but CBO’s FCRA subsidy estimates do not.
20 COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS

CBO

half of the unallocated $370 million was attributable to 

administration in the guaranteed loan program, onequarter to administration in the direct loan program, and 

the remaining one-quarter to administration in the Pell 

grant program. Those amounts yield an estimate that the 

government’s annualized origination and servicing costs 

equal about 0.3 percent of outstanding loan balances in 

the direct loan program and 0.1 percent in the guaranteed loan program. To produce fair-value subsidy rates, 

those estimates of administrative costs were applied to 

projected loan balances and discounted to the present. 

The costs incurred by FFEL lenders and guaranty agencies do not directly affect government spending because 

federal payments to lenders do not depend directly on 

lenders’ actual expenses. However, an estimate of those 

expenses is necessary to calculate the cost of capital for 

student loans and to identify the causes of the higher 

costs in the FFEL program.3

 Using an analysis of the 

reported administrative costs of a large FFEL lender in 

2006, CBO estimated that origination and servicing costs 

totaled 0.67 percent of outstanding balances for guaranteed loans, slightly more than twice the costs in the direct 

loan program. The greater costs for FFEL lenders can be 

attributed at least in part to higher service levels to students and schools, as well as to higher marketing costs 

arising from the need to compete with other lenders. 

CBO’s estimates of administrative costs for FFEL lenders 

involve considerable uncertainty, both because data are 

limited and because administrative costs are likely to vary 

greatly among lenders according to their size and efficiency. 

Fair-Value Cost of Capital 

The cost of capital refers to the expected return that private investors require on a risky security to be willing to 

buy it. CBO used the interest rates charged to borrowers 

on private student loans, adjusted for administrative 

costs, as the starting point for inferring the fair-value cost 

of capital for federal student loans. That cost of capital in 

turn was used to derive risk-adjusted discount rates. 

The main lenders in the private loan market are also the 

largest FFEL lenders: Sallie Mae, major national and 

regional commercial banks, and nonprofit entities. FFEL 

lenders have a competitive advantage over other potential 

entrants in the private student loan market because of 

economies of scale in marketing, systems administration, 

and funding as well as the experience gained from guaranteed lending. Borrowers turn to private lenders—

whose rates usually exceed those on federal student 

loans—when they have exceeded their federal lending 

limit or do not qualify for a federal loan. 

An important consideration in using private student 

loans to infer the cost of capital for federal loans is 

whether the risks of federal and private student loans are 

similar. Several factors suggest that private loans may be 

safer: Repayment is usually over a shorter period, and students with low credit scores are unlikely to be given loans. 

However, students who take out private loans tend to 

have higher levels of total indebtedness, which could 

reduce recovery amounts in cases of default. Private lenders also have the risk of adverse selection—students who 

are poor credit risks will be more inclined to try to borrow than students who are likely to repay. The federal 

programs are less susceptible to adverse selection because, 

by offering very favorable rates, they are more likely to 

attract safe borrowers as well as riskier ones. CBO 

assumed similar loss rates on federal and private loans on 

the basis of those offsetting considerations and limited 

data that suggest that historical loss rates from defaults 

have been broadly similar.4

The first step in adjusting for risk in CBO’s fair-value 

calculations is to estimate what portion of the spread 

between the interest rate charged to borrowers on private 

loans and the rate on Treasury securities of comparable 

maturity represents the student loan risk premium—the 

compensation that private investors require to invest in 

student loans over and above expected losses from 

default.5

 Before the recent financial crisis, lenders typically charged borrowers variable interest rates on private 

3. Administrative costs affect the interest rates that private lenders 

charge to borrowers because that is how lenders recover those 

costs. Administrative costs for FFEL and private lenders are likely 

to be similar, given that the large FFEL lenders also make private 

student loans. CBO used the interest rate charged on private 

loans, adjusted downward for the portion covering administrative 

costs and other factors, to infer the cost of risk. 

4. That inference is based on confidential data provided to CBO by 

a private lender. There is no public source of data on default and 

recovery rates for private student loans. 

5. Private student loans generally carry variable rates, whereas federal 

student loans carry fixed rates. Nevertheless, the spread between 

the rate charged on a private variable-rate loan and a short-term 

Treasury rate is a reasonable proxy for the premium that investors 

require for the default risk associated with federal student loans. 
APPENDIX COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS 21

CBO

student loans that were about 4 percentage points higher 

than the London interbank offered rate, or Libor (a 

short-term rate that banks charge other high-quality 

banks to borrow). Conceptually, that spread includes 

compensation for expected default losses, administrative 

costs, and a risk premium. CBO attributes approximately 

2 percentage points of the spread to administrative costs 

and losses from defaults, which leaves 2 percentage points 

as an estimate of the premium over Libor for private student loans in 2006, when credit conditions were relatively easy. At the time, Libor rates were about 0.3 percentage points over Treasury rates, implying a risk 

premium of 2.3 percentage points. 

During the financial crisis, spreads on student loans widened sharply, and private loans became much harder to 

obtain. CBO recently collected information from a large 

lender about rate spreads on private student loans and the 

credit quality of borrowers. Adjusting for administrative 

costs, and taking into consideration the disrupted market 

conditions, CBO estimates that the fair-value risk premium on private student loans was about 4 percentage 

points over Treasury rates in early 2010.6

 CBO assumes 

that after 2013, the risk premium will gradually decline 

to a long-term level of 2.5 percentage points as market 

conditions return to normal and the economy improves.

FFEL lenders’ net receipts reflect a combination of payments from borrowers, the federal government, and the 

capital markets in which the loans are funded. Considering the combined effect of those net payments suggests 

that some of the lenders’ cash flows should be discounted 

at close to a short-term Treasury rate, whereas others are 

affected by default and prepayment risk and should be 

discounted at a higher rate that is based on the inferred 

risk premium on student loans. CBO takes those considerations into account in determining the fair-value discount rates for payments to FFEL lenders.7

Estimating Subsidy Rates

CBO computes fair-value subsidy rates for the direct and 

guaranteed loan programs by applying discount rates 

imputed from the cost of capital to the programs’ various 

cash flows. In the direct loan program, the stream of borrowers’ payments net of collection costs and some administrative costs is discounted at the Treasury rate plus a 

spread that varies from 1 percentage point to 6 percentage points depending on the default rate associated with 

the type of loan. The subsidy rate for the direct loan program is the present value of cash flows per dollar of loans, 

net of the amount disbursed and up-front fees. The components of the subsidy for a direct loan (assuming the risk 

profile of a typical loan made in the FFEL program) are 

shown in Table 4 on page 12.

To properly account for differences in the risk of different 

cash flows in the guaranteed loan program, CBO computes subsidy rates by considering two sets of cash flows 

whose difference equals the government’s net cash flows. 

The first set is borrowers’ payments of principal and 

interest to FFEL lenders. The second set is the net payments that lenders receive from borrowers and the federal 

government, which include special allowance payments, 

payments of default claims, and various fees.8

The first set of payments (from borrowers to lenders) is 

valued in the same way as for the direct loan program: by 

discounting expected cash flows using a Treasury rate plus 

a risk premium that is adjusted for the risk of the loan 

pool in question. The second set of payments (from 

borrowers and the government to lenders) generates a 

stream of variable payments that is indexed to a shortterm commercial-paper rate, plus a fixed spread, plus 

the amounts recovered from the government if a loan 

defaults. CBO discounts the variable payments and principal payments at a rate that is only slightly above the rate 

6. The reported rates charged on private loans in 2009 ranged from 

Libor+4 percentage points to Libor+13 percentage points, with an 

average of Libor+11 percentage points. CBO judged that the high 

average spread reflected not only the riskiness of borrowers but 

also the shortage of risk capital in the market; as a result, CBO 

based its estimate of the cost of capital on a below-average spread. 

7. To discount the variable-rate payments included in lenders’ special 

allowance payments under FCRA, CBO uses a Treasury rate that 

corresponds to the maturity of the underlying loans. Fair-value 

estimates discount the payments at a short-term rate because variable-rate liabilities are economically equivalent to short-term liabilities. The effect of using a long-term Treasury rate is typically to 

bias downward the present value of those payments relative to 

their fair value.

8. In this breakdown, any benefits to borrowers that are paid by the 

lender are excluded from the first set of cash flows and included in 

the second set. Certain payments to guaranty agencies and other 

federal administrative costs are omitted from this breakdown, but 

CBO took their contribution to the subsidy into account; that 

contribution is computed by applying discount rates that reflect 

the risk of those cash flows.
22 COSTS AND POLICY OPTIONS FOR FEDERAL STUDENT LOAN PROGRAMS

CBO

on short-term Treasury securities, because the value of 

those cash flows is largely unaffected by default risk. 

However, some components of a lender’s cash flows, such 

as its share of credit losses and a portion of the fixed 

spread received, are more risky because they are sensitive 

to borrowers’ defaults and prepayments. Consequently, 

those components are discounted at higher rates.

A large part of the stream of combined payments from 

the government and borrowers to FFEL lenders corresponds to what the lenders pay out in interest to holders 

of the student-loan-backed securities that they issue. 

Principal on such securities is redeemed as loans are 

repaid or default. Holders of the securities typically earn a 

variable interest rate (indexed to Libor) plus a spread. The 

spread has averaged about 0.2 percentage points under 

normal market conditions, but it widened to as much as 

2 percentage points during the recent financial crisis. 

Equivalently, the rate is about 0.5 percentage points over 

the rate on short-term Treasury securities during normal 

times. That spread is difficult to understand given that 

the federal government bears most of the risk of loss associated with the securities and that the floating rate coupon helps insulate investors from price fluctuations. In its 

base-case estimates, CBO attributes about three-fifths of 

the normal spread over Treasury rates to a transfer of risk 

from the government to lenders. CBO judges that the 

remainder is attributable to a cost disadvantage for FFEL 

lenders resulting from counterparty risk, liquidity risk, 

and securitization inefficiency that are not present in the 

direct loan program.