Report to Congressional Requesters

United States Government Accountability Office

GAO

September 2004 FEDERAL FAMILY 

EDUCATION LOAN 

PROGRAM 

Statutory and 

Regulatory Changes 

Could Avert Billions in 

Unnecessary Federal 

Subsidy Payments 

GAO-04-1070 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

www.gao.gov/cgi-bin/getrpt?GAO-04-1070.

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact Cornelia Ashby 

at (202) 512-8403 or ashbyc@gao.gov.. 

Highlights of GAO-04-1070, a report to 

congressional requesters 

September 2004

FEDERAL FAMILY EDUCATION LOAN 

PROGRAM 

Statutory and Regulatory Changes Could 

Avert Billions in Unnecessary Federal 

Subsidy Payments 

As shown below, special allowance payments for 9.5% loans have risen 

dramatically in recent years, increasing from $209 million in FY 2001 to well 

over $600 million as of June 30, 2004. A primary reason for the increase is the

sharp decline in the variable interest rates paid by borrowers relative to the 

minimum 9.5% lender yield. 

Another reason for the increase in special allowance payments is the rising 

dollar volume of 9.5% loans, which increased from about $11 to over $17 

billion from FY 1995 to June 30, 2004. Given that current market interest 

rates are at or near historic lows, lenders have a financial incentive to 

maintain or increase their 9.5% loan volume and can do so in three ways: 

• After paying costs, including payments to bond investors, associated 

with a pre 10/1/93 tax-exempt bond, lenders can use any remaining 

money to reinvest in more FFELP loans that, by law, are also guaranteed 

a minimum 9.5% yield. 

• Lenders can issue a new bond, called a refunding bond, to repay an 

outstanding pre 10/1/93 tax-exempt bond that financed 9.5% loans. 

Consequently, the refunding bond finances the 9.5% loans and may have 

a later maturity date than the original bond, allowing lenders to maintain 

their 9.5% loan volume for a longer time. 

• By issuing a taxable bond and using the funds obtained to purchase 9.5% 

loans financed by a pre-10/1/93 tax-exempt bond, lenders can 

significantly increase their loan volume. Lenders can use the proceeds 

from the sale of loans previously financed by the pre-10/1/93 tax-exempt 

bond to make or buy additional loans, which are also guaranteed a 9.5% 

yield. Under Education’s regulations, loans previously financed by a pre 

10/1/93 tax-exempt bond and subsequently financed by (i.e., transferred 

to) a taxable bond continue to be guaranteed a 9.5% yield. 

Some Members of Congress and the Administration have proposed making 

statutory changes with respect to 9.5% loans, which could save billions of 

dollars in future special allowance payments. An official representing a 

leading credit rating agency and some major lenders told us that making 

changes to the minimum 9.5% yield for loans made or purchased in the 

future should not affect lenders’ ability to make required payments on 

outstanding tax-exempt bonds. 

To encourage lenders to make 

student loans under the Federal 

Family Education Loan Program 

(FFELP), the federal government 

guarantees lenders a statutorily 

specified rate of return—called 

lender yield. Some lenders may 

issue tax-exempt bonds to raise 

capital to make or purchase loans; 

loans financed with such bonds 

issued prior to 10/1/93 are 

guaranteed a minimum lender yield 

of 9.5% (hereafter called 9.5% 

loans). When the interest rate paid 

by borrowers is less than the lender 

yield, the government pays lenders 

the difference—a subsidy called 

special allowance payments. In 

light of the upcoming 

reauthorization of the Higher 

Education Act of 1965, we 

examined special allowance 

payments for 9.5% loans. 

What GAO Recommends

To address the issues identified in 

this report, Congress should 

consider changing the yield for 

loans made or purchased in the 

future with the proceeds of pre10/1/93 tax-exempt bonds, and any 

associated refunding bonds, to 

better reflect market interest rates. 

GAO recommends that Education 

change its regulations so that 9.5% 

loans transferred from a pre-10/1/93 

tax-exempt bond no longer receive 

a minimum 9.5% yield. Education 

agrees that special allowance 

payments should be reduced, but 

believes it has limited options to do 

so. GAO believes that Education 

has other options it can explore. 
Page i GAO-04-1070 Federal Family Education Loan Program 

Letter 1

Special Allowance Payments For 9.5 Percent Loans Have Increased 

More Than Threefold Since Fiscal Year 2001 3 

Changes to the Minimum 9.5 Percent Yield For Future Loans Could 

Save Billions and Is Unlikely to Cause Lenders to Default on 

Outstanding Tax-Exempt Bonds 6 

Conclusions 7 

Matter for Congressional Consideration 7 

Recommendation for Executive Action 7 

Agency Comments 8 

Appendix I Briefing Slides 11 

Appendix II Comments from the Department of Education 42 

Appendix III GAO Contacts and Staff Acknowledgments 45 

GAO Contacts 45 

Staff Acknowledgments 45 

Abbreviations

FFELP Federal Family Education Loan Program 

HEA Higher Education Act 

IRC Internal Revenue Code 

IRS Internal Revenue Service 

SAP special allowance payment 

Contents 

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Page 1 GAO-04-1070 Federal Family Education Loan Program 

September 20, 2004 

The Honorable Dale E. Kildee 

Ranking Minority Member, Subcommittee on 

 21st Century Competitiveness 

Committee on Education and the Workforce 

House of Representatives 

The Honorable Chris Van Hollen 

House of Representatives 

Under the Federal Family Education Loan Program (FFELP), lenders—

including banks, state agencies and other nonprofit and for-profit 

organizations—annually make, or originate, billions of dollars in loans to 

help students and families finance postsecondary education costs. To 

encourage lenders to make loans, the federal government guarantees 

lenders repayment and a statutorily specified rate of return—called lender 

yield—on the loans they hold. Lender yields as well as the interest rates 

paid by borrowers are typically tied to, and vary with, money market 

financial instruments, such as the 91-day Treasury bill. When the interest 

rate paid by borrowers is less than the guaranteed lender yield, the 

government pays lenders the difference—a subsidy called special 

allowance payments. In exercising its oversight of the FFELP, Congress 

has periodically changed the formula for lender yields to better reflect 

market interest rates, federal budget constraints, or the costs incurred by 

lenders to finance loans. To finance loans, some lenders, specifically state 

agencies and state-designated authorities, may issue tax-exempt bonds to 

raise capital to make or purchase loans, thereby providing other lenders 

with more funds to make more loans. Investors who buy these bonds 

receive interest income that is exempt from federal taxation. Because 

these investors do not pay taxes on their interest earnings, they are willing 

to accept a lower pretax rate of return on their investment, which lowers 

the financing costs for agencies and authorities issuing the bonds. As 

student loan borrowers repay their loans, loan holders use the money to 

repay, in turn, bond investors. 

Concerned that the lender yield for loans financed with tax-exempt bonds 

did not adequately reflect the lower costs associated with tax-exempt 

financing, Congress reduced the yield in passing the Education 

Amendments of 1980. To do so, Congress reduced the special allowance 

payments to be paid on loans financed with tax-exempt bonds to one-half 

United States Government Accountability Office

Washington, DC 20548 
Page 2 GAO-04-1070 Federal Family Education Loan Program 

of that otherwise payable. At the same time, however, Congress 

guaranteed that the lender yield for loans financed with tax-exempt bonds 

would be no less than 9.5 percent. Several years later, in passing the 

Omnibus Budget Reconciliation Act of 19931

, Congress eliminated the onehalf special allowance payment and minimum 9.5 percent yield provision 

for loans financed with tax-exempt bonds issued on or after October 1, 

1993. In so doing, Congress provided that lenders would receive the same 

yield on loans, regardless of whether tax-exempt bonds or other sources 

of funds had been used to finance the loans. Due to these changes, loans 

that are financed with the proceeds of tax-exempt bonds issued prior to 

October 1, 1993 are guaranteed a minimum 9.5 percent yield. (These loans 

are hereafter called 9.5 percent loans). 

Believing that changes to the law should have resulted in a decline in 

special allowance payments made for 9.5 percent loans since 1993, various 

news media, policy makers, and others have recently raised questions 

about the extent to which the government continues to make such 

payments. In light of the upcoming reauthorization of the Higher 

Education Act of 1965, which authorizes the FFELP, you asked us to 

examine special allowance payments for 9.5 percent loans. To conduct our 

examination, we analyzed the Department of Education’s (Education) data 

on 9.5 percent loan volume and special allowance payments paid to 

lenders from fiscal year 1986 through the third quarter of fiscal year 

2004, the most current data available at the time of our review. On the 

basis of our review of the documentation for these data and our 

discussions with Education officials about the steps they take to ensure 

the reliability and validity of these data, we determined that the data were 

sufficiently reliable for the purpose of our examination. In addition, we 

interviewed officials with Education; the Internal Revenue Service; a 

major credit rating agency that examines and rates the quality of student 

loan bonds, including those issued by several holders of 9.5 percent loans; 

a leading bond counsel law firm that provides legal advice to lenders that 

issue tax-exempt student loan bonds; and 12 lenders that reported holding 

9.5 percent loans in fiscal year 2003. We gathered additional data on the 

amount of 9.5 percent loans in taxable bonds from the top 10 holders of 

9.5 percent loans in fiscal year 2003. These 10 lenders held 70 percent of 

reported 9.5 percent loan volume in fiscal year 2003. 

 1

Public Law 103-66, secs. 4105 and 4111, 107 Stat. 312 (1993) 
Page 3 GAO-04-1070 Federal Family Education Loan Program 

On August 19, 2004, we briefed your staff on the results of our work. This 

report summarizes the information we shared with your staff and 

transmits the slides we used to brief your staff that day. In this report, we 

are also making a recommendation to the Secretary of Education and 

suggesting a matter for Congress’s consideration. We conducted our work 

between December 2003 and August 2004 in accordance with generally 

accepted government auditing standards. 

Special allowance payments for 9.5 percent loans have risen dramatically 

in recent years, increasing from $209 million in fiscal year 2001, to 

$556 million in fiscal year 2003 and reached about $634 million at the end 

of the third quarter of fiscal year 2004. Two reasons account for this 

increase: (1) a decline in the interest rate paid by borrowers and (2) a rise 

in the dollar volume of 9.5 percent loans. In some cases, restrictions exist 

on how the nonprofit, for-profit, and state agency lenders that hold 9.5 

percent loans may use their earnings, including their special allowance 

payments, from 9.5 percent loans. 

The primary factor influencing the increase in special allowance payments 

has been the sharp decline in interest rates paid by borrowers relative to 

the minimum 9.5 percent government guaranteed yield for lenders. As 

borrower rates have declined, the amount the government has been 

required to pay to make good on its promise to lenders has increased. To 

illustrate, in 2001, the borrower interest rate was 8.2 percent.2

 Because this 

borrower rate is tied to the 91-day Treasury-bill rate and the Treasury-bill 

rate subsequently declined, the borrower interest rate on the same loan in 

2003 was 5.4 percent. While the borrower rate declined, the yield for a 

lender who used the proceeds, or funds obtained, of a pre-October 1, 1993, 

tax-exempt bond to originate or purchase the loan remained at 9.5 percent. 

Over this period, the difference, or spread, between the borrower rate and 

the 9.5 percent lender yield increased from 1.3 percent to 4.1 percent. As a 

result, the special allowance payment required to ensure a lender yield of 

9.5 percent increased for each dollar of loan volume in this example. 

 2

Statutory formulas used to calculate borrower rates are based on several factors, including 

when the loan was disbursed and loan type. The borrower rates used for this example are 

for Stafford loans disbursed after July 1, 1998 and are now in repayment. 

Special Allowance 

Payments For 9.5 

Percent Loans Have 

Increased More Than 

Threefold Since Fiscal 

Year 2001 

Decline in Interest Rate 

Paid by Borrowers Is 

Primary Reason for 

Increase in Special 

Allowance Payments 
Page 4 GAO-04-1070 Federal Family Education Loan Program 

Another factor influencing the increase in special allowance payments has 

been the rising dollar volume of 9.5 percent loans. Although the overall 

volume of 9.5 percent loans has increased since fiscal year 1995, volume 

among lenders has varied. Most lenders experienced a decrease in their 

9.5 percent loan volume between fiscal years 1995 and 2003, but by the end 

of the third quarter of fiscal year 2004, some of these lenders had sharply 

increased their 9.5 percent loan volume. For example, one lenders’ 

9.5 percent loan volume had decreased by 46 percent between fiscal years 

1995 and 2003 but then increased by 136 percent between 2003 and the end 

of the third quarter of fiscal year 2004, making its 9.5 percent loan volume 

greater than it was in 1995. 

There are primarily three ways—referred to as recycling, refunding, and 

transferring—that a lender can slow the decrease in, maintain, or increase 

its 9.5 percent loan volume. 

• First, after paying costs associated with a pre-October 1, 1993 taxexempt bond (such as payments of interest and principal to bond 

investors), lenders can reinvest, or recycle, any remaining money 

earned from 9.5 percent loans to make or purchase additional loans 

that, under the law, are also guaranteed a minimum 9.5 percent lender 

yield. Using this method, lenders are able to slow the decrease in, 

maintain, or slightly increase their 9.5 percent loan volume. 

• Second, lenders can issue a new bond, called a refunding bond, to 

repay the principal, interest, and other costs of an outstanding preOctober 1, 1993 tax-exempt bond. Based on how the HEA has been 

interpreted, 9.5 percent loans originally financed with a pre-October 1, 

1993 tax-exempt bond, but subsequently financed by a refunding bond, 

continue to carry the government guaranteed minimum yield for 

lenders of 9.5 percent. Moreover, the refunding bond may have a later 

maturity, or payoff, date than the original bond. Using this method, 

lenders can maintain their 9.5 percent loan volume. 

• Third, under Education regulations, a lender can significantly increase 

its 9.5 percent loan volume by issuing a taxable bond and using the 

proceeds to purchase 9.5 percent loans financed by a pre-October 1, 

1993 tax-exempt bond. The lender then uses the cash available from the 

pre-October 1, 1993 tax-exempt bond to make or buy additional loans, 

which are guaranteed the minimum 9.5 percent yield. Under 

regulations issued in 1992, the loans transferred to the taxable bond 

continue to be guaranteed the minimum 9.5 percent lender yield, so 

long as the original bond is not retired or defeased. (At the time the 

regulation was promulgated, Education anticipated that interest rates 

Increasing 9.5 Percent 

Loan Volume Is Another 

Reason for the Increase in 

Special Allowance 

Payments 
Page 5 GAO-04-1070 Federal Family Education Loan Program 

would rise, resulting in a higher lender yield for loans financed with 

taxable bonds than for loans financed with tax-exempt bonds. 

Education believed that if the 1992 regulation was not promulgated, 

lenders would have had an incentive to transfer loans from tax-exempt 

bonds to taxable bonds in order to obtain a higher yield, thus resulting 

in higher special allowance payments for the government.) Among the 

top 10 lenders holding 9.5 percent loans, more than half of the dollar 

volume of their 9.5 percent loans had been transferred to taxable bonds 

as of March 31, 2004. The extent to which lenders have transferred 

9.5 percent loans to taxable bonds varies considerably. For example, 

one lender had none of its 9.5 percent loans in a taxable bond, while 

another held 90 percent of its 9.5 percent loans in a taxable bond as of 

March 31, 2004. Some lenders interviewed have been transferring 

9.5 percent loans for several years, while another lender just started to 

transfer 9.5 percent loans in 2004. Additionally, some lenders have also 

transferred 9.5 percent loans to tax-exempt bonds issued after October 

1, 1993, thereby continuing the 9.5 percent minimum guaranteed yield. 

As a result of recycling, refunding, and transferring, the overall dollar 

volume of 9.5 percent loans has increased from about $11 billion in fiscal 

year 1995 to over $17 billion at the end of the third quarter of fiscal year 

2004. While the dollar volume of 9.5 percent loans presently accounts for 

only about 8 percent of all outstanding FFELP loan volume, these loans 

account for 78 percent of all special allowance payments made to FFELP 

lenders thus far in fiscal year 2004. 

Under the Internal Revenue Code (IRC), earnings on loans financed by 

tax-exempt bonds are limited. 3 Lenders can reduce their earnings on loans 

financed with tax-exempt bonds, and avoid exceeding IRC limitations, by 

providing benefits to borrowers. Some lenders reported that they have 

used, or plan to use, earnings in excess of IRC limits to provide interest 

rate reductions or loan cancellation for borrowers. In contrast to taxexempt bonds, earnings on taxable bonds are not limited. As a result, 

lenders have discretion in how they use their earnings from taxable bonds 

that have financed 9.5 percent loans. 

 3

Special allowance payments may or may not be included in the calculation of excess 

earnings for Internal Revenue Service purposes depending on when a tax-exempt bond, or 

any associated refunding bond, was issued. 

Earnings on Tax-Exempt 

Bonds that Finance 9.5 

percent Loans May be 

Used for Borrower 

Benefits 
Page 6 GAO-04-1070 Federal Family Education Loan Program 

Changing law and regulations with respect to 9.5 percent loans made or 

purchased in the future could reduce the amount of special allowance 

payments required to be paid by the government without compromising 

lenders’ ability to meet their obligations under their outstanding taxexempt bonds. The Administration and some members of Congress have, 

in fact, already put forth proposals to make such changes. The 

Administration has proposed limiting the extent to which lenders can 

receive the substantially higher special allowance payments on 9.5 percent 

loans in the future and estimates savings of $4.9 billion over fiscal years 

2005 through 2014 by doing so. Proposed legislation introduced in the 

108th Congress also seeks to revise the law pertaining to 9.5 percent loans 

in order to reduce special allowance payments and change lender yields to 

reflect current market interest rates. 4

 

Changing current regulations that allow lenders to transfer 9.5 percent 

loans to taxable bonds and retain the minimum 9.5 percent yield could 

also significantly reduce potential special allowance payments in the 

future. While Education officials told us that they had considered revising 

the department’s regulations, they believed that Congress could effect 

such a change by law more quickly and easily. Education officials told us 

that promulgating new FFELP regulations would likely be difficult and 

time-consuming, in light of the HEA’s requirement that the department 

engage in negotiated rule making in promulgating FFELP regulations. 

Negotiated rule making requires the department to convene a committee 

that would include FFELP industry representatives, such as lenders, and 

attempt to reach consensus among committee members on proposed 

regulations. Given the interest of lenders who hold 9.5 percent loans, 

reaching consensus on new regulations would likely prove to be very 

difficult, according to Education officials. However, the inability to reach 

consensus does not invalidate the negotiation of rules.5

 Moreover, 

regulations are not subject to the negotiated rulemaking requirement if the 

Secretary determines that applying this requirement would be 

'impracticable, unnecessary, or contrary to the public interest.' 

Representatives from a major credit rating agency as well as some lenders 

who hold 9.5 percent loans told us that eliminating the minimum 

9.5 percent yield for loans made or purchased in the future should not 

affect lenders’ ability to meet their obligations under, and make required 

 4

See, for example, the College Quality, Affordability, and Diversity Improvement Act of 

2003 (S. 1793) and the College Access and Opportunity Act (H.R. 4283). 

5

See, U. S. Group Loan Servicing Inc. v. Riley, 82 F. 3d 708 (7th Cir 1996). 

Changes to the 

Minimum 9.5 Percent 

Yield For Loans Made 

or Purchased in the 

Future Could Save 

Billions and Is 

Unlikely to Cause 

Lenders to Default on 

Outstanding TaxExempt Bonds 
Page 7 GAO-04-1070 Federal Family Education Loan Program 

payments on, their outstanding tax-exempt bonds, nor should it have longterm negative effects in the student loan bond market. 

Unlike other loans for which the lender yield varies with current market 

interest rates, the lender yield for loans financed with pre-October 1, 1993 

tax-exempt bonds are guaranteed a minimum yield of 9.5 percent. Given 

that current market interest rates are at or near historic lows, lenders have 

a significant financial incentive to slow the decrease in, maintain, or 

increase the volume of loans that yield such a relatively high rate of return 

unavailable on other FFELP loans. This incentive will remain even if 

market interest rates gradually rise in the future. Ironically, moreover, an 

Education regulation over 10 years old and originally intended to limit the 

government’s exposure to increased special allowance payments has today 

presented lenders with an extraordinary opportunity to generate 

additional loans that earn a 9.5 percent yield. As we have shown, lenders 

are taking advantage of these opportunities. Industry experts acknowledge 

that the government could take action to eliminate the 9.5 percent yield for 

loans made or purchased in the future without compromising the ability of 

lenders to meet their obligations with respect to their pre-October 1, 1993 

tax-exempt bonds. Without government action, the taxpayers remained 

exposed to additional special allowance payments that can easily and 

rapidly escalate into the billions of dollars. 

In light of the rapid increase in special allowance payments for loans 

guaranteed a minimum 9.5 percent yield and the continuing financial 

incentive for lenders to originate or purchase additional loans that qualify 

for a guaranteed yield of 9.5 percent, Congress should consider amending 

the HEA to address the issues identified by this report, but particularly to 

change the yield for loans made or purchased in the future with the 

proceeds of pre-October 1, 1993 tax-exempt bonds, and any associated 

refunding bonds, to more closely reflect these loans’ financing costs and 

current market interest rates. 

Given that lenders are increasing the volume of 9.5 percent loans based on 

Education regulations that allow lenders to transfer 9.5 percent loans to 

taxable bonds and tax-exempt bonds issued after October 1, 1993 while 

retaining the special allowance payment provisions applicable to loans 

financed with pre-October 1, 1993 tax-exempt bonds, and the resulting 

increased costs for taxpayers, we recommend that the Secretary of 

Education promulgate regulations to discontinue the payment of the 

Conclusions 

Matter for 

Congressional 

Consideration 

Recommendation for 

Executive Action 
Page 8 GAO-04-1070 Federal Family Education Loan Program 

special allowance applicable to loans financed with pre-October 1, 1993 

tax-exempt bonds that are subsequently transferred to taxable bonds or 

tax-exempt bonds issued on or after October 1, 1993. 

We provided a draft of this report to Education for review and comment. 

In commenting on our report, Education agreed that special allowance 

payments for 9.5 percent loans should be scaled back considerably and 

that, as noted in our report, such a proposal was included in the 

President’s fiscal year 2005 budget.6

 Education also stated that it had 

considered changing its regulation or its interpretation of the regulation 

last year, but believed at that time that the HEA would be reauthorized and 

amended to address the issues discussed in our report before any 

proposed regulation or regulatory interpretation it might undertake could 

become effective. Education stated this was the case because of certain 

requirements contained in the HEA and other laws, including a 

requirement that it engage in negotiated rule making. 

Education also commented on the statutory exception to the general 

requirement that it engage in negotiated rule making, which we highlighted 

in our report. As mentioned in our report, the Secretary need not subject a 

rule making to the negotiated rule making process if the Secretary 

determines that the process would be “impracticable, unnecessary, or 

contrary to the public interest.” In its comments, Education stated that the 

courts have construed this exception only to cover routine determinations 

that are insignificant in nature and impact, inconsequential to industry and 

to the public, or which raise issues of public safety. While we believe that 

it is Education’s responsibility to interpret the law as it relates to its own 

programs, on the basis of our review of the case law, we disagree with 

Education’s characterization of the case law concerning the scope of the 

exception in the Administrative Procedure Act. Specifically, it does not 

fully address the courts’ treatment of the “public interest” prong of the 

three-pronged exception noted above. 

The federal courts have interpreted the three-pronged exception in many 

cases involving a wide variety of factual situations. Education’s 

characterization of the case law describes the courts’ discussion of the 

first two prongs, “impracticable” or “unnecessary,” but does not fully 

address the potential applicability of the third prong, which, if met, would 

independently justify use of the exception. In fact, in the case cited by 

 6

A similar proposal was made in the prior Administration’s fiscal year 2001 budget. 

Agency Comments 
Page 9 GAO-04-1070 Federal Family Education Loan Program 

Education in its comments, Utility Solid Waste Activities Group v. 

E.P.A., 236 F.3d 749 (D.C. Cir. 2001), the court briefly explains the “public 

interest exception” by pointing to a situation where announcement of the 

rule in advance would “enable the sort of financial manipulation the rule 

sought to prevent.” Id. at 755; see also, Attorney General’s Manual on the 

Administrative Procedure Act, pp. 30-31. Thus, it is clear that the 

applicability of the “public interest” exception turns neither on the 

insignificance of the rule nor on whether it raises issues of public safety. 

See also Nader v. Sawhill, 514 F.2d 1064 (D.C. Cir. 1975). Moreover, in 

reviewing challenges to an agency’s use of an exception, the Court of 

Appeals for the District of Columbia has stated that it will review the 

“totality of the circumstances,” including the complexity of the statute and 

congressionally imposed time frames. See Methodist Hosp. of 

Sacramento v. Shalala, 38 F.3d 1225 (D.C. Cir. 1994); Petry v. Block, 737 

F.2d 1193 (D.C. Cir. 1984). 

Determining whether the unique circumstances present here support the 

agency’s use of an exception is beyond the scope of our report and is a 

matter, in the first instance, for Education. Nevertheless, we continue to 

believe that Education should consider all of its options in effecting the 

desired policy change as we recommend in the report. This could include, 

for example, determining whether Education could use less formal 

guidance, as it has in the past, to clarify or alter its position; whether a full 

consideration of all the facts and circumstances as well as all the 

applicable case law would support use of an exception to the negotiated 

rule making requirement; whether an interim final rule could be issued to 

take effect immediately; or whether negotiated rule making could be 

accomplished on an expedited basis. Given Education’s position that it is 

essentially unable to implement regulations until July 1, 2006, more than 

21 months away, we think it is important that Education fully explore all 

of its options, consistent with applicable law. Education’s written 

comments appear in appendix II. 

We are sending copies of this report to the Secretary of Education, 

appropriate congressional committees, and other interested parties. In 

addition, the report will be available at no charge on GAO’s Web site at 

http://www.gao.gov. 
Page 10 GAO-04-1070 Federal Family Education Loan Program 

If you or your staff have any questions about this report, please contact me 

at (202) 512-8403 or Jeff Appel, Assistant Director, at (202) 512-9915. You 

may also reach us by e-mail at ashbyc@gao.gov or appelc@gao.gov. Other 

contacts and staff acknowledgments are listed in appendix III. 

Cornelia M. Ashby 

Director, Education, Workforce, 

 and Income Security Issues 
Appendix I: Briefing Slides 

Page 11 GAO-04-1070 Federal Family Education Loan Program 

Appendix I: Briefing Slides 

1

Lender subsidy payments for loans 

financed with tax-exempt bonds issued 

prior to October 1, 1993, have increased 

significantly

Briefing to Congressional Requesters

August 19, 2004
Appendix I: Briefing Slides 

Page 12 GAO-04-1070 Federal Family Education Loan Program 

2

Overview

• Introduction

• Research Objectives

• Scope and Methodology

• Summary of Findings

• Background

• Key Findings

• Concluding Observations
Appendix I: Briefing Slides 

Page 13 GAO-04-1070 Federal Family Education Loan Program 

3

Introduction

• Private and public lenders made about $42 billion in new loans to 

students in school year 2002-03 through the Federal Family 

Education Loan Program (FFELP).

• To encourage lenders to make FFELP loans, the federal 

government guarantees repayment and provides lenders a 

guaranteed rate of return.

• Guaranteed rate of return equals the greater of the statutorily 

specified lender yield or the borrower interest rate.

• When the borrower rate is less than the lender yield, the 

government makes subsidy payments, called special allowance 

payments (SAP), to lenders.
Appendix I: Briefing Slides 

Page 14 GAO-04-1070 Federal Family Education Loan Program 

4

Introduction

Through the years Congress has made changes to the lender yield to

reflect lenders’ financing costs and to limit SAP.

• The Education Amendments of 1980 changed the SAP for loans 

financed with tax-exempt bonds to reduce profits for loans financed 

with tax-exempt bonds. Loans disbursed on or after 10/1/80 receive 

half the SAP of loans financed with taxable bonds but are guaranteed 

a minimum yield of 9.5 percent.

• The Omnibus Reconciliation Act of 1993 eliminated the minimum 

9.5 percent yield for loans financed with tax-exempt bonds issued on 

or after 10/1/93 and these loans are guaranteed the same rate of

return as that for loans financed with taxable bonds or other sources.

• Because of these changes, loans that are financed with tax-exempt 

bonds issued prior to 10/1/93 are guaranteed a minimum 9.5 percent 

yield, hereafter called 9.5 percent loans.
Appendix I: Briefing Slides 

Page 15 GAO-04-1070 Federal Family Education Loan Program 

5

Introduction

Bonds are used to finance student loans.
Appendix I: Briefing Slides 

Page 16 GAO-04-1070 Federal Family Education Loan Program 

6

Research Objectives

• To what extent have lenders received SAP for 9.5 percent 

loans?

• What factors influence SAP?

• What would be the effects of making statutory and regulatory 

changes to the guaranteed minimum 9.5 percent yield?
Appendix I: Briefing Slides 

Page 17 GAO-04-1070 Federal Family Education Loan Program 

7

Scope and Methodology

• Analyzed student loan data submitted by lenders to the Department 

of Education (Education). These data include information on 9.5 

percent loan volume and SAP paid to lenders. On the basis of our 

analysis, we have determined that data from 1986 onward are 

sufficiently reliable for purposes of our review.

• Interviewed 12 lenders that reported holding 9.5 percent loans in 

fiscal year 2003.

– Gathered data from top 10 lenders that held 9.5 percent loans 

in FY 2003. These lenders held 70 percent of reported 9.5 

percent loan volume in FY 2003.

• Interviewed officials at Education about laws, regulations and 

policies related to the minimum 9.5 percent yield and Internal 

Revenue Service (IRS) about legal aspects of tax-exempt bonds.
Appendix I: Briefing Slides 

Page 18 GAO-04-1070 Federal Family Education Loan Program 

8

Scope and Methodology

• Interviewed a major ratings agency that examines and rates the 

quality of bonds and a law firm that provides legal advice to lenders 

that issue tax-exempt bonds for student loans.

• To estimate what the SAP for 9.5 percent loans would have been 

from FY 1995 to 2003 had these loans not been guaranteed a 

minimum 9.5 percent yield, we used Education’s data on SAP 

made by fiscal year, loan type, and special allowance code (which 

contains information on when the loan was issued), along with 

several assumptions.

• Had the loans not been guaranteed a minimum 9.5 percent 

yield, we assumed that they would have received the yield for 

the same loan type financed with taxable bonds with the same 

disbursement date and repayment status.
Appendix I: Briefing Slides 

Page 19 GAO-04-1070 Federal Family Education Loan Program 

9

Summary of Findings

In FY 2003, 37 lenders received SAP for 9.5 percent loans and these 

payments have increased by $347 million, from $209 million in FY 2001 to 

$556 million in FY 2003. SAP have exceeded $600 million through the 

third quarter of FY 2004.

A decline in the interest rates paid by borrowers and a rise in the dollar 

amount of 9.5 percent loans have influenced the increased SAP. 

Changing the yield for 9.5 percent loans made or purchased in the future 

should decrease SAP and is unlikely to cause outstanding bonds to default, 

but lenders may not be able to offer the same borrower benefits, such as 

loan cancellation and interest rate reductions, in the future because 

earnings from their tax-exempt bonds may decrease.
Appendix I: Briefing Slides 

Page 20 GAO-04-1070 Federal Family Education Loan Program 

10

Background

Since 1991, the guaranteed yield for loans financed with tax-exempt bonds issued 

prior to 10/1/93 has typically been higher than the yield on other Stafford loans

Annual guaranteed yield (in percent)

Source: GAO analysis.

Fiscal year

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

Note: Lender yield varies depending on loan type, when the loan was disbursed, and whether the loan is in repayment status. As a result, 

there can be multiple lender yields in a given year.

0

2

4

6

8

10

12

14

16

18

Guaranteed yield for loans financed with a tax-exempt bond issued prior to 10/1/93

Guaranteed yield for Stafford loans not financed with a tax-exempt bond issued prior to 10/1/93: lowest yield

Guaranteed yield for Stafford loans not financed with a tax-exempt bond issued prior to 10/1/93: highest yield
Appendix I: Briefing Slides 

Page 21 GAO-04-1070 Federal Family Education Loan Program 

11

Background

SAP calculations are based on formulas established in the Higher

Education Act

• SAP equals the difference between the lender yield and the borrower interest rate (calculated as a quarterly rate) times the 

principal balance. 

• If the borrower rate is greater than the lender yield, SAP is zero.

• Lender yield is established by statute and varies depending on whether tax-exempt or taxable funds were used to finance the 

loan.

• Other factors, such as loan type, whether the loan is in repayment status, and when it was disbursed, also affect the 

lender yield calculation. As a result there are multiple lender

yields.

• Borrower rate adjusts annually, based on a statutorily established market-indexed rate-setting formula.1

1 Borrower rates for some Stafford loans disbursed prior to September 30, 1992, have a fixed interest rate.
Appendix I: Briefing Slides 

Page 22 GAO-04-1070 Federal Family Education Loan Program 

12

Background

Rules for tax-exempt bonds are specified in the Internal Revenue Code

• Tax-exempt bonds can be issued for qualified “private 

activities,” and a statutory formula determines how much can 

be issued by each state in each year, called volume cap 

allocation. 

• Student loans are one of the qualified “private activities” to 

which states can allocate volume cap for tax-exempt bonds.1

• Federal law requires that proceeds of tax-exempt student 

loan bonds and earnings of loans financed with those bonds 

be used for residents of the state in which the bond was 

issued or students that attend schools in that state.

– Some earnings are used to provide benefits to borrowers, 

such as interest rate reductions and loan cancellation.

1Other private activities include mass commuting facilities and sewage facilities.
Appendix I: Briefing Slides 

Page 23 GAO-04-1070 Federal Family Education Loan Program 

13

Background

About $20 billion of new tax-exempt student loan bonds was issued 

between 1983 and 1993

• Bonds’ proceeds were used to make or purchase FFELP 

loans.

• It is difficult to ascertain how much of the bonds issued 

remains outstanding because some portions of a bond issue 

may mature earlier than others. 

– A tax-exempt bond may be composed of several series of 

bond issues. Each series could have a different maturity 

date, typically before the bond’s final maturity date.

• Among top 10 holders of 9.5 percent loans in FY 2003, 

approximately $3.8 billion of $11.7 billion in tax-exempt 

bonds issued prior to 10/1/93 remains outstanding (this 

includes refunding bonds).1

1 A refunding bond is a new bond issued to pay the principal, interest, and other costs of an outstanding bond issue.
Appendix I: Briefing Slides 

Page 24 GAO-04-1070 Federal Family Education Loan Program 

14

Special Allowance Payments

37 lenders received SAP for 9.5 percent loans in fiscal year 2003

• In FY 2003, a mix of for-profit, nonprofit, and state agency 

lenders received about $556 million in SAP for 9.5 

percent loans.

• Why do for-profit lenders hold 9.5 percent loans?

• One for-profit lender acquired two nonprofits.

• Three nonprofit lenders converted to for-profit companies.

Number of 

lenders

Percentage of 

SAP for 9.5% 

loans in FY 2003

Percentage of 

total 9.5% loans 

in FY 2003

For-profit 4 37 36

Nonprofit and 

state agency 33 63 64
Appendix I: Briefing Slides 

Page 25 GAO-04-1070 Federal Family Education Loan Program 

15

Source: U.S. Department of Education.

Special Allowance Payments 

SAP for 9.5 percent loans have risen dramatically in recent years, increasing by 

$425 million between FY 2001 & the third quarter of FY 2004

0

100

200

300

400

500

600

19861987198819891990

19911992

19931994

19951996

1997199819992000200120022003

2004

Special allowance payments for 9.5 percent loans (nominal dollars in millions)

Fiscal year

2004 data 

are for the 

first three 

quarters
Appendix I: Briefing Slides 

Page 26 GAO-04-1070 Federal Family Education Loan Program 

16

Two factors have influenced increase in SAP for 9.5 

percent loans

• Major factor that has influenced increase in SAP is the 

significant drop in borrower rate relative to 9.5 percent yield.

• The volume of 9.5 percent loans has not decreased as 

expected, which has also influenced the SAP increase.
Appendix I: Briefing Slides 

Page 27 GAO-04-1070 Federal Family Education Loan Program 

17

Source: GAO analysis.

Factors influencing SAP

Difference between borrower rate and minimum 9.5 percent yield has 

widened significantly since FY 2001

0

1

2

3

4

5

6

7

8

9

1 0

1986

19871988

19891990

1991199219931994

1995

1996

1997

19981999

20002001

20022003

G uaranteed yield for loans financed w ith a tax-exempt bond issued prior to 10/1/93

Borrower rate

Interest rate (in percent)

Fiscal year
Appendix I: Briefing Slides 

Page 28 GAO-04-1070 Federal Family Education Loan Program 

18

• SAP = (9.5% - borrower rate)

4 (quarter) * principal balance

• As an illustrative example, the borrower rate dropped from 8.2 

percent in 2001 to 4.1 percent in 2003 for recently originated 

Stafford loans.1

– Estimated SAP for $1,000 of 9.5 percent loans in quarter 1 

2001 = 

(9.5%-8.2%)/4 x $1,000 = $3.28

– Estimated SAP for $1,000 of 9.5 percent loans in quarter 1 

2003 = 

(9.5%-4.1%)/4 x $1,000 = $13.60

Factors influencing SAP

Example of how low borrower rates affect SAP

1These borrower rates are for Stafford loans from October to June of that fiscal year disbursed after July 1, 1998, that were in repayment.
Appendix I: Briefing Slides 

Page 29 GAO-04-1070 Federal Family Education Loan Program 

19

Factors influencing SAP 

The volume of 9.5 percent loans has not decreased as expected, which 

has also contributed to the SAP increase

Source: U.S. Department of Education.

Fiscal year

9.5 percent loan volume (nominal dollars in millions)

0

2 ,0 00

4 ,0 00

6 ,0 00

8 ,0 00

1 0 ,0 00

1 2 ,0 00

1 4 ,0 00

1 6 ,0 00

19871988

19891990199119921993

1994199519961997

1998199920002001200220032004

Note: 2004 data are as of June 30, 2004
Appendix I: Briefing Slides 

Page 30 GAO-04-1070 Federal Family Education Loan Program 

20

Factors influencing SAP 

Increase in total amount of 9.5 percent loans masks differences in 9.5 

percent loan volume by lender

• For 21 lenders, the amount of 9.5 percent loans they held between 

FY 1995 and FY 2003 decreased.

• Some of these lenders, however, have increased the amount of 

9.5 percent loans they held in the first three quarters of 2004.

• For the remaining 16 lenders, the amount of 9.5 percent loans held 

between FY 1995 and FY 2003 has increased.

• There are three primary ways that a lender could slow the decrease 

in, maintain, or increase its 9.5 percent loan volume:

– recycling earnings to make or purchase loans

– transferring loans from pre-10/1/93 tax-exempt bond financing to taxable bond financing

– refunding a pre-10/1/93 tax-exempt bond
Appendix I: Briefing Slides 

Page 31 GAO-04-1070 Federal Family Education Loan Program 

21

Factors influencing SAP 

Recycling allows lenders to maintain or slightly increase 9.5 percent 

loan volume

• After lenders pay costs (such as interest payments and servicing fees) 

associated with a tax-exempt bond, they may use any remaining money 

earned from loans to reinvest in FFELP loans, called recycling. These 

loans are guaranteed the minimum 9.5 percent yield.

• All 12 lenders interviewed utilize recycling to reinvest in 9.5 percent loans.

• Length of time that a lender can recycle depends on the terms of the 

bond—some lenders have recycling periods of 1 to 3 years while others

have recycling periods that last until the bond matures

– Lenders may ask ratings agency to extend their recycling period up to 

the bond’s maturity date.

– For a bond with a maturity date in 2025 and a recycling period that 

lasts until maturity, the lender can likely recycle and slow the decrease 

in, maintain, or slightly increase its 9.5 percent loan volume until that 

time.
Appendix I: Briefing Slides 

Page 32 GAO-04-1070 Federal Family Education Loan Program 

22

Factors influencing SAP 

Transferring loans from pre-10/1/93 tax-exempt bonds to taxable bonds 

increases lenders’ 9.5 percent loan volume
Appendix I: Briefing Slides 

Page 33 GAO-04-1070 Federal Family Education Loan Program 

23

Factors influencing SAP 

Almost all lenders interviewed have transferred loans to taxable bonds, 

which has increased their 9.5 percent loan volume

• Among top 10 lenders the proportion of 9.5 percent loans that have been 

transferred to a taxable bond increased between FY 2003 and 2004.

– Percentage of 9.5 percent loans financed by a taxable bond in the first half of FY 2004 varied among the 10 lenders, from 0 to 90 percent.

– Some lenders interviewed have been transferring for several years while another just started in 2004.

– Some lenders have also transferred to tax-exempt bonds issued after 10/1/93.

Proportion of Top 10 Lenders' 9.5% Loans Financed by Taxable Bonds

Total 9.5% 

loan volume

Percentage in 

taxable bond 

Total 9.5% Loan 

Volume

Percentage in 

taxable bond 

9,593,466,896 46% 11,569,635,549 54%

one lender reported FY 2004 data as of June 14, 2004

FY 2003 FY 2004 (as of 3/3/1/04)
Appendix I: Briefing Slides 

Page 34 GAO-04-1070 Federal Family Education Loan Program 

24

Factors influencing SAP

Policy that allows lender to transfer loans and increase 9.5 percent loan 

volume was intended to limit SAP

• In 1992, Education issued regulations intending to limit SAP by changing 

how SAP is calculated for a loan that is transferred from a tax-exempt bond 

to a taxable bond. 

– Under the 1992 regulation and clarified in a 1996 guidance letter, a loan transferred from a pre-10/1/93 tax-exempt bond to a taxable bond 

remains subject to the SAP provisions applicable to loans financed 

with the tax-exempt bonds so long as the lender retains a legal interest 

in the original tax-exempt bond and the original bond has not been 

retired or defeased.

• At that time, Education anticipated that interest rates would rise, resulting in 

a higher lender yield for loans financed with taxable bonds compared with 

loans financed with tax-exempt bonds.

• Education believed that if the regulation was not issued lenders would have 

an incentive to transfer loans from tax-exempt bonds to taxable bonds, 

which would mean that the federal government would have paid greater 

SAP for those loans.
Appendix I: Briefing Slides 

Page 35 GAO-04-1070 Federal Family Education Loan Program 

25

Factors influencing SAP 

Refunding a pre-10/1/93 tax-exempt bond extends the life of a bond, and 

loans continue to be guaranteed the minimum 9.5 percent yield

• Lenders may refund a pre-10/1/93 tax-exempt bond, and the 

refunding bond may have a later maturity date than the original 

bond.

• Based on interpretation of the Higher Education Act, loans now 

financed with the refunding bond continue to be guaranteed the 

minimum 9.5 percent yield.

• Almost all nonprofit lenders interviewed refunded a pre-10/1/93 taxexempt bond.

– A lender that did not refund made this choice because its bonds 

had maturity dates 20 to 30 years from their issue date.

– For-profit lenders are not permitted to refund tax-exempt bonds.

– Some reported reasons to refund included: to obtain a lower interest rate than paid on the original bond or to extend period

of time loans are guaranteed the minimum 9.5 percent yield.
Appendix I: Briefing Slides 

Page 36 GAO-04-1070 Federal Family Education Loan Program 

26

Factors influencing SAP 

Lenders have refunded tax-exempt bonds using the IRS’s 17-year rule or 

with new volume cap allocation

• Most lenders interviewed refunded using the 17-year rule.

– Using the 17-year rule, a lender does not need to receive 

authority to issue a refunding bond from the state. However, 

the maturity date must not be later than the longer of 17 years 

from the original bond issue date or the average maturity of the

original bond.

• Some lenders interviewed have used a new volume cap allocation 

from the state to refund a bond, and the loans continue to be 

guaranteed the minimum 9.5 percent yield.

– When a lender uses new volume cap allocation from the state 

to refund a bond, the maturity date for the new bond is not 

restricted as it is under the 17-year rule.
Appendix I: Briefing Slides 

Page 37 GAO-04-1070 Federal Family Education Loan Program 

27

Changing the yield for 9.5 percent loans made or purchased in 

the future should decrease SAP while not having a significant 

effect on lenders or borrowers

• Changing the yield for 9.5 percent loans to a yield that 

eliminates the minimum could lower SAP for loans 

made or purchased in the future.

• Changing the yield for 9.5 percent loans made or 

purchased in the future is unlikely to cause outstanding 

bonds to default, but lenders may not be able to offer 

the same borrower benefits, such as loan cancellation 

and interest rate reductions, in the future.
Appendix I: Briefing Slides 

Page 38 GAO-04-1070 Federal Family Education Loan Program 

28

Source: U.S. Department of Education.and GAO estimate.

Fiscal year

1995 1996 1997 1998 1999 2000 2001 2002 2003

Effects of Changing 9.5 Percent Yield

Estimated SAP for 9.5 percent loans would have been $1.7 billion less if 

the yield used was the same as that for taxable loans 

0

100

200

300

400

500

600

Actual SAP Estimated SAP using yields of taxable loans

Special allowance payments on 9.5 percent loans (dollars in millions)
Appendix I: Briefing Slides 

Page 39 GAO-04-1070 Federal Family Education Loan Program 

29

Effects of Changing 9.5 Percent Yield

Changes to the minimum 9.5 percent yield should lower future federal 

costs significantly

• Education’s HEA reauthorization proposal includes changing the 

9.5 percent yield prospectively and estimates savings of $4.9 billion 

for loans issued between FY 2005 and 2014.

• The Congressional Budget Office estimates that Education’s 

proposed changes would save $1.8 billion for loans issued between 

FY 2005 and 2014.

• H.R. 4283 College Access and Opportunity Act of 2004 and S.1793 

College Quality, Affordability, and Diversity Improvement Act of

2003, also seek to make changes with respect to 9.5 percent loans.
Appendix I: Briefing Slides 

Page 40 GAO-04-1070 Federal Family Education Loan Program 

30

Effects of Changing 9.5 Percent Yield

Changes to minimum 9.5 percent yield for loans made or purchased in the future 

should not cause bonds to default but may curtail some future borrower benefits

• A major ratings agency and some lenders interviewed stated that making 

changes to the minimum 9.5 percent yield for loans made or purchased in 

the future should not cause lenders to default on outstanding bonds nor 

should it have long-term negative effects in the student loan bond market. 

• If the 9.5 percent yield were changed for loans made or purchased in the 

future, lenders reported that earnings from their tax-exempt bonds may 

decrease, and as a result they may not be able to offer the same borrower 

benefits, such as loan cancellation, in the future.

– Some lenders have earned amounts on their student loan investments 

in excess of what is allowed for tax-exempt bonds by law.

– By law lenders can use these excess earnings to provide benefits to 

borrowers whose loan is financed by the tax-exempt bond.1

– Taxable bonds do not have any legal restrictions on earnings.

1 SAP may or may not be counted in calculations of excess earnings depending on when a bond, and any 

refunding bonds, was issued. Lenders could also rebate excess earnings to the federal government.
Appendix I: Briefing Slides 

Page 41 GAO-04-1070 Federal Family Education Loan Program 

31

Concluding Observations

• Unlike other loans whose rates of return vary because they are tied 

to market interest rates, those financed with pre-10/1/93 tax-exempt 

bonds have a guaranteed minimum rate of return.

• In an environment where interest rates are low, current law and 

policies provide an opportunity for lenders to increase the amount 

of loans guaranteed a minimum 9.5 percent rate. 

• Even if interest rates rise somewhat in the future, the difference 

between the borrower rate and the minimum 9.5 percent yield will

still be large. This will require the government to continue to pay 

larger SAP than it would otherwise have if the loans did not have a 

guaranteed minimum of 9.5 percent.
Appendix II: Comments from the Department 

of Education 

Page 42 GAO-04-1070 Federal Family Education Loan Program 

Appendix II: Comments from the Department 

of Education 
Appendix II: Comments from the Department 

of Education 

Page 43 GAO-04-1070 Federal Family Education Loan Program 
Appendix II: Comments from the Department 

of Education 

Page 44 GAO-04-1070 Federal Family Education Loan Program 
Appendix III: GAO Contacts and Staff 

Acknowledgments 

Page 45 GAO-04-1070 Federal Family Education Loan Program 

Jeff Appel, Assistant Director (202) 512-9915 

Andrea Romich Sykes, Analyst-in-Charge (202) 512-9660 

In addition to those named above, the following people made significant 

contributions to this report: Cynthia Decker, Margaret Armen, Richard 

Burkard, Jason Kelly, Rebecca Christie, and Jeff Weinstein. 

Appendix III: GAO Contacts and Staff 

Acknowledgments 

GAO Contacts 

Staff 

Acknowledgments 

(130411) 
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