GAO-02-84SP

Alternative Market Mechanisms

for the Student Loan Program

A Report by the U.S. Department of Education

and the U.S. General Accounting Office

December 18, 2001



CONTENTS

 Page

Overview 1

Chapter 1: Program Background and the 1998 HEA Mandate 8

Chapter 2: Adjustments to the Current FFELP System 25

Chapter 3: Loan Origination Rights Auction 32

Chapter 4: Loan Sale 42

Chapter 5: Federal Funding 49

Chapter 6: Market-Set Rates 55

Chapter 7: Income-Contingent Repayment 63

Appendixes

Appendix I: Mandate From the Higher Education Amendments of 1998 69

Appendix II: List of Study Group Members 71

Appendix III: Technical Aspects of Auction Design 75

Appendix IV: Details on Income-Contingent Repayment in FDLP 82

Appendix V: Call Options as a Mechanism for Determining Net

 Lender Yields 93

Appendix VI: Additional and Dissenting Views From Rene Champagne 96

Appendix VII: Additional and Dissenting Views From Michael Hershock and

 Richard Pierce 97

Appendix VIII: Additional and Dissenting Views From Paul Tone and

 Richard Pierce 103

Appendix IX: Public Comments From Career College Association 131

Appendix X: Public Comments From CBA, NCHELP, and SLSA 134

Appendix XI: Public Comments From FinAid Page 137
Appendix XII: Public Comments From National Student Loan Program 138

Appendix XIII: Public Comments From Oklahoma Lender Advisory Council 140

Appendix XIV: Public Comments From Philip Schrag 143

Appendix XV: Public Comments From Patricia Smith, Study Group Member 145

Appendix XVI: Public Comments From Texas Guaranteed Student Loan

 Corporation 147

Glossary 150

Tables

Table 1: The Four Sets of Evaluation Criteria 4

Table 2: General Differences Between the Five Models 6

Table 3: Outstanding Loan Balances at End of Fiscal Year 2000 12

Table 4: Loan Originations in Fiscal Year 2000 12

Table 5: Concentration of FFELP Outstanding Loan Balances at the End of

 Fiscal Years 1994-2000 15

Table 6: Concentration of FFELP Loan Originations in Fiscal Years 1994-2000 15

Table 7: Federal Costs for the FFELP Fiscal Year 2000 18

Table 8: The Four Sets of Evaluation Criteria 21

Table 9: Summary of Analysis for Adjustments to the Current System Model 31

Table 10: Summary of Analysis for Loan Origination Rights Auction Model 41

Table 11: Summary of Analysis for Loan Sale Model 48

Table 12: Summary of Analysis for Federal Funding Model 54

Table 13: Summary of Analysis for Market-Set Rates Model 62

Table 14: Direct Loans in Repayment by Loan Type 83

Table 15: Direct Loans in Repayment by Plan 83

Table 16: Source of Direct Consolidation Loans in Repayment 84

Table 17: Direct Consolidation Loans in Repayment by Plan 84

Table 18: Direct Consolidation Loans in Repayment by Plan: Defaulted Loans

 Formerly Held by DCS 85

Table 19: Direct Consolidation Loans in Repayment by Plan: Regular

 Consolidation of Non-DCS Loans 85

Figure

Figure 1: Cash Flows for an FFELP Loan From Origination Through Repayment 19

Figure 2: Cash Flows for an FFELP Loan in Default 20
Abbreviations

AGI adjusted gross income

CBO Congressional Budget Office

CP Commercial Paper

DCS Debt Collection Service

EPA Environmental Protection Agency

FAFSA Free Application for Federal Student Aid

FCC Federal Communications Commission

FDLP William D. Ford Federal Direct Loan Program

FFELP Federal Family Education Loan Program

FHA Federal Housing Administration

GSE government sponsored enterprise

HEA Higher Education Act of 1965

HEAL Health Education Assistance Loan

HHS Department of Health and Human Services

ICR income-contingent repayment

IDEA Income Dependent Education Assistance

IRS Internal Revenue Service

OMB Office of Management and Budget

PLUS Parent Loan for Undergraduate Students

PRC Postal Rate Commission

SAP special allowance payment
Page 1

OVERVIEW

In the Federal Family Education Loan Program (FFELP), lenders annually make more than $22

billion in loans to eligible student borrowers who attend postsecondary institutions and their

parents. Additionally, through the William D. Ford Federal Direct Loan Program (FDLP), the

federal government makes more than $11 billion available to these borrowers. The federal

government insures FFELP loans against default and assures lenders of a specified yield that

adjusts with interest rates.1 Borrowers pay interest at a variable rate up to a maximum rate

established by law. The federal government pays a ìspecial allowanceî to lendersóthe

difference between a borrowerís rate and the specified yieldówhen the borrowerís rate is lower.

The Congress occasionally adjusts both the borrowerís rate and the lenderís yield.

In setting lender yield, the Congress attempts to ensure a yield high enough to maintain lender

participation in the program but not so high as to require spending more taxpayer dollars than

necessary. While the Congress considers information from Education, other federal agencies, and

program participants in setting the lender yield, it often lacks critical information on the costs to

lenders of making and servicing loans. Thus, setting lender yield is difficult, as illustrated by the

extensive deliberations surrounding the 1998 reauthorization of the Higher Education Act of

1965 (HEA).

When the Congress considered the reauthorization of HEA in early 1998, both House and Senate

committees expressed concern about the process of setting lender yield. The House Committee

on Education and the Workforce stated in its report:

ìCurrently, the Federal Family Education Loan (FFEL) program is a market-based

program with private sector participation. However, to a large extent lender returns are

set through a political process rather than a market process. This is disturbing for two

reasons. First, if lender yield is set too low, private capital will become unavailable, and

the student loan programs will collapse. Second, if the rate of return is set too high, the

Federal Government forgoes savings that could be put to better uses or returned to the

taxpayer.î2

The report of the Senate Committee on Labor and Human Resources expressed similar concerns

when it stated that the committee ìhas wrestled with its desire to balance the twin objectives of

reducing the interest rate paid by borrowers and preserving access to loans under the FFEL

program.î3

 

1

FFELP loans are guaranteed by one of 36 nonprofit agencies designated by the Secretary of Education. If a loan

goes into default, the guaranty agency generally pays the lender 98 percent of principal and accrued interest. The

federal government then generally reinsures 95 percent of the guaranty agencies' payments to lenders (and also pays

them fees for loan processing and issuance, account maintenance, and default aversion). The lenderís yield is the

face value of the interest rate on the FFELP loan. Currently, this is specified in legislation as the 90-day commercial

paper rate plus 2.34 (1.74) percentage points for loans (not) in repayment.

2

H.R. No. 105-481, at 154-5 (1998).

3

S.R. No. 105-181, at 53 (1998).
OVERVIEW

Page 2

The 1998 amendments to HEA required that GAO and Education jointly convene a study group

to identify and evaluate means for establishing a market mechanism for the delivery of student

loans. See appendix I for the full text of the mandate. This study group consisted of

representatives of the Department of the Treasury, the Office of Management and Budget

(OMB), the Congressional Budget Office (CBO), entities making FFELP loans, other entities in

the financial services community, other participants in the student loan programs, and other

individuals designated by GAO and Education. See appendix II for a list of study group

members. GAO and Education, in consultation with the study group, were charged with

identifying at least three different potential market mechanisms and evaluating them with respect

to 13 criteria laid out in the mandate.

In January 2001, a draft report prepared by GAO and Education was released for public

comment. The draft report analyzed several models based on research and analysis, discussions

with study group members, and comments received from others not on the study group. Serving

on the study group does not constitute agreement either in whole or in part with the proposed

models or the analysis of models presented in this report. Some study group members have

provided additional or dissenting views, which appear here as appendixes.

BACKGROUND AND METHODOLOGY

Lenders in FFELP make loans to student and parent borrowers and receive a yieldóan interest

rate on the loansóthat is set by legislation. Borrowers choose a lender, typically from a list their

schools maintain. A guaranty agency reviews the loan application and issues a guarantee on the

loan. As long as the loan is serviced properly, the guarantee is maintained, and the guaranty

agency repays the lender if the borrower defaults on the loan. Education oversees lender, school,

and guaranty agency participation in the program and reimburses the guaranty agencies for

default payments provided to lenders. In addition, Education makes payments to lenders to make

up the difference, if any, between the interest rate the borrower pays and the yield the lender is

entitled to receive.

The yield that lenders receive from FFELP loans has been adjusted occasionally since 1977.4

For Stafford loans and their predecessors, the Congress set lender yield generally at the 91-day

Treasury bill (T-bill) rate plus a markup of 3.5 percentage points in 1977. The Congress made

downward changes in the markup over the T-bill rate in 1986 and 1992. In 1995, different rates

for loans in different stages were established, so that the markup was reduced for loans that were

in school, grace, or deferment periods relative to the markup for loans in repayment. Both

 

4

Before 1977, a committee composed of the Secretary of Health, Education, and Welfare, the Secretary of the

Treasury, and the Director of OMB decided the level at which lender yield should be set. Since 1977, the yield has

been established by using a formula set in legislation rather than by a committeeís determination, and the Congress

adjusts this formula periodically.
OVERVIEW

Page 3

markups were reduced further in 1998. Finally, in 1999, the Congress changed the basis for the

yield from the 91-day T-bill to the 3-month Commercial Paper (CP) index.5

In making these changes, the Congress has generally tried to set a yield that would maintain

lender participation in the program without spending more than is necessary. Lenders require a

reasonable return on their investment in the program to continue to take part in it. Without a

reasonable return, they would be likely to devote their resources to more profitable investments,

jeopardizing the continued availability of loan capital for FFELP. However, if the yield is set too

high, federal funds could be wasted.

In order to explore ways of bringing market information to bear on the yield-setting process, the

Congress, in the 1998 HEA reauthorization, mandated a study of the potential use of market

mechanisms in FFELP. The mandate calls for evaluating at least three different market

mechanisms relative to 13 criteria. We grouped the evaluation criteria into four sets, as shown in

table 1.

 

5

The lenderís yield is the face value of the interest rate on the FFELP loan. Currently, this is set in legislation at the

CP rate plus 2.34 percentage points for loans in repayment. It is the lenderís total interest revenues as a percentage

of the value of the loans. A lenderís net yield is the lenderís yield less all costs, which include the costs of (1)

raising funds to make the loans, (2) servicing the loans, (3) defaults, and (4) other administrative expenses. Loan

servicing functions include maintaining contact with borrowers, billing for repayments, and taking steps to avoid

defaults if loans become delinquent.
OVERVIEW

Page 4

Table 1: The Four Sets of Evaluation Criteria

Set Related criteria from the 1998 HEA amendments

Description of model, including

variations

 A description of how the mechanism will be administered and operated

(12)

 The proposed federal and state role in the operation of the mechanism

(11)

 Transition procedures (13)a

Costs, savings, and effects on

subsidies for program

participants

 The cost or savings of loans to or for borrowers, including parent

borrowers (1)

 The cost or savings of the mechanism to the federal government (2)

 The cost, effect, and distribution of federal subsidies to or for participants

in the program (3)

Effects on lender participation,

loan availability, and service

quality

 The effect on the diversity of lenders, including community-based lenders,

originating and secondary market lenders (7)

 The availability of loans to students by region, income level, and

categories of institutions (10)

 The effect on loan availability during a transition period (13)a

 The effect on investment in human capital and resources, loan servicing

capability, and the quality of service to the borrower (6)

 The degree to which the mechanism will provide market incentives to

encourage continuous improvement in delivering and servicing loans (9)

Simplicity, regulatory burden,

and program integrity

 The effect on the simplicity of the program, including the effect of the plan

on the regulatory burden on students, institutions, lenders, and other

program participants (5)

 The effect on program integrity (8)

Note: The numbers in parentheses refer to the number assigned to the specific criteria in the legislative mandate.

The analysis related to the fourth criterionóthe ability of the mechanism to accommodate the potential distribution

of subsidies to students through an income-contingent repayment (ICR) optionówas similar across all models.

Rather than repeat our analysis of this criterion for each model, we discuss it separately in chapter 7. Therefore, this

criterion does not appear in this table.

a

We split the thirteenth criterion, on transition procedures, into a descriptive part and a part related to loanavailability issues.

THE FIVE MODELS

To identify different market mechanisms for analysis, we reviewed reports and asked study

group members and others to submit proposals. We looked primarily for models in which some

type of market process either determines the lender yield or provides information used to set the

yield.

We grouped the proposals into five general models because similar characteristics emerged

among some of the proposals. In study group meetings and other conversations with group

members, including those with staff from the other government agencies, we discussed the

various models and their implications. We also researched comparable programs where they
OVERVIEW

Page 5

existed, such as other federal auctions and the experiences of student loan programs in other

countries.

The five models would make a variety of changes to FFELP.

The first of the five models we identifiedóadjustments to the current systemówould

involve the least change from the current FFELP. Information would be collected from

current market transactions for use in determining the appropriate level of lender yield, which

the Congress or some independent entity would still set through statute or regulation.

The loan origination rights auction model would involve lenders bidding for the right to

originate loans (either for the right to procure a certain volume, with which they could

originate loans at any school, or for the right to originate loans at particular schools). A

lenderís bid might consist of a specific yield level, so the yield would be directly determined

by this mechanism. Alternatively, the bid might consist of a dollar amount for the right to

originate loans, with the lenderís yield on these loans set outside the process.

In the loan sale model, in contrast, the government or a government-designated entity would

originate loans.6

 Private lenders would then bid in an auction to purchase these loans after

they have been originated. Again, the lender yield would be set outside the process, and

lendersí bids to purchase these loans would determine their net yield.

In the federal funding model, lenders would have the opportunity to borrow funds from the

federal government to make FFELP loans. They would borrow either at a predetermined

interest rate or at an interest rate determined by some type of bidding process. The lenderís

yield would still be set by the Congress, but by changing lendersí funding costs, this model

would determine the net yield for lenders.

Finally, in the market-set rate model, lenders and borrowers would negotiate their own

interest rates and perhaps other loan terms. Regulatory limits, such as a limit on the range of

interest rates a lender would be allowed to offer, could be imposed. This process would set

both the lender yield and the borrower interest rate.

Table 2 shows some of the major differences between the models, although most of the models

have several variations that would allow for further differentiation.

 

6

Schools could potentially originate loans as currently practiced in FDLP.
OVERVIEW

Page 6

Table 2: General Differences Between the Five Models

Question to Market mechanism model

differentiate

the models

Adjustments

to the current

system Loan

origination

rights auction

Loan sale Federal funding Market-set

rate

How does the

model work?

The Congress

or its designee

would use

market

information to

set lender yield

Lenders would

bid for the right

to make (1) a

certain volume

of FFELP

loans or (2)

loans at

specific

schools

Lenders would bid to

purchase loans after

the government or

some designated

entity originated the

loans

Lenders would

be allowed to

borrow funds

from the

government to

make FFELP

loans

Lenders and

borrowers, or

schools on

the

borrowersí

behalf, would

negotiate

interest rates

What rates or

costs does the

market

determine?

Rates or costs

are determined

only indirectly,

based on

market

information

Either version

above could

determine (1)

the lenderís

yield or

(2) lenderís

cost to receive

a given yield

Lenderís cost to

acquire the loan and

ensure a given yield

Lenderís funding

cost

Lenderís yield

and

borrowerís

interest rate

Who originates

loans?

Private lenders Private lenders Federal government,

through contractor or

other entity

Private lenders Private

lenders

Are private

lenders

restricted in

how much, or

at which

schools, they

originate?

No Yes, in some

cases

Not relevant No Unclear

Is the

borrowerís rate

or ability to

choose the

lender

changed?

No Yes, for lender

choice

Yes, for lender choice No Yes, for both

rates and

choice of

lender

How does the

role of schools

change?

No change Schools may

lose choice of

lenders

Schools may serve as

the originator of the

loan

No change Schools

would play a

stronger role

in determining

which lenders

to use

THE STRUCTURE OF THIS REPORT

Chapter 1 of this report includes background material, a brief history of FFELP, and a

description of the study groupís work. Chapters 2 through 6 contain the analysis of each of the

five models, relative to the 13 criteria set out in the mandate. Chapter 7 then discusses ICR as it

might be applied to any of the models.
OVERVIEW

Page 7

PUBLIC COMMENTS

We made a draft of this report available to the public for comment as mandated by section 801 of

the 1998 Amendments to HEA. Eight sets of written and/or electronic comments were submitted

by eight organizations and two individuals during the 60-day comment period of January 19,

2001, to March 19, 2001 (see apps. IX-XVI). These comments were made available to the study

group for review.

In summary, several of the respondents specifically recommended that FFELP continue without

change and that the current formula for lender yield remain in place. Several also expressed the

opinion that maintaining the availability of loans to borrowers and student access to higher

education was of greater importance than reducing federal program costs. One respondent

suggested that continued participation of local lenders helped ensure access for risky or less

profitable borrowers.

Several respondents expressed concern about potential consequences associated with introducing

one or more of the market mechanism alternatives. Some stated that adjustments to the current

system would cause the least disruption, while others stated that all market models could cause

disruptions. While a number of respondents expressed concern that market-set rates had the

potential for discrimination and denial of access to funds, one respondent stated that market-set

rates may cause less disruption than other market models.

Two respondents commented mainly on the ICR option. They expressed concern regarding

Educationís payment calculator, used by borrowers to compare the monthly payments of ICR

with other available loan repayment options, because it projects the total payments of repayment

plans by adding up the total dollars to be repaid. They commented that adding up the total

dollars can prove misleading. To remedy this, they recommended using a repayment calculator

that calculates the present value of total dollars to be repaid and noted that such a payment

calculator is available on the Internet. The respondents also referred interested readers to a

forthcoming book on ICR. Additionally, some respondents believed that the draft report

exaggerated the cost advantages of FDLP over FFELP. Several respondents also provided

technical comments that we incorporated where appropriate.
Page 8

CHAPTER 1

PROGRAM BACKGROUND AND 1998 HEA MANDATE

FFELP, established by HEA, as amended, provides more than $22 billion of loans annually to

students pursuing a postsecondary education and their parents. Since 1965, FFELP has made

higher education affordable for more than 40 million Americans. Access to FFELP loans is

nearly universal among students enrolled at least half time at postsecondary education

institutions eligible to receive at least an unsubsidized loan. More than 21 percent of all

undergraduate students receive FFELP aid.7

 Lenders make loans to eligible borrowers, and the

federal government guarantees the loans against default. Borrowers attending schools that

participate in FFELP are legally free to choose their own lender. Many borrowers select a lender

from a list provided by the school. Borrowers receive loans with differing levels of subsidies,

which are based on financial need and length of time in school. The federal government ensures

that lenders receive a certain yield, currently based on a CP interest rate, on FFELP loans. The

federal government pays lenders the difference between the borrowerís interest rate and the

lender yield. The Congress adjusts this yield occasionally, but because critical information on

lendersí costs and profitability is not available, the Congress cannot be sure that a particular yield

will ensure sufficient lender participation without spending more than necessary. To help the

Congress consider market-based alternatives to legislation, the Congress directed that GAO and

Education form a study group with government and non-government experts to analyze ways in

which lender yield in FFELP could be set through a market mechanism for the delivery of

student loans. In accordance with the 1998 amendments to HEA, each mechanism was to be

evaluated relative to 13 criteria set out in the mandate. The study group considered a number of

proposals, and GAO and Education conducted an analysis of five models that involve market

processes to different extents.

HOW THE FEDERAL LOAN PROGRAMS OPERATE

HEA has created two major federal loan programs for students pursuing postsecondary

education.8

 In 1965, the original HEA established the guaranteed student loan program

(subsequently renamed FFELP), in which loans are originated by lenders, guaranteed by statechartered guaranty agencies, and reinsured by the federal government. In 1993, HEA authorized

FDLP, a second major loan program, in which the federal government provides loan capital,

schools originate loans directly to students, and outside contractors perform loan origination and

servicing functions. Since that time, competition has increased in the student loan market and

student borrowers have benefited from reduced fees and lower interest rates.

 

7

Based on an analysis of the 1995-96 National Postsecondary Student Aid Study sponsored by the National Center

for Education Statistics.

8

HEA also authorized the Perkins Loan program, a relatively small program that provides funds to postsecondary

institutions that are used to establish a revolving fund from which loans to students are made. The Perkins Loan

programópreviously known as National Defense and National Direct Student Loan programsópredates HEA by 7

years.
CHAPTER 1: BACKGROUND

Page 9

Types of Loans

FFELP and FDLP both include four major types of loans: subsidized Stafford, unsubsidized

Stafford, PLUS, and consolidation loans.9

 Student borrowers receive subsidized and

unsubsidized Stafford loans. Parent borrowers receive PLUS loans. Borrowers may take out

consolidation loans before or after entering their repayment period.

Subsidized Stafford Loans

Needs-based subsidized Stafford loans are available to eligible students at participating

institutions. The guaranteed amount of a subsidized loan may not exceed a studentís ìunmet

financial need.î10 The maximum loan amount is also subject to annual and aggregate loan limits.

A key feature of the subsidized Stafford loan is its interest subsidy while the student is not in

repayment. The government pays, on the borrowerís behalf, all interest accruing on the

outstanding principal while the borrower is attending school at least half-time, for 6 months after

attendance (the ìgrace periodî), and for periods of authorized deferment. Stafford borrowers

participating in the standard repayment plan have a repayment period of 10 years, not counting

periods of authorized deferment and forbearance.11

FFELP and FDLP lenders may also offer graduated and income-sensitive or income-contingent

repayment plans to borrowers. Borrowers have the option of picking a different repayment plan

each year. If borrowers waive their selection, rules of the standard repayment plan apply.

As previously noted, the interest rate on subsidized Stafford loans is currently the 91-day T-bill

rate plus 1.7 percentage points when the borrower is in school or in other nonpayment periods

and the T-bill rate plus 2.3 percentage points when the borrower is in repayment. The rate is

reset on July 1 each year, based on the T-bill rate from the last Treasury auction conducted

before June 1.

Unsubsidized Stafford Loans

Unsubsidized Stafford loans differ from subsidized Stafford loans in three key respects: They are

not need-based, the government does not pay interest during in-school periods, and loan limits

are higher. The unsubsidized Stafford loan is not need-based; the approved amount is not limited

 

9

Originally, ìPLUSî stood for the official name of the program, ìParent Loans for Undergraduate Students.î Under

current law, the program is simply named PLUS. Formula interest rates charged to students under FDLP were set in

law generally equal to the formula maximum rates on corresponding FFELP loans.

10ìUnmet needî is, in its simplest terms, the borrowerís cost of attendance minus estimated family contribution

minus estimated financial aid from other sources.

11A deferment is a period during which borrowers do not need to pay principal and the federal government pays

interest. Borrowers are eligible for a deferment under certain conditions, such as going on to further schooling. A

forbearance is a period during which borrowers do not need to pay principal but are responsible for any interest that

accumulates. The borrowerís eligibility for a 10-year repayment schedule is conditioned by the requirement that the

borrower repay at least $600 per year. The 1998 amendments to HEA provide for a repayment schedule of up to 25

years for ìnew borrowersî who accumulate more than $30,000 in FFELP loans.
CHAPTER 1: BACKGROUND

Page 10

by the same financial need formula used for subsidized Stafford loans. Instead, the expected

amount of the unsubsidized Stafford loan may be considered all or part of the estimated family

contribution. Interest on the unsubsidized Stafford loan is paid entirely by the borrower and is

not subsidized by the federal government. The borrower is not required to make interest

payments during in-school, grace, and other deferment periods. However, interest accrued

during such periods may be capitalized (added to principal) when the loan enters repayment for

the first time or when it returns to a repayment status following a period of deferment. Higher

loan limits are available on unsubsidized Stafford loans to independent students.12 The

maximum borrowerís interest rate is the same as for subsidized Stafford loans.

PLUS Loans

The PLUS loan is available to parents for their student dependents. For a school to certify a

PLUS loan, both parent and student must meet program eligibility requirements. For the PLUS

loan, HEA requires the lender to determine that the parent borrower does not have an ìadverse

credit historyî before making the loan and to use as a minimum the guidelines for determining

adverse history in the student financial aid regulations. If the lender discovers adverse credit

history in the applicantís credit bureau report, it can still make the loan if it documents

ìextenuating circumstances.î Even without extenuating circumstances, the lender can still make

the loan if the borrower obtains a creditworthy endorser.

Like the unsubsidized Stafford loan, the PLUS loan is not need-based and may replace all or part

of the studentís estimated family contribution. Also like the unsubsidized Stafford loan,

payments of interest on the PLUS loans fall upon the borrower entirely, with no federal subsidy.

Payments of interest are not required during periods of authorized deferment but may be

capitalized upon expiration of the deferment.

Unlike both types of Stafford loans, there is no fixed annual or aggregate limit for PLUS loans.

A loan may not be made, however, for an amount greater than the studentís cost of attendance

less his or her estimated financial aid. Also unlike Stafford loans, the PLUS loan has no grace

periodóit enters repayment upon full disbursement, unless the borrower happens to qualify for a

deferment. Unless payments are deferred, the first payment due date for a PLUS must be

established within 60 days of final disbursement.

Consolidation Loans

Consolidation loans are new originations that do not contribute to the increases in outstanding

balances because they refinance already existing loans. Borrowers may consolidate FFELP

loans, FDLP loans, and Perkins loans authorized by legislation other than HEA.

 

12Independent students are students who, by meeting certain regulatory criteria, are presumed to receive no financial

support from their parents. A student is considered ìindependentî who is at least 24 years old and who is a graduate

or professional student, a veteran of the U.S. armed forces, or married or has dependents other than a spouse. A

financial aid administrator may also classify a student as independent under special circumstance, even if none of

these criteria is met.
CHAPTER 1: BACKGROUND

Page 11

The purpose of the consolidation loan program is to give a borrower who has multiple loansó

possibly from different lenders, different guarantors, and even from different loan programsóthe

opportunity to have them combined into a single debt. The consolidation loan offers two unique

advantages. First, the borrower who has been dealing with multiple servicers and repayment

schedules can deal with a single servicer and single repayment schedule. Second, a combined

debt of more than $7,500 qualifies the borrower for a repayment term longer than the maximum

10 years generally available on Stafford and PLUS loans. For example, consolidation loan

borrowers with at least $20,000 of combined qualifying debt may qualify for a repayment period

of 20 years, borrowers with more than $60,000 for the maximum 30 years.13 Periods of

deferment and forbearance are not included.

Borrowers who consolidate their loans give up certain benefits tied to the underlying loans

subject to consolidation. These benefits include certain deferments and all service and

employment cancellations available to borrowers under the Federal Perkins Loan Program.

Borrowers also give up the variable interest rate of the FFELP and FDLP loans consolidated in

lieu of a rate fixed for the life of the loan.

In recent years, consolidation loans have been used to resolve defaults. A borrower who has

defaulted on an FFELP or FDLP loan may pay that defaulted debt in full by consolidating it.

This has two effects. First, the borrowerís credit history is improvedóin some cases

immediately and in others after payments have been made. Second, resolution of the default

qualifies the borrower for additional student financial assistance. A borrower qualifies for

consolidation of a defaulted loan by making a satisfactory repayment arrangement with its

holder, as defined in regulations.

The availability of loan consolidation to borrowers must be considered as part of the analysis of

any market mechanism proposal. Loan consolidation allows borrowers to change lenders.

However, the ability to switch lenders affects the perceived federal benefit that could result from

some of the market mechanism models discussed in this report.

Student Loan Volume and Default Rates

FFELP loans represent more than half of federal student loans outstanding and newly originated,

and in both FFELP and FDLP, Stafford loans make up the bulk of overall outstanding loans. At

the end of federal fiscal year 2000, the total amount of outstanding FFELP loans was about $166

billion, while about $58 billion of FDLP loans were outstanding. During fiscal year 2000,

FFELP loans accounted for about 63 percent of new loan volume, FDLP for about 37 percent.

Tables 3 and 4 detail loan balances and new loan originations, respectively, for fiscal year 2000.

 

13This is based on the outstanding balances of all loans in the qualifying underlying loan programs.
CHAPTER 1: BACKGROUND

Page 12

Table 3: Outstanding Loan Balances at the End of Fiscal Year 2000

Loan Federal Family Total loans

Education Loan

Program

Federal Direct

Loan Program

Amount Percent

Stafford

 Subsidized $85,084 $23,976 $109,059 48.7%

 Unsubsidized 37,410 15,487 52,897 23.6

PLUSa 14,552 3,609 18,160 8.1

Consolidation 29,082 14,643 43,725 19.5

Total $166,128 $57,714 $223,841 100.0%

Note: Dollars are in millions. Totals do not sum because of rounding.

a

Includes loans from Supplemental Loans for Students, a program that no longer exists.

Source: Department of Education.

Table 4: Loan Originations in Fiscal Year 2000

Loan Federal Family Total loans

Education Loan

Program

Federal Direct

Loan Program

Amount Percent

Stafford

 Subsidized $11,259 $5,785 $17,044 37.8%

 Unsubsidized 9,126 4,240 13,366 29.6

PLUS 2,326 1,318 3,644 8.1

Consolidation 5,695 5,369 11,065 24.5

Total $28,406 $16,712 $45,119 100.0%

Note: Dollars are in millions. Totals do not sum because of rounding.

Source: Department of Education.

The cohort default rate for federal student loan programs hit its highest leveló22.4 percentóin

fiscal year 1990 but has since greatly declined. The reduction in the default rates has been

attributed to a variety of circumstances. Efforts by FFELP participants, actions by both the

Congress and Education, the availability of additional repayment plans, and the strong economy

have all contributed to decline. The most recent student loan default ratesóthe 1998 cohort

default ratesóshowed that overall, the direct and guaranteed student loan programs had similar

default ratesó6.6 percent for FDLP and 6.7 percent for FFELP.

Participants in the Student Loan Programs

FFELP involves many participants, including borrowers, schools, lenders, loan servicers,

guaranty agencies, and Education. Some of these participants also have roles in FDLP.
CHAPTER 1: BACKGROUND

Page 13

Borrowers

Every eligible student pursuing postsecondary education at least half-time at a participating school

meeting certain requirements may obtain a loan. In addition, in some cases parents of undergraduates

may also borrow through FFELP or FDLP. The loans can be used to pay for tuition and educationrelated expenses at eligible 4-year colleges and universities, 2-year community colleges, private colleges

and universities, and for-profit trade and technical schools (sometimes referred to as proprietary

schools).

For Stafford loans, student borrowers do not have to make payments while in school or in other

authorized periods of nonpayment. Depending on the borrowerís income, and the income of his or her

family, he or she may be responsible for the interest that accrues during these periods of nonpayment, in

which case it is added to the loan principal at the beginning of the repayment period. The maximum

interest rate a borrower may be charged is set in legislation as the 91-day T-bill rate plus an add-on of

1.7 percentage points when the borrower is in school or in other nonpayment periods and 2.3 percentage

points when the borrower is in repayment. The borrower rate is adjusted annually, based on the new

value each year of the T-bill rate, but it is capped at 8.25 percent no matter how high the T-bill rate.

Schools

Eligible schools decide whether to participate in FFELP, FDLP, or both; most schools choose to

participate in only one of the programs. In both programs, schools make various certifications

necessary for a borrower to obtain a loan, and in FDLP they perform certain loan origination

functions as well. Borrowers in FFELP schools are legally free to choose among all eligible

FFELP lenders. Schools often provide borrowers a recommended list of lenders that is based on

the services, loan terms (such as rate discounts for good performance), and other key services

offered by the lenders.14 Most borrowers use a lender that their school recommends.

Lenders and Secondary Markets

Lenders originate and hold FFELP loans. HEA limits eligibility to originate and hold these loans

primarily to (1) banks and certain other savings institutions, (2) pension funds, (3) insurance

companies, (4) one state or private, nonprofit agency for each state, and (5) with certain

limitations, schools. Lenders pay the government an origination fee of one-half percent for each

loan and, in the case of consolidation loans, a fee of 1.05 percent. The government offsets

interest and special allowance payments owed to lenders to collect a 3 percent borrower

origination fee and authorizes lenders to charge the borrower for this fee. Although lenders may

discount the fee to the borrower, so that the borrower may not pay the full 3 percent, the lender

must still pay the full fee to the government. The 1998 Amendments and regulations further

specified the circumstances under which lenders may charge borrowers a reduced origination

fee.

 

14Service competition by lenders involving ìinducements,î such as mailing unsolicited loan applications or paying

schools for referrals of loan applicants, is not permitted.
CHAPTER 1: BACKGROUND

Page 14

An eligible lender can approve and originate loans. Once the loan is originated, the lender can

keep the loan on its books and earn either a positive or negative return and interest spread

based on the lendersí yield and its own interest expenses and other expenses,

sell the loan to a purchasing lender and record the gain or loss on sale, or

securitize the loan by selling the loan to a trust that has beneficial ownership of the loans and

funds its holdings by selling debt to investors and book a gain or loss, depending on the terms

of the transaction.

In the FFELP student loan market, secondary markets refer to financial institutions that purchase

student loans from lenders and provide liquidity to the student loan market. In 1972, the

Congress chartered a national secondary market, Sallie Mae, as a shareholder-owned

government-sponsored enterprise (GSE) to provide liquidity for the student loan market. Some

other lenders also serve as secondary markets for FFELP loans. In addition, under HEA, each

state can designate a not-for-profit secondary market to help ensure that every student at every

eligible institution can receive a loan and to provide liquidity to originators.

Financial institutions other than those defined as eligible by HEA are not eligible for direct

participation as lenders in FFELP. However, HEA authorizes the use of trustees as eligible

lenders to hold loans for the benefit of others without regard to the latterís own eligibility.

Certain secondary markets, those that are not designated by their state to be the stateís eligible

lender, as well as other nonbank financial institutions, use trustees to originate loans.

Sallie Mae and some secondary markets also effectively manage or service an additional amount

that was held by originators with which these secondary markets have ìpipelineî arrangements.

Some of the funding for loans in the pipeline is borrowed by the originating lender from the

subsequent purchaser.15

In 2000, nearly 4,000 lenders took part in FFELP. Both loan holdings and loan originations were

concentrated in larger institutions, as shown in tables 5 and 6. The top 10 loanholders held 68

percent of outstanding loan balances and the top 10 loan originators originated 52 percent of the

loan volume in 2000. Both loan holdings and loan originations became increasingly

concentrated, as shown in tables 5 and 6.

 

15Under such arrangements, the secondary market performs all or some of the marketing, origination, funding, or

servicing functions for the originating lender of record while the student is in school. The loan is transferred to the

secondary market when or before the loan enters repayment pursuant to a forward purchase agreement, often at a

predetermined price.
CHAPTER 1: BACKGROUND

Page 15

Table 5: Concentration of FFELP Outstanding Loan

Balances at the End of Fiscal Years 1994-2000

Fiscal year end % Share held by

Top 10 loanholders Top 50 loanholders

1994 54 79

1995 55 82

1996 57 85

1997 58 87

1998 58 87

1999 62 89

2000 68 91

Source: Department of Education.

Table 6: Concentration of FFELP Loan Originations

in Fiscal Years 1994-2000

Fiscal year % Share originated by

Top 10 originators Top 50 originators

1994 37 67

1995 37 69

1996 40 73

1997 45 78

1998 52 79

1999 52 82

2000 52 82

Note: Originations exclude consolidation loans.

Source: Department of Education

FFELP lendersí yield and eligibility requirements are set by federal statute and are administered

by Education. This yield is based on a variable short-term index, which closely tracks changes in

the market cost of funds. The formula for lendersí yield for new Stafford loans in FFELPóthe

largest component of FFELPóis now based on a CP index. Lender yield is the 90-day CP rate

plus 1.74 percentage points while the borrower is in school or during other nonpayment periods

and it is CP plus 2.34 percentage points when the borrower is in repayment. The lender yield is

adjusted quarterly with new values of the CP rate. This rate applies to new FFELP loans made

after January 1, 2000.

After July 1, 2003, the Stafford formula is scheduled to change to a markup of 1 percentage point

over the rate for ìcomparable maturitiesî of Treasury securities, as determined by the Secretary

of Education in consultation with the Secretary of the Treasury. This new rate is both the
CHAPTER 1: BACKGROUND

Page 16

borrowerís rate and the lenderís yield. Such a change may narrow the interest margins earned by

lenders and will likely increase their funding risks as well as increase the costs of hedging.

Several study group members expressed concern that lenders may respond by exiting from

FFELP, which could potentially limit borrower access to student loan funds and disrupt ongoing

working relationships among schools, lenders, and students.

A special allowance payment (SAP) is a quarterly payment that the federal government makes to

FFELP lenders. It equals the difference between the rate a borrower pays and what the current

formula provides for lender yield. Thus, if the lender yield exceeds the maximum borrower rate,

the government pays the difference to lenders in the form of the SAP. If the difference is

negative, the lender receives the borrower rate and no SAP. The SAP is intended to maintain the

incentive associated with the yield for the lender if interest rates change, while permitting

borrowers to pay lower rates if interest rates fall. If CP declines, the quarterly lender yield

declines, and so does the SAP generally. The minimum or ìfloorî yield to lenders is the

borrowerís rate for the year. The SAP is designed to make sure that the lenders receive a

reasonable rate of return on average. However, because risks and costs can vary across

borrowers and lenders, so can returns. Therefore, implementing a market mechanism that results

in a variety of SAPs that reflect actual risks and costs could potentially lower the federal cost of

the program.

The borrowerís interest rate set in legislation is a maximum, and FFELP lenders may offer lower

interest rates to borrowers. Most often lenders charge FFELP borrowers the maximum rates at

the outset but then offer some rate reductions during repayment. For example, they may reduce

rates after the borrower makes a certain number of payments on time or if the borrower chooses

to make payments through electronic funds transfers. Many lenders now also offer rate

reductions upon loan origination or discounts on the 3 percent origination fee.

Loan Servicers

Loan servicers undertake the processing necessary to ensure that cash flows of the loans are

recorded and transferred to and from lenders, guaranty agencies, and Education. Loan servicing

is more concentrated than are loan holdings or loan originations, with the top two loan servicers

accounting for about 50 percent of the loan servicing market. Holders of student loans can

service their own loans or they can contract out for loan servicing to be performed by another

entity; this is known as a third-party servicer arrangement.16 If servicing does not conform to

procedures Education established by regulation, the lender may not be reimbursed if the

borrower defaults. Better servicing can reduce the risk of default and thus lower government

costs. Additionally, schools benefit because higher defaults could threaten some schoolsí

eligibility to participate in FFELP.

 

16Third-party servicers are not subject to eligibility limitations by organizational type. However, they must meet

federal requirements of administrative capability and financial responsibility, and they are subject to audit by

Education. Eligible lenders remain responsible for the performance of their legal duties, despite any delegation of

functions to third-party servicers, and they must monitor their servicersí activities.
CHAPTER 1: BACKGROUND

Page 17

Guaranty Agencies

Guaranty agencies administer the federal guarantee on FFELP loans, confirm borrower

eligibility, monitor the status of loans, provide delinquency and default aversion counseling, and

provide claims adjustments. FFELP loans are guaranteed by one of 36 nonprofit or state

agencies designated by the Secretary of Education. If a loan goes into default, the guaranty

agency generally pays the lender 98 percent of principal and accrued interest. The federal

government then generally reinsures 95 percent of the guaranty agenciesí payments to lenders

and also pays them fees for loan processing and issuance, account maintenance, and default

aversion. Guaranty agencies also retain a portion of the collections they are able to make after a

loan has gone into default. The government also directly guarantees or reinsures FFELP lenders

against the inability of guaranty agencies to fulfill their guarantees because of insolvency.

As long as the lender complies with the regulations, the guarantee substantially limits FFELP

lendersí losses due to borrower default. Federal reinsurance is available only if the guaranty

agency correctly enforced federal regulations and attempted to collect from delinquent

borrowers. If the loan servicing and collections are not done in accordance with federal

regulations, the reinsurance can be voided and can create losses for the guaranty agency.

Guaranty agencies are authorized to collect a single insurance premium from FFELP borrowers

of not more than 1 percent of the principal amount of their loans. Before 1998, some guaranty

agencies had selectively reduced or eliminated this insurance premium. Since reauthorization

eliminated the fee as a source of operating revenue, the elimination of guarantee fees has become

widespread because of market pressures. Any fees collected go into an agencyís federal reserve

account, which consists of federal funds that the guaranty agency maintains to pay default

claims.

The Department of Education

The Department of Education role in administering FDLP and FFELP differs significantly

between the two programs. Under FFELP, also known as the guaranteed student loan program,

money is borrowed from private lenders, such as banks, and the federal government guarantees

repayment if the borrowers default. Under FDLP, students or their parents borrow money

directly from the federal government through the schools the students attend, which include

vocational, undergraduate, or graduate schools.

HEA provides the structure of FFELP program requirements and then authorizes the Secretary of

Education to administer the program. Among the Secretaryís responsibilities is the promulgation

of regulations to provide detail on how requirements will be implemented. Sometimes, the

statutory requirement is very specific, in which case, the regulation simply restates the statutory

language (e.g., loan limits). In other cases, the statute expresses the requirement in only the

broadest terms and gives extensive authority to the Secretary to define standards of compliance

such as due diligence with respect to loan collection.

Education is also involved in two types of cash flows relevant to the topic of this report. First, it

reimburses a guaranty agency after the guaranty agency pays a lender for a defaulted loan.
CHAPTER 1: BACKGROUND

Page 18

Second, it makes certain payments to lenders, including the difference between the borrowerís

interest rate and the lenderís yield, for all borrowers, and interest during in-school and other

authorized periods, for borrowers with subsidized Stafford loans. Education is also responsible

for

determining a studentís eligibility to receive federal student financial assistance;

gatekeeping, monitoring, and enforcement activities for postsecondary schools;

recognizing accrediting agencies;

monitoring the participation of guarantors, lenders, secondary markets, and third-party

servicers in FFELP;

managing FDLP;

collecting and resolving defaulted FFELP and FDLP loans;

maintaining a centralized database on individuals who apply for and receive federal student

financial assistance;

managing the financial aspects of the Federal Student Financial Aid Programs, such as

receipt, disbursement, accounting, and financial reporting for federal funds;

developing and disseminating information about the federal student loan programs;

developing cost estimates for the student loan programs; and

providing technical support and information for financial aid administrators.

The federal costs of FFELP include borrower defaults and loan discharges, borrower interest

subsidies, and payments to lenders and guaranty agencies. The federal costs associated with

FFELP for fiscal year 2000 are presented in table 7. Figure 1 depicts the cash flows in an FFELP

program loan to and from the student borrower, school, lender, loan servicer, guaranty agency,

and Education. Figure 2 depicts the cash flows associated with a FFELP program loan in

default.

Table 7: Federal Costs for the FFELP Fiscal Year 2000

Item Amount

Interest benefits $1,943,067,250

Default claim reimbursement 1,646,483,901

Special allowance payments 975,825,865

Death, disability, and bankruptcy 309,476,408

Account maintenance fees 180,000,000

Loan processing and issuance fees 149,799,369

Collection costs 78,558,740

Total $5,283,211,533

Source: Department of Education.
CHAPTER 1: BACKGROUND

Page 19

Figure 1: Cash Flows for an FFELP Loan From Origination Through Repayment
CHAPTER 1: BACKGROUND

Page 20

Figure 2: Cash Flows for an FFELP Loan in Default

Determining the actual financial performance and the true costs of the FDLP at present is

difficult. Because FDLP is a relatively new program, little repayment activity and historical data

are available. This lack of historical FDLP data has caused Education to rely heavily on data

from FFELP to develop estimates for most key cash flow items. Also, estimating the subsidy

cost of FDLP is difficult because of their dependency on interest rate projections and

corresponding fluctuations in subsidy costs which depend on the extent of changes in interest

rates.17

MANDATE IN THE 1998 AMENDMENTS

TO HEA AND THE STUDY GROUPíS WORK

The Study Group and Its Objectives, Scope,

and Methodology

The 1998 amendments to HEA mandated that GAO and Education form a study group to

identify and evaluate a means of establishing a market mechanism for the delivery of student

loans. This study group consisted of representatives of CBO, OMB, Treasury, entities making

FFELP loans, other entities in the financial services community, other participants in the student

loan programs, and other individuals designated by the Comptroller General and the Secretary of

Education. (See app. I for the full text of the mandate and app. II for a list of study group

members.) The group met as a whole four times before the public release of a draft of this

report, and various group members corresponded with GAO and Education between group

meetings as well.

 

17GAO recently reported that the estimated cost savings associated with FDLP are sensitive to changes in the student

borrower rate and the rate at which Education borrows from Treasury. See Department of Education: Key Aspects

of the Federal Direct Loan Program's Cost Estimates (GAO-01-197, Jan. 12, 2001).
CHAPTER 1: BACKGROUND

Page 21

The mandate calls for the evaluation of at least three different market mechanisms relative to 13

criteria. We grouped the evaluation criteria into four sets, as shown in table 8.

Table 8: The Four Sets of Evaluation Criteria

Set Related criteria from the 1998 HEA amendments

Description of model, including

variations

 A description of how the mechanism will be administered and operated

(12)

 The proposed Federal and State role in the operation of the mechanism

(11)

 Transition procedures (13)a

Costs, savings, and effects on

subsidies for program

participants

 The cost or savings of loans to or for borrowers, including parent

borrowers (1)

 The cost or savings of the mechanism to the Federal Government (2)

 The cost, effect, and distribution of Federal subsidies to or for participants

in the program (3)

Effects on lender participation,

loan availability, and service

quality

 The effect on the diversity of lenders, including community-based lenders,

originating and secondary market lenders (7)

 The availability of loans to students by region, income level, and

categories of institutions (10)

 The effect on loan availability during a transition period (13)a

 The effect on investment in human capital and resources, loan servicing

capability, and the quality of service to the borrower (6)

 The degree to which the mechanism will provide market incentives to

encourage continuous improvement in delivering and servicing loans (9)

Simplicity, regulatory burden,

and program integrity

 The effect on the simplicity of the program, including the effect of the plan

on the regulatory burden on students, institutions, lenders, and other

program participants (5)

 The effect on program integrity (8)

Note: The numbers in parentheses refer to the number assigned to the specific criteria in the legislative mandate.

The analysis related to the fourth criterionóthe ability of the mechanism to accommodate the potential distribution

of subsidies to students through an ICR optionówas similar across all the models. Rather than repeat our analysis

of this criterion for each model, we discuss it separately in chapter 7. Therefore, this criterion does not appear in

this table.

a

We split the thirteenth criterion, on transition procedures, into a descriptive part and a part related to loan

availability issues.

The group solicited proposals for market mechanisms that might meet the intent of the mandate.

Group members, as well as outside observers, submitted proposals for consideration. GAO and

Education considered all submissions and grouped them where we saw some similarities within

the proposals. For example, under the general idea of conducting an auction for the right to

make FFELP loans, there were two main possibilities as to how such an auction might be

conducted, as well as many different considerations at the level of specific auction design.

Rather than selecting one of the main possibilities and a specific set of auction design decisions,

we analyzed this type of model in general, weighing the advantages, disadvantages, and tradeoffs

in the different possible choices.
CHAPTER 1: BACKGROUND

Page 22

In study group meetings and other conversations with group members, including staff from the

other government agencies, we discussed the various models and their implications. Two of the

group meetings were devoted to generating ideas about possible changes to FFELP, including

some general factors to consider and some specific proposals. In the third meeting, the group

discussed preliminary analysis results, and in the fourth meeting, the group discussed a draft of

this report.

GAO and Education also researched comparable programs in existence, such as other federal

auctions and the experiences of student loan programs in other countries. We used previously

published reports, material available from the Internet, and contributions from study group

members for much of this research.

The Five Models Discussed in This Report

The potential changes to FFELP discussed in this report are grouped under five general models:

adjustments to the current system,

loan origination rights auction,

loan sale,

federal funding, and

market-set rate.

A model involving adjustments to the current system would change the process of setting lender

yield by building upon competition for loan originations, purchases, and servicing that is a part

of FFELP today. Proposals within this model include (1) making periodic incremental

downward adjustments in the lender yield while monitoring any resulting changes in lender

participation; (2) using information about lendersí cost of funds and servicing costs to set the

yield; (3) establishing an independent blue ribbon commission to gather information, analyze

data, and either set lender yield or recommend a yield level to the Congress; and (4) using

information from secondary market loan sales transactions to determine the value lenders place

on loans, and establishing a one-time payment to lenders based on this value to replace the

quarterly SAP.

A loan origination rights auction would require lenders to bid to participate in FFELP. The

borrowerís interest rate and other loan terms would be set through legislation or regulation and

could remain the same as today. Lenders would generally submit bids to participate in FFELP

loan origination, and bidders offering the best terms to the government would win the

allocations. Variations within this type of model differ as to how restrictive the outcomes would

be. A volume procurement auction would require lenders to bid on the right to an amount of

loan volume at a particular interest rate (or price, for a predetermined interest rate), perhaps for
CHAPTER 1: BACKGROUND

Page 23

volume within different sectors of schools.18 An actual origination rights auction, in contrast,

would require lenders to bid for the right to originate at groups of schools.

The loan sale model presumes that private lenders would purchase loans sometime after they are

originated by the government or by some entity under government contract. The loan would be

government property until sold at auction. The government would assemble packages of loans,

and private lenders would evaluate the packages and submit bids. Loans would carry the same

borrower terms as today, and the lender yield would be set legislatively and could be the same as

the borrowerís interest rate. Loan origination could be performed by the federal government;

schools, private lenders that bid to originate and service the loans but operate under government

contract, or state agencies or some other entity. Loans could be sold immediately after

origination or held until a borrower graduates or otherwise completes schooling, at which time a

borrowerís loans could be sold as part of a package. Loan servicing could be performed by the

purchaser, if servicing responsibilities are sold with the loan, or by some other entity.

The federal funding model would adjust funding costs for FFELP lenders, ultimately

determining lenderís net yield. Private lenders would continue to originate loans, except that

they would be allowed to borrow funds from the federal government to make FFELP loans. The

interest rate at which they borrow, in conjunction with the lender yield on FFELP loans, would

determine lendersí net yield. This process could be made mandatory for lenders who want to

participate in FFELP, or it could be offered as an option, with lenders still being allowed to fund

student loans through traditional methods. Once lenders receive these funds, or if they choose

not to participate, everything else would proceed functionally as in the current system. The

funds lenders borrow from the government could be payable on either a regular amortization

schedule or a schedule tied to borrower repayments on the FFELP loans made with the federal

funds. Finally, the markup over a Treasury-based interest rate, such as the 91-day T-bill rate or

the 10-year Treasury bond rate, could be fixed, or lenders could bid on the markup.

In a market-set rate model, the borrower or the school chooses among lenders for the best

attainable interest rate. Unlike with the other models, the borrowerís interest rate would no

longer be set by legislation. Instead, it would emerge from negotiations between lenders and

borrowers or likely between lenders and schools.19 The resulting rate would thus be both the

borrowerís rate and the lenderís yield. Loans would still be federally guaranteed, and lenders

would face no limitations on the amount of loans they could originate and hold. Under this

model, some borrowers might pay a higher interest rate. Possible variations could limit the

potential effects on disparate groups of borrowers. For example, one alternative would place a

limit on the maximum range of rates or fees a lender could offer.20 Another possibility would be

 

18For instance, volume for 2-year and 4-year schools, or public, nonprofit private, and proprietary schools, could be

offered in separate auctions.

19Lenders would be likely to assume that enough common characteristics exist across borrowers at a school to

enable them to give the same rate to all a schoolís borrowers rather than to try to negotiate with each borrower.

20This would be similar to a limit that exists in the Federal Housing Administration (FHA) insurance program. FHA

limits the variation between the highest and lowest ìmortgage charge ratesî (analogous to FFELP origination fees)

that a lender may offer to any borrower within a given time period to no more than 2 percentage points within welldefined markets, as defined by geographic region and ìrisk characteristics,î among other factors.
CHAPTER 1: BACKGROUND

Page 24

for the government to provide subsidies to borrowers who cannot otherwise obtain low interest

rates from lenders.

The models we discuss might or might not be accompanied by changes in the role of guaranty

agencies in FFELP. To analyze such changes, the models would have to be specified in more

detail than is possible in this report. For this reason, we do not discuss possible changes in

guaranty agenciesí role.

The models we discuss may present budgetary issues. The Credit Reform Act of 1990 changed

the budget treatment of federal credit programs to put the scoring of direct and guaranteed loans

on an equal footing. Under credit reform, loan program budget estimates for a given fiscal year

reflect the estimated long-term cost to the government when the loan is disbursed. The cost to

the government is the net present value of all cash flows to and from the government, including

loan disbursements, repayments of principal, interest payments, recoveries or proceeds of asset

sales, and payments by the government to cover defaults, interest subsidies, origination and other

fees, penalties, and recoveries. (Federal administrative costs are excluded from these

calculations.) For the student loan programs, Education generates these estimates for the

administration using a governmentwide credit subsidy model developed by OMB. Projected

program cash flows for the life of each loan cohort are generated by an Education model and

discounted by an OMB credit subsidy model using a discount rate based on Treasury instruments

with a maturity comparable to that of the underlying loans. For the student loan programs, this

comparable maturity rate is the 10 to 20 year bond rate. Shifts in the timing of payments and

receipts would need to be considered within the context of credit reform requirements. To

analyze such changes, or "score" the proposals for budgetary purposes, would require more

detailed specifications than is possible in this report. For this reason, we do not calculate or

compare the budgetary costs of models we present in this report.
Page 25

CHAPTER 2

ADJUSTMENTS TO THE CURRENT FFELP SYSTEM

The proposals to adjust the current FFELP system focus on lendersí sensitivity to interest rates,

secondary market trends, and lender costs. Whether or not the Congress maintains its legislative

authority to set the lender yield, each of these adjustments would modify the process, making

FFELP a system more responsive to student loan market conditions. Each of the four proposals

would preserve the existing relationships between borrowers, schools, lenders, and other FFELP

participants, while relying on the acquisition of new or better information to adjust lender yields.

Current options for borrowers to consolidate loans would continue to be available under these

proposals. These proposals would affect lender yields similarly to the proposals discussed in

other chapters. However, the proposals discussed in this chapter might take longer to affect

lender yields than would the proposals we discuss elsewhere in this report. Each adjustment to

the current system could reduce federal costs but possibly at the expense of discounts that

lenders currently offer to some borrowers. The extent to which each proposal can realize these

savings depends on choices regarding design and implementation.

DESCRIPTION OF MODEL AND VARIATIONS

Each of the proposals maintains the structure of FFELP while changing the mechanism for

determining lender yield. The proposed adjustments to the system include

incremental adjustments proposal,

cost of funds proposal,

proposed blue-ribbon commission that would set lender yields, and

loan transaction proposal that would use data from secondary market transactions to improve

the yield-setting process.

Incremental Adjustments

Under the incremental adjustments proposal, the Congress would reduce the lender yield

incrementally, either annually or as needed, while carefully monitoring lender participation after

each adjustment. If such a reduction in lender yield caused lender participation to drop to a

dangerously low level or caused an erosion of service quality, the Congress could raise the lender

yield until it believed that lender participation and service quality were once again at acceptable

levels. Legislation would be necessary for each adjustment, as it is in todayís program, unless

the Congress specifically delegated the rate-setting role to an executive agency or to an

independent government commission.

Cost of Funds

The cost of funds proposal relies on lendersí cost data to determine lender yield. Data on

lendersí costs would include the actual expense to lenders associated with raising funds, loan
CHAPTER 2: ADJUSTMENTS TO THE CURRENT SYSTEM

Page 26

origination, and loan holding, as well as an estimation of servicing costs deemed reasonable to

maintain high-quality service to borrowers. On the basis of these factors, the Congress could

determine an appropriate differential between the cost of funds and the cost of servicing. This

differential could be applied to the determination of a market-based lender yield. The Congress,

an executive agency, or an independent government commission could administer the cost of

funds approach.

Blue-Ribbon Commission

There are two distinct ways in which a blue-ribbon commission could be organized. It could be

an advisory commission whose members could include expert staff from the executive branch,

representatives from the student loan or banking industries, and recognized authorities on higher

education finance. This type of commission could consider the costs of funds, loan transaction

cost, or other similar information. The commission could also, for example, recommend

different methods for paying or calculating special allowance payments. The Congress would

retain responsibility for setting the rate and could accept or reject the commissionís

recommendation as it saw fit. Alternatively, the Congress could establish the commission as an

executive branch agency or as an independent federal entity and could give it the responsibility

of determining the lender yield.

Loan Transaction Information

This proposal would use data from loan transactions to gauge the underlying value that participating

FFELP lenders place on loans. The government would collect information on the terms and conditions

of secondary market transactions in the existing FFELP. This information could serve as the basis for a

modified determination of lender yield.

Another component of this proposal is its modification of the SAP that lenders receive. Under

this plan, the SAP would be made to the loan holder only once, either when the loan was initiated

or when and if consolidation or refinancing occurred, rather than quarterly as in the current

FFELP. The proposal empowers an executive agency or an independent commission to establish

this single supplemental payment for loans made each year rather than having the Congress

continue to legislate the SAP. The amount of the single supplemental payment would be

influenced by data gathered from transactions in the secondary market. Additionally, the amount

of a modified SAP could vary according to lender size, student loan activity, type of loan or type

of school, or any other characteristics deemed relevant.

COSTS, SAVINGS, AND EFFECTS ON SUBSIDIES

FOR PROGRAM PARTICIPANTS

Each of the proposed adjustments to the current system could potentially reduce or increase the

federal operating costs of FFELP. Further, each of these proposals makes two assumptions

regarding the current FFELP: (1) lendersí participation in the student loan program is contingent

on profit sustainability, and (2) the current lender yield results in profits beyond those necessary
CHAPTER 2: ADJUSTMENTS TO THE CURRENT SYSTEM

Page 27

to maintain sufficient active lender participation. These assumptions, and the corresponding

reforms these proposals envision, drive the cost and savings effects for program participants,

potentially saving money for the taxpayers.

If the lender yield is lowered incrementally and lender participation is maintained, the action

might cost lenders a portion of their profits while saving the government some of what it

otherwise would have spent on payments to lenders. As lender yield is reduced, profits for

participating lenders could fall and lenders could begin to leave the program. Smaller lenders

(those with low volume or high cost) would likely be the first to exit the program. However,

remaining lenders might be likely to make up for this loss by acquiring the assets of the outgoing

firms or simply by increasing lending activity. Thus, remaining lenders would grow larger,

further concentrating the market. Larger lenders, able to operate at a lower cost per dollar of

loan originated, might pass savings on to borrowers or might make improvements to service

delivery.

Like the incremental adjustments proposal, the cost of funds approach could result in either costs

or savings to the federal government and program participants. The cost of funds approach calls

for a mechanism by which lenders can detail and report their costs and the government can form

objective judgments to analyze and justify these estimates. Although some savings might be

realized through reduced federal payments to lenders, this proposal would impose additional

administrative costs on the federal government because cost data are not readily available. If

these figures were accessible, the government could assess cost data by using a number of

criteria. These could include the types of students or schools served.

An additional question is the role that the government should have in determining the accuracy

of cost estimates under this proposal. The outcome of these decisions directly affects both the

federal administrative cost of implementing the model and the federal payments to lenders in the

program. If, for example, lenders document substantial costs for raising funds and the

government accepts these figures, then the lender yield could rise, increasing the governmentís

cost. In contrast, if the government chooses to contest these figures, it may become embroiled in

a political and controversial investigation that could stall FFELP loan delivery.

The use of loan transaction information could result in decreased costs for the taxpayer. For

example, while the federal government would incur some costs associated with the pursuit and

analysis of information regarding secondary market loan sales, these costs might be small

compared to any potential savings from reduced payments to lenders.

EFFECTS ON LENDER PARTICIPATION, LOAN

AVAILABILITY, AND SERVICE QUALITY

The adjustments to the current system would be likely to affect the current FFELP structure less

than the models discussed in other chapters. These proposals could preserve or possibly improve

the quality of loan service. There is consensus among the study group members that FFELP

lenders have responded to the competitive pressure introduced by FDLP.
CHAPTER 2: ADJUSTMENTS TO THE CURRENT SYSTEM

Page 28

The incremental adjustments proposal might reduce the number of lenders in the program. For

example, the adjustment process might initially set the lender yield so low that it would force out

lenders with high costs or low volume. If these lenders leave the program, they may find reentry costs prohibitively high should the yield be raised in a subsequent adjustment.

Determining what number of lenders is sufficient is a value-laden assessment. Mergers and

acquisitions resulting in fewer lenders but the same loan volume and more efficient service

provision may be desirable. However, a decline in lender participation might reduce loan

availability or disrupt services to students and schools.

The cost of funds proposal relies more heavily on lender information to set the lender yield by

considering lendersí operating costs as a component of the yield determination. Thus, the cost of

funds proposal has the potential to improve the quality of service that lenders provide. If lenders

recognize that the yield will reflect their funding costs as well as their service costs, they may

have the incentive to reduce costs for borrowers or to enhance service delivery by purchasing or

developing new technology. While these actions would have clear benefit to borrowers, higher

lender costs would force the government to increase the yield, raising federal FFELP costs.

Merely establishing a blue-ribbon commission would not affect lender participation, loan

availability, or lender diversity. Establishing a blue-ribbon commission is a procedural reform,

and commissioning an independent entity alone to implement adjustments to FFELP would do

little to alter the provision of loans or the quality of service. Consequently, the extent to which

loan availability, service quality, or lender diversity would change hinges on the rate-setting

strategy the commission chose to employ.

The implementation of the loan transaction proposal relies on lender-provided information. This

proposal requires the government to collect secondary market sales data. According to

Education, this new data collection would impose additional reporting burdens on lenders, but

the extent is unclear.

SIMPLICITY, REGULATORY BURDEN,

AND PROGRAM INTEGRITY

Each proposal presents logistical and regulatory challenges to the Congress. The incremental

adjustments approach calls for carefully monitoring lender activity, while the cost of funds

proposal represents a shift toward oversight and evaluation of lender operations. Lendersí

potential unwillingness to release cost information, as well as the difficulty inherent in analyzing

it, would present challenges to implementing this proposal. While the blue-ribbon commission

approach aims to remove rate setting from the congressional arena, the extent to which an

independent entity could effectively oversee a program of this size remains unknown. Although

a blue-ribbon commission might be empowered to set the yield, it would be subject to

administrative requirements that might leave it open to the same budget and political pressures

that the Congress faces. Finally, collecting data from loan sale transactions might complicate

FFELP administration, requiring the government to track the prices associated with secondary

market loan sales. Since lender yield would still have to be set by the Congress or some other

entity under each approach rather than emerging from a market process, the rate-setting
CHAPTER 2: ADJUSTMENTS TO THE CURRENT SYSTEM

Page 29

mechanism still might not be free from the political process. Any of these approaches could

result in either more or less regulation, while all would impose new administrative burdens.

The incremental adjustments proposal could entail additional regulatory burden for FFELP.

Specifically, the incremental adjustments proposal would require carefully monitoring lender

response each time an adjustment was made. The need for timely information and for prompt

action to counteract excessive adjustments requires special considerations. Some mechanism

would be required to halt further downward adjustments from negative consequences such as

lender departure. In addition to regulatory burden, this proposal could create significant

administrative burden. If this proposal were to be implemented, it might require delegation to an

independent entity such as the blue-ribbon commission. In any case, some entity would have to

monitor the program and make recommendations as to further changes.

Concerns exist regarding the implementation of the cost of funds proposal as well.

Administering a cost of funds model would introduce additional data collection needs. This

proposal requires the annual development of two sets of proprietary lender information (costs of

raising funds and an estimation of servicing expenditures) for use in setting lender yield.

Collecting and verifying lender cost information could present new challenges. The data

collection process itself might be impeded by the complexity of lender transactions (such as

securitizations and forward purchase agreements) and by the variation in lender structure (freestanding, part of a holding company whose main focus is student loans, part of a larger bank for

which student loans may be a small business). Inaccurate and inadequate data would limit the

governmentís ability to manage this program. The proposal would also require the subsequent

modification of lender yield if lender cost data indicated that the current rate were inappropriate.

Some of these assessments, however, require normative judgments about the degree to which

costs should vary by the types of schools and students lenders serve.

Many of these challenges to simplicity and regulatory burden apply also to the blue-ribbon

commission proposal. Panel selection might become politicized and controversial. Additionally,

while establishing the commission would reduce the direct congressional role in setting yield, it

remains unclear whether the commission would be advisory or authoritative, how the panel

would access data, and whether consensus would be required for commission decisions. The

commission would need authority to gather relevant data as well as the resources to analyze

them. Implementation decisions would also center on the type of legislation necessary to

establish the commissionís tasks and objectives and on the delegation of congressional staffers

for administrative and substantive assistance.

The blue-ribbon commission might or might not remove the setting of the lender yield from the

political process. If the commission were advisory, then the Congress would still be responsible

for setting the rate and could still face political pressure from FFELP participants who disagreed

with its recommendation. If the commission were a federal agency, then the Congress would not

face such pressure directly but the commission might. Political pressure on the commissionís

decision could be especially great if the Congress required it to publish a public notice of its

proposed decision and respond to public comments on its proposal before implementing it. The

Congress has imposed such a requirement on most federal agency rulemaking decisions. If the

Congress decided to exempt the commission from this requirement, then the commission would
CHAPTER 2: ADJUSTMENTS TO THE CURRENT SYSTEM

Page 30

be less subject to political pressure but would also be less accountable to the public and might

lose the benefit of information that public comments could provide.

One federal agency that functions like a blue-ribbon commission is the Postal Rate Commission

(PRC). PRC is an independent executive agency that recommends postal rates to the U.S. Postal

Serviceís board of governors. When the Postal Service requests a rate change, it must provide

PRC with data about the relevant costs. Before making a rate recommendation, PRC must hold

public hearings, which include testimony and written submissions from the Postal Service, its

competitors, and others that are interested. In making a recommendation, PRC must consider

nine legislatively established criteria as well as the record of its hearings. The postal ratemaking

process is lengthy and complicated. There is a process for modifying or rejecting PRC

recommendations, but those recommendations have usually been accepted without modification.

The loan transaction information proposal requires the government to monitor lender

participation and corresponding secondary market transactions. However, collecting and

verifying private secondary market transaction information might present challenges, especially

considering the proprietary nature of agreements between secondary market participants.

Carefully monitoring the secondary market will demand administrative oversight, forcing

decisions about what information will be gathered and how it will be analyzed.

The federal government, or its designated blue-ribbon commission, could periodically auction a

limited amount of direct loans as an alternative source of secondary market information. Existing

law authorizes sales of direct loans. However, selling a portion of the FDLP portfolio could

present budgetary challenges. Under federal credit reform, such sales could possibly be recorded

as a loss, which would require offsets under current budget rules. Other ways to offset the

subsidy cost of selling direct loans would be to securitize some of the FDLP loans in Education's

portfolio.

Finally, implementing an auction of FDLP loans could increase administrative burden.

Insufficient competition could threaten the integrity of the bidding process. It would also

involve decisions on who would facilitate the auction and how competition would be preserved.

Auction design issues and the importance of competition are discussed in detail in appendix III.

The results of the analysis for the adjustments to the current system are summarized at a broad

level in table 9.
CHAPTER 2: ADJUSTMENTS TO THE CURRENT SYSTEM

Page 31

Table 9: Summary of Analysis for Adjustments to the Current System Model

Description of model,

including variations

 All proposals maintain current roles and relationships for FFELP

participants.

 Proposals use information from the marketplaceófor example, data on

lendersí cost of funds or secondary market salesóto set the yield level.

 Might involve establishing a blue-ribbon commission to either set the yield or

recommend a yield level to the Congress.

Costs, savings, and effects

on subsidies for program

participants

 Federal FFELP costs could increase or decrease but are more likely to

decrease.

 Savings to the taxpayer, if any, could come at the expense of some

discounts that lenders currently offer to some borrowers.

Effects on lender

participation, loan

availability, and service

quality

 Loan availability should not be greatly affected if adjustments are

incremental.

 The number of lenders in the program could fall if adjustments force out

lenders with low volume or high cost.

 Service quality would be subject to the same pressures.

Simplicity, regulatory

burden, and program

integrity

 Relationships between FFELP participants would change little.

 Oversight of lender operations, and required data gathering and analysis,

might prove difficult.

 Blue-ribbon commission would require administrative framework.
Page 32

CHAPTER 3

LOAN ORIGINATION RIGHTS AUCTION

The origination rights auction model would require lenders to bid for the right to originate and

obligate them to lend FFELP loans. Auctions rather than the legislative process would set the

yield that lenders would receive. If the auctions were sufficiently competitive, bidding would

eliminate any excess in what the government currently pays lenders and would maintain lender

incentives to reduce their costs. Therefore, auctions have the potential to reduce federal FFELP

costs. The effects of auctions on borrower interest rates, the distribution of federal payments to

lenders, the quality of service, and the burden on borrowers and schools are uncertain. The

effects depend on the details of auction design as well as on a number of assumptions about

markets that may or may not be valid in relation to the student loan program. The diversity of

lenders would likely decline unless special provisions were made to ensure the participation of

small lenders. Studentsí and parentsí access to loans could be reduced during the transition to

auctions and, depending on auction design details, perhaps permanently. The federal

government would have to develop new regulations to govern the conduct of the auctions and, in

particular, to preserve competition in bidding. Students, lenders, and schools would all bear the

burden of adjusting to the auction system.

DESCRIPTION OF MODEL, INCLUDING VARIATIONS

In origination rights auctions, lenders would bid for the right to originate student loans. The

federal government would develop regulations to implement the auctions and would maintain its

current subsidies to borrowers. Major choices that must be made in designing the auctions

include

whether the auctioned rights are rights to originate all loans at particular schools or groups of

schools or rights to originate a specified volume of loans at any of a number of schools,

whether origination rights or volumes are grouped by school,

whether each student borrower is allowed to keep all loans with a single lender, and

which bidding method is used, including whether lenders bid on the interest rate they would

receive on loans they originated or on the price they pay to originate loans at a predetermined

interest rate.

Basic Model and Role of Participants

All versions of the origination rights auction model share several features. The borrowerís

maximum interest rate, in-school subsidy policy, and some other loan terms would be set through

federal legislation or regulation, as at present. Lenders would bid for the right to originate loans.

They would indicate the prices that they were willing to pay or the interest rates they were

willing to accept for the right to originate at particular schools or to originate a specified loan

volume. In each auction, a lender could submit a single bid or multiple bids that incorporated

different prices or interest rates. The government would sort bids by price or interest rate, and
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Page 33

the most favorable bids would win the right to originate. It would be possible to set aside some

origination rights for nonbidders. However, most rights would be determined through the

bidding process. Lenders who submitted winning bids would be allowed to originate only at the

schools where they won rights or to originate only the volume they won. Except for nonbidders

who received set-asides, nonwinning lenders would not be permitted to originate loans. Lenders

could buy and sell origination rights after the auction but before loans were originated. They

could also buy and sell loans after origination, as they do today.

The federal government could be responsible for conducting the auctions and ensuring borrowers

access to loans. The government would determine whether lenders were eligible to participate in

FFELP. Education might also act as a loan consolidator, as in the current FDLP. It might need

to establish procedures to ensure that eligible borrowers received loans and that winning lenders

performed as promised. The government would also need to establish procedures to ensure

access to loans when loan demand exceeded auctioned loan volume. In addition, it might need to

re-auction loan origination rights for lenders who could not or would not perform as promised,

although it would be possible instead for these rights to be resold in the secondary market.

During the transition from the current system of setting FFELP lender yield to an auction system,

the government would have to develop new regulations to govern the conduct of auctions,

develop the expertise to conduct auctions itself or contract with a nongovernment entity to

conduct the auctions, educate lenders and borrowers about auctions, and act as lender of last

resort to ensure that all eligible borrowers have uninterrupted access to loans. No state role is

envisioned beyond the one that now exists in FFELP.

Major Variations on the Model

Several high-level decisions must be made in designing an origination rights auction model. The

items to be auctioned could be either the rights to originate all loans at particular schools or

groups of schools or the rights to originate a specified volume of loans at any of a number of

schools. Origination rights or volumes may or may not be grouped by school. The right to lend

includes the obligation to lend. A variety of bidding methods could be used. Finally, each

student borrower may or may not be allowed to keep all loans with a single lender.

The study group considered three alternative designs for an origination rights auction. In the

ìrights auction,î lenders would bid for the right to originate all loans at a particular school or

group of schools. In the ìvolume procurementî design, lenders would bid for a specified loan

volume that could be used at any school and either all winning lenders would pay the same price

or each would pay the price it bid. The Income Dependent Education Assistance (IDEA) version

resembles volume procurement, except that each winning bidder would pay the price bid by the

next highest bidder and there would be an explicit ICR provision. These three proposals

illustrate but do not exhaust the range of available alternatives. Other combinations of auction

characteristics are possible. For example, the right to originate at specific schools could be

combined with each winnerís paying the next highest bid price. Any origination rights auction

could either include or exclude income-contingent repayment.

The three versions of the model illustrate a fundamental choice that must be made in the design

of an origination rights auction. In the rights auction version, lenders bid on the right to originate
CHAPTER 3: LOAN ORIGINATION RIGHTS AUCTION

Page 34

loans to students at a particular school or group of schools. In the volume procurement and

IDEA versions, they bid on a specified volume of loans, which they can lend to students at any

of a number of schools.

Under any alternative, schools may or may not be grouped together when origination rights are

auctioned. In rights auctions, grouping would mean that lenders would bid for the right to

originate at particular groups of schools. In volume procurement, it would mean that lenders

would bid on a volume of loans that they could use only at particular groups of schools. Under

either alternative, the rights to originate at all groups of schools could be sold at the same

auction, or else a separate auction could be held for each group. At the opposite extreme, the

government could decide not to group schools but to require lenders to bid for the right to make

loans to all FFELP-eligible students, regardless of school.

A variety of bidding methods could be used. One important issue is whether lenders would bid

on the interest rate they would receive on loans they originated or on the price they would pay to

originate loans at a predetermined interest rate. If lenders bid on an interest rate, then that rate

would likely be expressed as a markup over a reference rate that bears some relationship to

lendersí cost of funds, such as a T-bill rate or the CP rate. If lenders bid on a price, then their

bids might or might not be allowed to be negative. (A negative bid would be one in which the

lender asked the federal government to pay it a specified price in order to make it willing to

lend.) Issues related to auctions, including the grouping of schools and the choice of bidding

method, are discussed further in appendix III.

A final important design choice is whether to allow each borrower to borrow from a single

lender, at least for the duration of a particular degree program. For example, a student entering

an undergraduate program could be given the right to borrow from one lender until he or she

completed that program, even if that lender did not win the right to originate at that studentís

school for all the years in which the student was enrolled in that program. Alternatively, a

student could be required to switch lenders whenever his or her previous lender lost the right to

originate at his or her school.

COSTS, SAVINGS, AND EFFECTS ON SUBSIDIES

FOR PROGRAM PARTICIPANTS

Auctions have the potential to reduce federal FFELP costs, but their ability to realize this

potential depends on whether there is sufficient competition in bidding. The frequency with

which auctions were held, the definition of auctionable rights, and the choice of bidding method

could also affect federal costs. The distribution of federal payments to lenders would be more

uneven in some types of auctions and unchanged in others. Auctions could reduce all borrowersí

interest rates, raise some borrowersí rates, or leave all borrowersí rates unchanged.

In an ideally competitive auction, bidding competition among lenders would eliminate any

excess profits that lenders would otherwise receive. The bidding process would ensure each

lender just enough profit to make that lender willing to remain in FFELP. Furthermore, the

winning lenders would be the ones with the lowest loan origination costs. Appendix III

describes an ideally competitive auction, explains how such an auction would produce these
CHAPTER 3: LOAN ORIGINATION RIGHTS AUCTION

Page 35

results, and shows how the less-than-ideal auctions that would be likely could produce most of

the same results.

Regardless of whether lenders currently receive excess profits, lenders might reduce their costs

by developing less expensive methods of originating loans to secure volume by lower bids.

Lower bids would mean reduced federal payments to lenders. However, origination rights

auctions will only reduce federal FFELP costs if there is sufficient competition among lenders.

Whether the student loan origination market at present is sufficiently competitive for origination

rights auctions to reduce federal costs is unclear.

Evidence from other federal auction programs suggests that origination rights auctions could

produce savings, which could be retained by the federal government or passed on to the

borrower. In the Health Education Assistance Loan (HEAL) program, under which lenders bid

for the right to originate student loans to students of the health professions, the federal

government kept the volume artificially low by capping loan volume. This resulted in a drop in

the spread over T-bills from 3 percent in 1993 to 1.5 percent in 1997.21 The Federal

Communications Commissionís (FCC) auctions of wireless spectra have yielded revenues

exceeding their costs, but these auctions took several months on some occasions, and auctions on

certain spectra had to be recompeted because of the lack of competition.

The current student loan market, however, may not be competitive enough to enable origination

rights auctions to produce savings for the federal government. As chapter 1 showed, a limited

number of large lenders hold a large share of loans in the student loan market; furthermore, it

may be costly for new lenders to enter the market. If the limited number of lenders is the result

of natural scale economies, the associated cost savings have the potential to benefit all

participants. If the limited number of lenders results in less competition and excess lender

profits, this market structure is undesirable, with or without auction mechanisms, and is best

addressed by our nationís laws regarding monopolistic practices. In either case, because the

number of lenders is limited, the dominant lendersí influence on the winning bids could

conceivably lead to FFELP costs that were as high as or higher than current costs. Some believe

that lenders might also collude in setting their bids. The relatively small number of lenders in the

market would make collusion easier.

FCCís wireless spectrum auctions illustrate this problem and some solutions to it. In some FCC

auctions, bidders were able to signal their bidding strategies to other bidders by using the last

three digits of the amount bid or by strategically withdrawing from the bidding. FCC corrected

the former problem by setting minimum bid increments that bidders were required to use in

raising bids. It solved the latter problem by limiting the number of withdrawals a bidder was

allowed to make during an auction.

A competitive secondary market in loan origination rights could at least partially compensate for

insufficiently competitive auctions. Such a market, which does not now exist, would enable

lenders to buy and sell rights to originate student loans outside the auctions and would add a new

 

21In contrast to FFELP or FDLP, the HEAL program never exceeded more than $500 million in insurance authority

for a single year. The experiences under the HEAL program may or may not indicate the potential for savings

through the adoption of an auction mechanism in a larger program.
CHAPTER 3: LOAN ORIGINATION RIGHTS AUCTION

Page 36

layer of complexity to the program.22 The Environmental Protection Agency (EPA) sulfur

dioxide emission allowance auctions provide an example. Allowances sold at those auctions

have been concentrated in the hands of a relatively few firms. However, the secondary market,

on which allowances are traded outside auction, is much larger than the auction market. After

the first few years of EPA auctions, the secondary market, rather than the auctions, appears to

have determined the price of allowances. Because the auction price reflected the secondary

market price, insufficient competition in the auction might have been less of a problem than it

would have been in the absence of a secondary market.23

Although sufficiently competitive auctions could reduce federal payments to lenders, their

overall effect on FFELP costs would also depend on details of the auction design. The frequency

with which auctions were held, the definition of auctionable rights, and the choice of bidding

method could influence FFELP costs. They could do so by affecting either federal payments to

lenders or the cost of conducting auctions.

At present, all lenders receive a uniform federal payment equal to the difference between the

lender yield and the maximum borrower interest rate, both set by law. Some types of origination

rights or volume procurement auctions would lead to an unequal distribution of federal payments

to lenders, while others would not change the current pattern of equal payments to all lenders.

Both the choice of bidding method and the grouping of schools would affect the distribution of

federal payments to lenders. A full discussion of competition, auction design and frequency,

bidding methods, and the grouping of schools is in appendix III.

In addition, if borrowers do not have the option of borrowing from a single lender until they

complete their education program, these proposals could increase the attractiveness of

consolidation to borrowers. If lenders expect the use of consolidation to increase, they will bid

less, and federal revenues from the FFELP auctions could decline.

EFFECTS ON LENDER PARTICIPATION, LOAN

AVAILABILITY, AND SERVICE QUALITY

Auctions could either reduce the quality of service or have no effect on it. In the absence of

special provisions, they could reduce the diversity of lenders. The definition of auctionable

rights, the choice of bidding method, and the frequency with which auctions were held could

affect borrower and lender access to FFELP as well as the quality of service. Some students and

parents could have difficulty obtaining loans during the transition to an origination rights

auction. Some transitional challenges might be anticipated and thus minimized through the use

of a pilot auction program, although results from a pilot might be difficult to interpret if

participating lenders are uncertain as to the likelihood of the programís continuation.

 

22A secondary market in origination rights would differ from the existing secondary market, in which loans are

bought and sold after they have been originated.

23FCC and EPA auction models are dissimilar in many ways from a loan origination rights auction. For example,

end users of wireless spectrum communication often have readily available alternatives and thus are not likely to

suffer if an auction winner does not provide such service. Further, consumers may actually benefit if the holders of

emission rights are not exercised. Caution is necessary in using these auctions as models for an origination rights

auction.
CHAPTER 3: LOAN ORIGINATION RIGHTS AUCTION

Page 37

Auctions may or may not reduce service quality but are unlikely to improve it. The number of

lenders permitted to serve each school, the frequency with which auctions were held, and the

method by which bids were evaluated could also affect service quality.

Auctions might shift the balance of competition in the student loan market toward price

competition and away from service competition. At present, FFELP lenders compete to a limited

extent on the basis of price, through discounts to preferred borrowers. They also compete on the

basis of service. Auctions would force lenders to place more emphasis on price competition,

since the major (and, in most variants, the sole) criterion for determining auction winners would

be the price or interest rate bid. It is possible, although not certain, that lenders would pay less

attention to service as they paid more attention to price.

Service quality could be higher if multiple lenders were allowed to serve each school than if

there were only one lender per school. If more than one auction winner could serve each school,

then students could choose among lenders. Lenders would have an incentive to compete for

students on the basis of service quality. This incentive would not exist if only one lender could

win the right to serve each school.

Finally, service quality could be improved if the government were allowed or required to take

service quality into account in choosing auction winners, but there are important drawbacks to

this. One option would be to evaluate bids on the basis of service quality as well as price or

interest rate. Another would be to prequalify bidders using service quality criteria and then

conduct the auction on the basis of price or interest rate alone. These procedures would make

auctions more complex than if bids were evaluated solely on the basis of price or interest rate.

The added complexity could deter small lenders from participating in FFELP. Loans that had

service quality features as legally enforceable terms would also be more difficult to sell in the

secondary market than loans without such features.

Auctions could increase, decrease, or have no effect on lender diversity in the short term but

might reduce it in the long term.24 Provisions to protect small biddersí access to FFELP could be

built into the auction design. Small-bidder protections may make auctions more competitive as

well as ensure small lendersí participation in FFELP. The choice of bidding method, the number

of lenders allowed to originate at each school, and the frequency with which auctions were held

could also affect lender diversity.

In the short term, auctions may have any of several effects on the number of FFELP lenders.

They may increase lender participation by enabling new lenders to enter the market on relatively

equal terms with existing lenders. Or they may have no effect on participation if entry into the

origination market is so expensive that no new lenders are willing to enter. It is also possible

that auctions would increase large lendersí dominance of FFELP market. Large lenders would

have several advantages over small lenders in origination rights auctions. Because they can

usually obtain loan funds more cheaply and spread their costs over a larger volume of loans,

large lenders would generally be able to outbid their smaller competitors. In addition, auctions

 

24As we showed in chapter 1, the student loan industry is highly concentrated and is becoming more concentrated. If

the trend toward reduced competition in the industry were expected to continue regardless of FFELP rules, then

auctionsí effects on lender diversity would have to be evaluated relative to this trend.
CHAPTER 3: LOAN ORIGINATION RIGHTS AUCTION

Page 38

would necessarily make lenders uncertain about their prospects of continuing to participate in

FFELP. This uncertainty may be more likely to deter small lenders than it would be to deter

large lenders. In the long term, it is possible that auctions would gradually reduce the number of

lenders, although we do not know how likely this outcome is. Lenders who did not win

origination rights in one auction might leave FFELP permanently because it might be expensive

to re-enter the origination market. If losing bidders dropped out permanently after each auction,

then the number of bidders would gradually decline. Only a few large lenders might be left to

originate student loans.

Evidence from the HEAL program neither clearly supports nor clearly refutes this argument.

The number of HEAL bidders declined during the last 4 years of the program.25 (These are the

only years for which we were able to obtain comparable data.) However, this decline may have

stemmed from lenders withdrawing from the auctions after the Congress decided to end the

program. Moreover, the number of lenders receiving loan origination rights did not fall

continuously. There were four or five large HEAL lenders in the last few years of the program

until the very last year. Furthermore, lenders entered and re-entered rather than dropping out

permanently after losing at auction.

Small-bidder protection measures and the choice of bidding method could affect the diversity of

lenders. Auctions can be designed to enhance small biddersí ability to compete. More lenders

might participate in auctions if all auction winners paid the same price than if each paid a

different price. Lender participation might also be greater in an auction with multiple rounds of

bidding than in one with a single round. However, a single-round auction might be more

attractive to small lenders because it would be simpler than a multiple-round auction. Lender

diversity would probably be greater if more than one lender were allowed to originate at each

school than if there were only a single lender per school. More lenders would be likely to

participate in FFELP if multiple lenders could serve each school. For more details on these

issues, see appendix III.

An additional complication associated with the volume procurement proposal would be the

challenge of estimating the annual borrowing needs of students. An underallocation of loan

volume could result in delays in funding and in loan access problems for student loan providers.

The Congress might want to include additional requirements to ensure that loans were available

to all eligible borrowers. For example, it could require the federal government to serve as a

lender of last resort or design a mechanism to increase the allocation for lenders who were

approaching their allocated limit. Alternatively, the federal government could pay lenders to

serve borrowers who would otherwise not receive loans. (Allowing lenders to submit negative

price bids at auctionóthat is, requesting that the federal government pay them to serve certain

groups of schoolsówould be one way of implementing such payments.)

Auctions should be held when borrowers can receive loans when they need them. After an

auction is completed, time is needed to process bids and notify the winning lenders. The

winning lenders, in turn, need time to disburse loans after they are notified. For borrowers to

 

25Most HEAL lenders were also large FFELP lenders and considered HEAL lending complementary and marginal in

importance to their FFELP lending activities. Many schools found the HEAL program unsatisfactory, believing it

unstable and unpredictable.
CHAPTER 3: LOAN ORIGINATION RIGHTS AUCTION

Page 39

receive loans when they need them, all these things have to be done before the start of the school

term. If there were a secondary market in origination rights, then trades on this market would

also have to be timed to enable lenders to receive funds and disburse loans in time for the

beginning of school. Schoolsí academic calendars vary widely, and academic programs can start

at any time of year. Therefore, it would not be possible to link the timing of auctions to that of

loan disbursements. However, it would be possible for loans to be disbursed continuously

between auctions. For example, auctions could be held once every 3 to 5 years, and the winners

of each auction could use the origination rights they won at any time between that auction and

the next yearís auction.

Finally, the transition to auctions could temporarily disrupt both student and parent access to

FFELP loans. Lenders would require some time to become accustomed to the auction system.

Some lenders might at first miss deadlines or fail to submit payments that the government might

require before the auctions. Some might decide not to participate in the initial auctions. Those

who did participate might not bid on as many origination rights as they would if they were more

familiar with the auction process. The government might experience delays in processing bids

and notifying auction winners. For all these reasons, auctions could initially reduce FFELP loan

volume. The federal government could maintain student and parent access to loans during the

transition period by acting as the lender of last resort or by paying private lenders to do so. In

addition, the federal government could identify potential access problems during the transition

by conducting an auction pilot program before implementing an auction system for all FFELP

loans. Using knowledge gained from the pilot program, it could then take steps to minimize

those problems.

SIMPLICITY, REGULATORY BURDEN,

AND PROGRAM INTEGRITY

Because insufficient competition could threaten the integrity of the bidding process, auctions

would require special rules to preserve competition. The definition of auctionable rights, the

choice of bidding method, and the frequency with which auctions were held could affect the

simplicity and integrity of FFELP and the burden that auctions would place on lenders, students,

and schools. Lenders, students, and schools would all bear the burden of adjusting to new

regulations and market practices. Some transitional challenges could be anticipated and thus

lessened through the use of a pilot program.

To preserve the integrity of auctions, the federal government would have to adopt and enforce

regulations to maintain competition in bidding. Rules to prevent bidders from colluding would

be necessary, and their nature and complexity would depend on the kinds of collusion to which a

particular type of auction could be vulnerable. FCC, for example, set minimum bid increments

to prevent bidders from signaling their bidding strategies by using the final digits of their bids.

Collecting the data needed to administer this program could present new challenges. Tracking

the results of auctions and administering a program with origination rights auctions or volume

procurement auctions requires data not currently available. At a minimum, the government

would require the ability to monitor eligible lendersí loan portfolios by school and loan volume.

Insufficient data would limit the governmentís ability to manage this program.
CHAPTER 3: LOAN ORIGINATION RIGHTS AUCTION

Page 40

All auctions would require rules to ensure that bidders were able to pay the amounts they bid.

Without such rules, nonserious bidders could distort competition. Other federal auctions provide

examples of rules that could be adopted in an origination rights auction. EPA requires each

bidder in sulfur dioxide emission allowance auctions to send a certified check or letter of credit

to cover its bid before the auction. (This rule is feasible only for sealed-bid auctions, in which

each bidder submits a single bid.) FCC requires bidders in its wireless spectrum auctions to

submit refundable deposits to cover the cost of placing bids. A final option, not used in any

federal auction, is to require all potential bidders to show some evidence of their ability to pay.

One way of implementing this option is to use the current FFELP eligibility criteria as evidence

of ability to pay. Another alternative is to require FFELP-eligible lenders to pass additional

ability-to-pay tests before allowing them to participate in the auction.

The greater the total number of auction winners, the longer and more complex the process of

determining winners is likely to be. Length and complexity will probably be greater, for

example, the larger the number of groups into which schools are divided and the greater the

number of winners per group or per school. The longer and more complex the bid evaluation

process, the greater the burden on lenders. If lengthy and complicated bid evaluation methods

caused delays in the disbursement of loans, then they could also impose burdens on borrowers.

Bidding methods differ in their simplicity, speed, and vulnerability to collusion. An auction that

has a single round of bidding is faster than one with multiple rounds, and the bid evaluation

process is simpler. Allowing lenders to bid on groups of schools that they define complicates the

evaluation of bids. (See app. III for details.) It is simpler and faster to evaluate bids on the basis

of price or interest rate alone than to include service quality criteria in the evaluation. Finally, as

appendix III explains, a multiple-round auction may be more vulnerable to collusion than a

single-round auction, and an auction in which each bidder pays a different price could be either

more or less susceptible to collusion than one in which all bidders paid the same price.

Frequent auctions could impose substantial burdens on lenders, students, and schools. Because

participating in auctions would cost lenders both money and time, more frequent auctions would

be more burdensome to lenders. In addition, according to some school representatives in the

study group, students and schools value the ability to deal with a single lender. Therefore, more

frequent auctions could impose a greater burden on schools and students by disrupting long-term

student-lender and school-lender relationships.

Any origination rights auction system would require lenders, students, and schools to adjust to

new regulations and changes in the student loan market that resulted from auctions. The nature

of the regulations adopted to implement auctions would depend heavily on the specifics of the

auction design. However, those regulations would probably have to be very detailed, and

monitoring lender compliance could be costly. Regardless of the particulars, lenders would have

to learn how to participate and might be subject to new regulations to ensure their ability to use

the origination rights they won. All origination rights auctions would restrict studentsí and

schoolsí ability to work with the lenders of their choice, and those with a single winning lender

per school would eliminate their ability to do so. Lenders, students, and schools would all have

to adapt to the changes in loan availability, lender and borrower interest rates, and service quality
CHAPTER 3: LOAN ORIGINATION RIGHTS AUCTION

Page 41

that could result from auctions. Table 10 summarizes the analysis for the loan origination rights

auction model at a broad level.

Table 10: Summary of Analysis for Loan Origination Rights Auction Model

Description of model,

including variations

 Lenders submit bids to originate loans. Some win right to originate and

others do not.

 Auction could be conducted for the right to originate at specific schools or

groups of schools or for a certain loan volume that could be used at any of

a number of schools.

 Other major design options include grouping schools, choice of bidding

method, whether a borrower keeps all loans with one lender.

Costs, savings, and effects

on subsidies for program

participants

 Federal costs could lessen if competition is sufficient.

 Distribution of payments to lenders would be unchanged or more uneven,

depending on auction type.

 Borrowersí interest rates could decline for all, remain unchanged for all, or

increase for some.

Effects on lender

participation, loan availability,

and service quality

 Loan origination costs could lessen if competition is sufficient.

 Service quality may decline or remain unchanged.

 Diversity of lenders is likely to decline unless auctions included smalllender protections.

 Schoolsí ability to work with preferred lenders could be reduced.

 Loans would not be available to all students in some types of auctions.

Simplicity, regulatory burden,

and program integrity

 Program integrity would require new rules to preserve competition.

 Burden on lenders, students, and schools would differ, depending on

auction type.

 Lenders, students, and schools would bear the burden of adjusting to new

auction regulations developed by the government.
Page 42

CHAPTER 4

LOAN SALE

Under the loan sale model, the federal government, or some entity other than private lenders,

would originate all student loans, and the government would later sell them at auction in a

secondary market to the highest bidding lenders. Preferably, the government would elect to sell

loans immediately following origination or later when the borrower enters repayment. Because

the federal government would be responsible for loan origination, and the loan guarantee terms

could change, the federal role in FFELP would be vastly different from today. Purchasers of the

secondary market loans could include todayís FFELP lenders as well as new participants,

however some current lenders, including lenders who currently originate loans but subsequently

do not hold them, might not choose to participate. The federal costs of the loan program could

also be lower, partly because the governmentís lower cost of securing the funds to make loans

and reduction in fee payments to guaranty agencies for services related to verifying lender

eligibility. If there is sufficient competition, then the auction among secondary market

participants could reduce federal FFELP costs. Secondary market concentration would be likely

to increase with this mechanism, perhaps reducing the participation of small community-based

lenders. Loan availability would be universal, with the federal government being the only

program lender. Centralizing the loan origination and distribution functions may simplify the

loan process. Schools and borrowers would deal only with the federal government or the

designated entity to obtain loan aid. Adjustment to the new system could prove burdensome for

some lenders.

DESCRIPTION OF THE MODEL, INCLUDING VARIATIONS

The loan sale model and variations we discuss in this chapter share several features. Generally,

some entity other than private lenders would originate student loans. The terms of the loan, such

as the borrowerís maximum interest rate and the in-school subsidy policy, would be set through

legislation, as now. Packages of student loansówith or without a guaranteeówould be

purchased privately at periodic sales or auctions. While the purchaser buys loans, either the

purchaser or some other entity may perform the servicing functions. In each auction, a lender

could submit a single bid or multiple bids that incorporated different prices. The government

would sort bids by price, and the highest bids would win the right to purchase loans. The

government could set a minimum price below which it would not sell any of the loans it

originated. It would be possible to set aside some loan packages for nonbidders. However, most

purchase rights would be determined through the bidding process. A variety of bidding methods

could be used, as described in appendix III.

Proposals for this model vary as to who originates loans, how loans are grouped when they are

sold, who is responsible for servicing loans, whether the loans sold are federally guaranteed, and

whether payment is due in full at the completion of the loan sale. Origination could be carried

out by a federal entity or by private contractors, as is in FDLP. The government could sell these

loans immediately or it could hold off selling the loans until a borrower enters repayment. If the

loans are sold with government servicing, the purchaser is buying the stream of payments and the
CHAPTER 4: LOAN SALE

Page 43

government needs to contract for servicing.26 If the loans are bundled and auctioned off without

government servicing, purchasers can arrange for servicing or possibly they can retain the

services of the government contract servicer. Loan bundles are less valuable if they are sold

without a guarantee than if they are sold with a federal guarantee. Allowing lenders to make

payments in installments could foster competitive participation in loan sales.

Several options are available for loan origination. One alternative would be to give a

government entity (such as a new government-sponsored enterprise) the authority to originate

federally guaranteed student loans. The government could maintain the origination procedures

in place for FDLP, using private contractors to originate loans. Another option would be for the

government to require the student-lending industry to charter a mutually owned corporation that

would originate and provide short-term funding of loans. The objective would be to structure the

entityís ownership and transactions to give it an incentive to keep down its costs. Achieving that

objective could be difficult without competition, however.

Loans from particular groups of schools may or may not be bundled together when loans are

auctioned. Grouping by schools would mean that lenders would bid for packages of loans that

were originated at particular groups of schools. The loans from each grouping of schools could

be sold at the same auction, or else a separate auction could be held for each group. In defining

groups of schools, several alternatives are possible. An Internet-accessible interface could

inform potential purchasers of the characteristics of loans bundled as a package. Issues related to

the grouping of schools at auctions are presented in appendix III.

There are several options for servicing loans after they are sold at auction. One would be that the

government could keep the responsibility of servicing loans that were later sold at auction. This

could possibly increase auction proceeds by attracting bidders who do not have servicing

capacity but are interested in receiving interest income and loan principal. Auction proceeds

would also vary, depending on whether the lenders expect the governmentís servicing to be more

or less costly than other servicing options. If the purchaser services loans, combining the loans

of all borrowers reduces the burden on each borrower. Some provisions would need to be made

for loan consolidation and loan deferment. Either the government or the private lender could

consolidate the loans if the borrowers return to school.

Another issue is whether the loans or securities are sold with federal guarantee. If the loans are

sold with a guarantee, then the guarantee could be set at the current 98 percent of principal or it

could be set higher or lower. The government would have to decide on the extent of the

guarantee and would have to define the conditions under which the guarantee applies, such as

death or bankruptcy. One variation is to have no explicit federal guarantee or due diligence

requirements. In another variation, lenders could have the right to resell the loans to Education

in the event of death, disability, bankruptcy, or the borrowerís election of ICR. Other variations

assume that federal loan guarantees continue, as with the current program.

 

26A variation on loan sales with government servicing is selling securities backed by student loans. Securitization is

the process of selling debt securities to investors with groups of loans serving as collateral for the debt.
CHAPTER 4: LOAN SALE

Page 44

One variation would allow lenders to pay for bundled loans in installments. Installment

financing arrangements could be tied to the loan payment revenues received by the purchasing

lender or to a fixed repayment schedule, and the appropriate interest rate would have to be

determined. Either arrangement reduces the initial funds needed to purchase loan bundles,

thereby potentially increasing lender participation.

Treasury developed an additional variation of this model and presented an outline of it to the

study group. The study group did not review this and this outline is reproduced in appendix V.

COSTS, SAVINGS, AND EFFECTS ON SUBSIDIES

FOR PROGRAM PARTICIPANTS

Loan sales could potentially raise enough revenue to reduce overall federal FFELP costs, but

their ability to realize this potential depends on sufficient competition in secondary market

bidding. The federal government (or some entity acting on its behalf) will originate all loans,

taking advantage of the governmentís ability to raise funds at a lower interest rate. The grouping

of loans into packages, the choice of bidding method, and the frequency of auctions could also

affect federal costs. If competition prevails, there could be a lower net lender yield. However,

insufficient competition could threaten the integrity of the bidding process. Auctions are not

likely to affect borrower costs. However, schools participating in FFELP could incur costs in

implementing a new delivery system.

Reduced federal costs could result from eliminating federal payments to originating lenders and

financing loans with low-cost Treasury financing. Removing originating lenders would

eliminate their current federal SAP as well as the need to pay private lenders the in-school

interest subsidy. Separating loan origination from the rest of the student loan process might

enable the federal government to take advantage of any savings because of greater specialization

in student loan origination. An entity responsible solely for student loan origination would not

have to be concerned with raising necessary funds competitively or with servicing loans

efficiently. However, removing competition from loan origination could eliminate incentives to

continuously improve the efficiency of the origination process.

Further federal savings could accrue if loan sales foster competition in the secondary market for

loans, but savings would depend in part on auction design decisions. Ideally, competitive

bidding for loans among secondary market lenders would result in loans being held and serviced

by those with the lowest cost of funds and the most cost efficient at servicing loans. Increasing

concentration in the existing secondary market for student loans raises questions about the extent

to which competition will operate in loan sales and the extent to which potential cost savings will

accrue to the federal government. If auctions are not sufficiently competitive, then increased

lender net yield could result, potentially reducing federal revenues from the sales and thereby

increasing federal FFELP costs. Although sufficiently competitive auctions could reduce net

lender yield, their overall effect on FFELP costs would also depend on the details of the auction

design. Auction frequency, the choice of bidding method, and the definition and grouping of

auctionable packages could either lower or increase FFELP costs.
CHAPTER 4: LOAN SALE

Page 45

The terms of sale affect the price that bidders pay for loans in an auction. Lenders bid more for

loans that are sold with a guarantee.27 The net effect on federal costs would then depend on a

comparison of the additional revenue raised by guaranteeing loans to the federal cost of

providing a guarantee. Also, federal costs could depend on whether winning bids are payable in

full immediately after the close of the auction or whether a schedule of installment payments is

allowed. Allowing installment payments extends federal funding to secondary market

participants, possibly enabling small bidders to participate more easily. Small bidders would

have to come up only with a down payment rather than with the full purchase price, enabling

bidders with less funding to compete with better-funded large bidders. However, allowing loan

purchasers to pay in installments could result in new risks and potential costs. The most

significant of these risks would be that lenders obtaining federal funding might be unable to

repay the money they borrow from the government. Several considerations might mitigate this

risk. For example, lenders could be made to meet additional criteria, related to financial

soundness and creditworthiness, before being allowed to borrow from the federal government.

In addition, legislation or regulation could treat the auctioned loans as collateral for the

borrowing. The cost of administering an installment payment option would be an additional

source of increased federal government costs for FFELP.

Ultimately, borrower costs are unlikely to change much after the sale of loans at auction is

implemented. Some lenders now offer origination fee or interest rate discounts off of the

maximum rate to some borrowers (for example, those who attend schools with low default rates).

If lenders are providing discounts from profits, then auctions could eliminate the discounts by

reducing those profits. As a result, some borrowers who now receive discounts may no longer

receive them. However, if discounts do not come from lendersí profits, then auctions would not

eliminate the discounts and would have no effect on borrowers. Furthermore, if auctions reduced

federal FFELP costs, the Congress could decide to pass those savings on to borrowers by

lowering the maximum borrower interest rate. In that event, all borrowers would benefit from

lower interest rates. Other discounts that loanholders currently provide occur after the loan has

entered repayment. Lenders have provided these discounts for automatic electronic payment and

demonstrated timely payment experience. Loan holders will continue to have an incentive to

encourage timely or electronic repayments which result in lower costs by offering discounts.

Issues related to competition, auction frequency, auction design, bidding methods, grouping, and

payment methods are presented in detail in appendix III.

EFFECTS ON LENDER PARTICIPATION, LOAN

AVAILABILITY, AND SERVICE QUALITY

With loan sales, the federal government or some entity other than private lenders would originate

all student loans. Loans would be universally available to all eligible borrowers. Concentration

in the secondary market would be likely to continue to increase, resulting in reduced diversity of

lenders. As lenders focus more on price paid to the government, they might pay less attention to

service quality.

 

27The budget-scoring effects for loans sold with a guarantee are beyond the scope of this report.
CHAPTER 4: LOAN SALE

Page 46

In the short term, auctions may have any of several effects on the number of FFELP lenders.

They may increase lender participation by enabling new lenders to enter the market on relatively

equal terms with existing lenders. It is also possible that auctions would increase large lendersí

dominance of the secondary market. Large lenders would have several advantages over small

lenders. Because they can usually obtain loan funds more cheaply and can spread their costs

over a larger volume of loans, large lenders would generally be able to outbid their smaller

competitors. In addition, auctions would necessarily make lenders uncertain about their

prospects of continuing to participate in FFELP. Small lenders are more likely than large lenders

to be deterred by this uncertainty.

Over the long term, lenders who do not win in one auction might leave FFELP permanently, if

they find it expensive to reenter the market. If losing bidders drop out permanently after each

auction, then the number of bidders could gradually decline, leading to higher federal costs.

However, it is also possible that the losing biddersóespecially those participating by holding

and servicing loans from prior yearsówill not leave FFELP. With a loan sale, a participant who

has been a winner for 3 years but does not win in year four will probably not leave FFELP,

because that lender still has revenue from the previous yearsí loans. That lender may find it easy

to reenter in the next year, and this may be less a concern than in the loan origination rights

auction model.

One way the Congress could ensure lender diversity and pervasive participation would be to

include special provisions, such as installment payment payments, that would protect small

biddersí ability to compete. Although small-bidder protections may restrict the ability of larger

firms to compete, they may also improve the overall competitiveness of the market. Another

way of promoting competition in auctions is to adopt rules to ensure that all bidders are able to

pay the amounts they bid. Without such rules, nonserious bidders could distort the auction

results by placing bids that were unrelated to their valuations of the rights. Details of auction

provisions regarding these features are presented in appendix III.

Loan sale auctions may affect the service quality of loan origination. In some models, such sales

could remove competition from loan origination and could eliminate existing incentives to

continuously improve the efficiency of the origination process. A single originating lender may

not feel competitive pressure and therefore might be less likely to introduce new and innovative

loan options.

There is some concern that auctions could shift the nature of competition in the student loan

market toward price competition and away from service quality competition. At present, FFELP

lenders compete to some extent on the basis of price through discounts to preferred borrowers.

They also compete to some extent on the basis of service quality. Auctions would force lenders

to place more emphasis on price competition, since the major (and, in most variants, the sole)

criterion for determining auction winners would be the price bid. It is possible, although not

certain, that lenders would pay less attention to service quality as they paid more attention to

price.28

 

28Service quality could be higher if multiple servicers rather than only one servicer were allowed. If students have

the opportunity to select servicers or to choose a lender for consolidating loans, servicing lenders would have
CHAPTER 4: LOAN SALE

Page 47

SIMPLICITY, REGULATORY BURDEN,

AND PROGRAM INTEGRITY

Loan sales could simplify the origination process for borrowers and schools by centralizing the

origination and distribution of all loans. Some transitional challenges could be anticipated and

thus lessened through the use of a pilot program. Lenders choosing to continue their FFELP

participation would face an adjustment period during which they would need to learn how to

participate in auction sales. While the integrity of the student loan program is not expected to

suffer, auctions would require the federal government to establish special rules to preserve

competition.

Loan sales could extend FDLPís origination and distribution channels. Borrowers and schools

would no longer be able to choose a lender. This change would require adjustments in the short

run by schools not currently participating in FDLP. Since required transitions primarily affect

loans entering repayment, the effect on student borrowers should be minimal. It is possible that

the current distinction between FFELP and FDLP would be eliminated if all loans were sold at

auction.

Lenders who continue in the program would have to learn how to participate in the new program.

Regardless of the way auctions are designed, they require participating lenders to develop skills

and procedures that they do not now have. Initially, lenders would need to make decisions

without experience as a guide. In addition, the federal government could identify some potential

logistical problems during the transition by conducting a pilot program before implementing a

loan sales system. Using knowledge gained from the pilot program, it could then take steps to

lessen those problems.

The government would have to adopt and enforce regulations to maintain competition in bidding

and ensure that participating lenders were creditworthy. Rules to prevent bidders from colluding

would be necessary, especially if the trend toward increased secondary market concentration

continues. The nature and complexity of these rules would depend on the types of collusion to

which a particular type of auction could be vulnerable.

Operating and administering a loan sales program require additional federal data collection. An

installment payment option tied to borrower repayments would require tracking the payments

received by participating lenders from borrowers and matching this information to lender

installment payments. As previously discussed, obtaining and using accurate data are critical to

effectively managing the program. Results of the analysis for the loan sale model are

summarized at a broad level in table 11.

 

incentive to compete for students on the basis of service quality. A proposed borrower Web interface would better

inform borrowers of their repayment options, where and to whom to send their payments, and other related matters.

This could serve to limit or reduce delinquency and reduce servicing issues.
CHAPTER 4: LOAN SALE

Page 48

Table 11: Summary of Analysis for Loan Sale Model

Description of model,

including variations

 The government or a government-designated entity originates loans.

 Private entities bid to purchase packages of loans, either after origination

or upon borrowerís graduation.

 Loans could be sold with or without a guarantee.

 Purchase could be paid up front or financed and paid over time.

Costs, savings, and effects

on subsidies for program

participants

 Federal costs could be lower; effect would depend on how loans are

packaged.

 No federal payment would be made to originating lenders.

 Federal payments to guaranty agencies could be reduced or delayed.

 Borrower costs would be unaffected.

Effects on lender

participation, loan availability,

and service quality

 Loans would be available to all.

 The concentration of loanholders could increase.

 Schools could serve as loan originators.

 The service quality in repayment could decline.

Simplicity, regulatory burden,

and program integrity

 Simple for borrowers; federal role more complex.

 Continuing lenders must learn auction mechanism.

 Program integrity is not expected to suffer.
Page 49

CHAPTER 5

FEDERAL FUNDING

The federal funding model would give lenders the opportunity to borrow from the federal

government funds with which to make FFELP loans. Borrowing could be provided as an option

to lenders or could be made mandatory for lender participation in FFELP. Lenders would be

required to bid on the interest rate they would pay to the government for the use of the federal

funds. The total amount of federal funds available to FFELP lenders would be limited. Lender

yield would be set legislatively and could be the same as the maximum borrower interest rate,

which is currently based on Treasury rates. This model would affect lendersí cost of funds rather

than lender yield. Federal costs could increase, decrease, or remain the same. Some roles of

FFELP participants could change, depending on how the model is implemented, including major

changes for the role of lenders. The model could also potentially affect the ability of schools and

students to work with lenders of their choice, as well as the availability of loans and the quality

of service to borrowers.

DESCRIPTION OF MODEL, INCLUDING VARIATIONS

In the federal funding model, the federal government would auction to lenders a predetermined

volume of federal funds set aside for them to use to make FFELP loans. Each bid would include

an interest rate and the volume the bidder wanted to borrow at that interest rate. The interest rate

at which each winning lender borrowed, in conjunction with a legislatively set lender yield that

could equal the FFELP maximum borrower interest rate, would determine that lenderís net yield.

Borrowing from the federal government could be made mandatory for lenders who want to

participate in FFELP, or it could be offered as an option, with lenders still being allowed to fund

student loans by traditional methods. Finally, lenders could repay the funds they borrowed from

the government on either a regular amortization schedule or a schedule tied to borrower

repayments on the FFELP loans made with the federal funds.

Basic Model and Roles of Participants

The federal government would estimate the volume of loans that students will demand in a given

year. Lenders would submit one or more bids for a portion of the total volume. For example, a

lender could bid for a certain volume at one interest rate, and then additional volume at a

different rate, for as many different rates as desired. The agency operating the bidding system

would collect all bids, sort the interest rates from high to low, and total the volume that all

bidders desired at each interest rate. The interest rate emerging from the auction would be the

lowest interest rate bid at which the sum of the desired volumes just exhausted the volume of

federal funds being allocated. All lenders whose bids were above or equal to this rate would

receive the allocation they bid. To prevent any one lender from gaining an unacceptably large

share of the FFELP market, the government might limit the volume of federal funds that any

lender could receive.
CHAPTER 5: FEDERAL FUNDING

Page 50

As in the current FFELP, the Congress would continue to set the maximum borrower interest

rate. The reference rate for the maximum borrower interest rate (and the lender yield) could be

any interest rate. However, because lenders would be likely to borrow from the government at

Treasury-based rates (that is, at rates that are markups over the interest rate paid on a Treasury

debt instrument), the Congress might consider keeping the maximum borrower rate Treasurybased as well and changing the lender yield back to a Treasury-based rate. This rate could

change from the 91-day rate to a longer-term rate. By giving lenders a Treasury-based source of

funds, this model could allow the borrower rate to remain Treasury-based and give lenders the

ability to match-fund.29

The bidding is likely to be based on the same Treasury rate as the basis for the maximum

borrower interest rate, to eliminate concerns about basis risk.30 For example, the relevant

Treasury rate could be the 91-day T-bill rate or the 10-year Treasury bond rate. The interest rate

for bidding could then be expressed as a specified number of percentage points above or below

the Treasury rate.31

The lender yield for FFELP loans would continue to be set legislatively. One option is for the

Congress to set the lender yield equal to the maximum FFELP borrower interest rate so that the

government makes no SAP.32 Lendersí net yield, which depends on the difference between the

legislatively set yield and their funding and operations costs, would be affected in this model by

changes to funding costs.

To ensure that loans were available to students, lenders who won at auction would be required to

use the entire volume they borrowed from the government to originate FFELP loans. Lenders

would be required to return the unused portion of funds borrowed. To avoid having the

government lend more funds than necessary, requiring a process to accommodate the return of

funds, lenders could apply for federal funds after originating the FFELP loans. Otherwise, the

government would need to match the timing of lender borrowing and payment to the

corresponding student loan disbursements and repayments. In other respects, this model would

leave the roles of FFELP participants unchanged. In addition, FDLP could remain as it is today,

with terms for students the same as in FFELP.

 

29ìMatch fundingî refers to lenders matching the basis of the interest rate at which they borrow to finance a loan

with the basis of the interest rate that they receive from the loan. If they are able to do so, then changes in the

interest rate affect their costs and revenues identically and do not affect their net profits. If their funding costs and

their revenues are based on different interest rates and those rates do not move in tandem, then their net profits could

fluctuate.

30Basis risk is the risk created by a mismatch between the interest rate at which an entity borrows and the rate at

which it lends. For example, borrowing at a CP-based rate and making loans at a Treasury-based rate introduces

risk because, if the CP rate were to rise relative to the Treasury rate, borrowing costs would rise relative to income

from the loans. This would reduce profits.

31Another option would be to establish a borrowing rate and then conduct bidding in terms of the price that lenders

are willing to pay to borrow at that rate rather than bidding on the rate directly. For example, the rate could be set at

the maximum borrower rate plus a small markup, and lenders could bid a dollar amount for the right to borrow a

certain volume of federal funds at that rate. Lenders willing to pay the most would win the right, and enough

winners would be selected to exhaust the volume that was put up for auction.

32The government would presumably still pay lenders a SAP if the borrower rate were high enough to hit its cap.
CHAPTER 5: FEDERAL FUNDING

Page 51

Major Variations on the Model

Participation in this system could be made optional or mandatory for FFELP lenders. Lenders

could be offered the option of borrowing from the federal government or funding their FFELP

loans and competing as they do now. The lender yield would have to be sufficiently high that

nonparticipation was a realistic option and nonparticipants could make a reasonable profit. If the

lender yield were too low, participation would effectively become mandatory. Alternatively,

participation could be made mandatory so that only lenders who took part in this borrowing

would be allowed to make FFELP loans.

The volume of federal funds that the government would have to make available at auction would

depend on whether federal funding were mandatory or optional for lenders. If lenders were

required to use federal funds for FFELP loans, or if federal funding were mandatory in effect

even though optional in principle, then the government would have to set aside sufficient funds

to meet the loan volume that it expected students to need. If lendersí use of federal funding were

truly voluntary, then the government would have to set aside less than the total loan volume

expected.

Auction design details, such as the choice of bidding method, could affect the results. These

design issues are common to all the auction models we discuss in this report. For further details

on auction design issues, see appendix III.

COSTS, SAVINGS, AND EFFECTS ON SUBSIDIES

FOR PROGRAM PARTICIPANTS

Federal FFELP costs under this proposal could increase, decrease, or remain the same. Costs

could decline as a result of a bidding process if auctions were sufficiently competitive. The

frequency with which auctions were held and the choice of bidding methods could also affect

federal FFELP costs. (See app. III for an explanation of these issues.) However, the federal

government would also face new risks and potential costs in a federal funding model. The most

significant would be that lenders who obtain federal funding might be unable to repay the money

they borrowed from the government, although the likelihood of this might be quite low.

Requiring lenders to meet certain criteria for borrowing federal funds could mitigate this risk.

The cost of distributing funds to and collecting repayments from lenders would be an additional

source of increased federal government costs for FFELP. Some of a cost increase might be

recovered by reducing or eliminating the SAP.33

In addition, the federal government could face conflicting incentives in the guarantee process. If

the federal government is both reinsuring student loans and providing funds for them, then strict

enforcement of due diligence rules could create a loss risk for the government. For example, if

an FFELP loan loses its guarantee because of improper servicing, the lender might have

difficulty repaying a portion of the funds it borrowed from the government. If the guarantee

 

33If due diligence regulations are not followed or something else threatens the guarantee, one recourse that

Education has now is to withhold SAP payments to the lender. If the SAP were eliminated, the government might

have less leverage over the lender than it now has.
CHAPTER 5: FEDERAL FUNDING

Page 52

were maintained, the lender would receive the insurance payment for the defaulted loan and

would then have funds available to repay the government. In effect, the government could be

seen as guaranteeing its own loans. However, the federal guarantee could operate in different

ways. Rather than paying a default claim, the government could simply reduce the amount that

the lender owes by the amount of the default. Or, if a student defaults, the guaranty agency

might pay the government directly (with that portion of the lenderís debt to the government

being erased) rather than the guaranty agencyís paying the lender.

This model would change net yield for lenders by determining their funding costs rather than

affecting lender yield. Net yield depends on lender yield and costs, such as funding and

operating costs. Most of the market mechanism models use the mechanism to explicitly set the

lender yield, but this model uses it to set one portion of costs. Either approach ultimately has an

effect on net yield.

Costs could decline for lenders who used federal funds. If these federal funds bear a low enough

interest rate, then lendersí costs could decrease and their net yield could increase. Additionally,

if the model gives lenders a source of funds tied to Treasury rates, potentially allowing lenders to

match their revenues from FFELP loans, lenders would not bear the risk and costs of interest rate

mismatches. Lender costs could be lowered as lenders gained the ability to match the movement

in their cost of funds to the movement in the lender yield. As noted, both would be likely to be

based on Treasury rates, so lenders would face no basis risk.

If lenders were not required to use federal funds to originate FFELP loans, then participating

lenders might be forced effectively to give up all or some of the savings they realized in order to

make competitive bids. This could, in turn, affect discounts offered to borrowers. Participating

lendersí costs might remain unchanged or decline. Therefore, those lendersí gross profit margins

might remain unchanged or increase.

If lenders were required to use federal funds to originate FFELP loans, then lenders might be

forced to give up all or some of the savings they realized, or even more than the amount of those

savings, to make competitive bids. This could also affect discounts to borrowers. Lendersí costs

could increase, remain unchanged, or decrease. Lendersí gross profit margins could, therefore,

decline, remain unchanged, or rise.

An implicit subsidy to borrowing lenders would be present if lenders had the use of federal funds

before student loan disbursements and after loan repayments by student borrowers.

EFFECTS ON LENDER PARTICIPATION, LOAN

AVAILABILITY, AND SERVICE QUALITY

This model could potentially reduce the diversity of lenders, particularly if lenders were required

to use federal funding to originate FFELP loans. Additionally, the relationships among FFELP

participants could substantially change. The effects of federal funding on loan availability would

depend on whether lendersí use of federal funding were optional or mandatory and on whether

and sufficient federal funding were available. The service quality could decline if federal

funding were mandatory for FFELP.
CHAPTER 5: FEDERAL FUNDING

Page 53

If lenders using this process secured significant funding cost advantages relative to other lenders,

and if other aspects of FFELP remained competitive, then over time competition could squeeze

out nonparticipating lenders or force them to participate. Lenders with different costs of funds,

such as those who have access to tax-exempt funding compared with those who do not have

access to it, would be affected differently. The process might effectively become mandatory to

ensure profitability, at least for certain types of lenders, and the number and diversity of lenders

could decrease.

Like origination rights auctions, federal funding auctions can reduce the participation of small

lenders in FFELP, especially if the use of federal funding is mandatory. Small lenders, who

usually cannot borrow funds in the private market at rates as low as those paid by large lenders,

might not be able to bid as high for federal funds as large lenders could. If maintaining a large

number of lenders or a diversity of lender types is desired, certain design features could be built

into the model. Appendix III describes these options.

Several questions remain about lendersí relationships to the federal government. The process

might be seen as reducing the lendersí role to that of a contractor for a system that appeared

similar to FDLP. In contrast, lenders would own the loans they originate, and they would still

compete on price and service quality after getting their funding. A further consideration is

whether, after a change from private to federal funding for FFELP, private sector funding could

be brought back easily if it were deemed necessary.

The effects of federal funding on loan availability would depend on whether lendersí use of

federal funding were optional or mandatory and on whether sufficient federal funding were

available. If federal funding were mandatory and the volume of federal funds auctioned were

insufficient to meet student needs, then loan availability would be reduced. If federal funding

were mandatory but the federal government auctioned a sufficient volume of funds to meet

student needs, then some students might have temporary difficulty finding a lender who had

federal funds available from which to lend, but permanent effects on loan availability would be

unlikely. If federal funding were optional, then loan availability might be less likely to be

affected because FFELP lenders would have access to alternative sources of funds.

Under this model, service quality might decline or remain unchanged. If a particular lender did

not win any federal funding in a particular year (or even over a longer time period), then the

borrowers and schools that were accustomed to dealing with that lender would have to go to

other lenders during that year. Borrowers might have more difficulty meeting their repayment

obligations if they had to deal with multiple lenders than if they could each deal with a single

lender. Some borrowers might be more inclined to consolidate their loans rather than deal with

multiple lenders. In addition, schools could lose the ability to work with nonwinning lenders and

could be required to adapt their information technology systems and student financial aid

procedures to accommodate winning bidders. These concerns, including fixed investments in

computer technologies specific to particular lenders, could be important for high-quality service

to schools.
CHAPTER 5: FEDERAL FUNDING

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SIMPLICITY, REGULATORY BURDEN,

AND PROGRAM INTEGRITY

Bidding on the interest rate lenders would pay the federal government would require its own set

of administrative decisions and a regulatory framework for how the bidding process would be

conducted. If criteria for lender participation in the auction were established, beyond criteria that

lenders must currently meet to participate in FFELP, these would add to administrative burden.

As with origination rights auctions, lenders could face difficulties during the transition to federal

funding, and both the transition and the timing of auctions could affect the availability of loans to

student borrowers. Some transitional challenges could be anticipated and thus lessened through

the use of a pilot program.

Operating and administering a federal funding program would create additional data collection

needs. The government would need to keep track of the funds borrowed by participating lenders

and match lender draw-downs to the timing of student loan disbursements and match lender loan

payments to loan repayments by student borrowers. As mentioned previously, collecting

sufficient and accurate data is key to managing the program and reducing the risk of loss of

government funds. Executive agencies have expressed concern about the federal funding model.

In addition, the federal government could identify some potential logistical problems during the

transition by conducting a pilot program before implementing a federal funding system for all

FFELP loans. Using knowledge gained from the pilot program, it could then take steps to lessen

those problems. The results of the analysis for the federal funding model are summarized at a

broad level in table 12.

Table 12: Summary of Analysis for Federal Funding Model

Description of model,

including variations

 Lenders would borrow funds from the federal government to make FFELP

loans.

 The process could be made optional or mandatory for FFELP participation.

 Lenders would be charged an interest rate determined through a bidding

process.

Costs, savings, and effects

on subsidies for program

participants

 Federal FFELP costs could increase, decrease, or remain the same.

 Funds borrowed from the federal government might not be repaid.

 Lenders could potentially eliminate risks from interest rate mismatches.

Effects on lender

participation, loan availability,

and service quality

 If federal funding were optional, lenders could continue to participate in FFELP

and not change behavior.

 If participating lenders secured significant cost funding advantages, all lenders

might have to use federal funding, and lender diversity might eventually decline.

 Loan availability should not be threatened if sufficient federal funds are made

available.

 Service quality could decline or remain unchanged.

Simplicity, regulatory burden,

and program integrity

 Regulations would be required to govern the bidding process.

 Additional requirements might be possible to allow lenders to participate in

auctions.
Page 55

CHAPTER 6

MARKET-SET RATES

A FFELP guaranteed student loan program with market-set borrower and lender interest rates

would use competition to determine the interest rates and other terms and conditions of student

loans. The primary distinguishing feature of this model is that the borrower rate, as well as the

lender yield, would be determined in the marketplace and rates could vary across borrowers and

lenders. Student borrowers, or schools, would shop for the most favorable loans. Lenders would

charge the interest rates that borrowers agree to pay. Other possible changes might include no

legislatively mandated rate ceiling for borrowers, no federal subsidies to lenders, and no federal

payment of interest while borrowers were in school. Because of this, federal costs would be

likely to decline in a simple version of the model. Lenders could offer interest rates and other

loan features based on the needs of different students at different schools. Competition might

lead lenders to offer different loan packages to different students on the basis of lendersí

perceptions of risks and costs. Because a federal guarantee on student loans would remain, the

range of rates might not be exceptionally wide. In addition, the increased competition might

induce improvements in loan origination and processing that could improve the delivery system

for both schools and students. Some study group members believe all students should receive a

comparable interest rate set by the Congress. Allowing the market to set the rate is likely to

affect students with the greatest need. Market-set rates could reduce or eliminate some

borrowersí access to loans. However, there are variations to this model that could ameliorate

this problem. The market-set rate model would also place a greater burden of adjustment on all

FFELP participants than would the other models we discuss in this report.

DESCRIPTION OF MODEL, INCLUDING VARIATIONS

In the model we describe in this chapter, student borrowers, or schools negotiating on their

behalf, would shop among lenders for the best available interest rates. Market competition

would determine the interest rates lenders would receive, which would be the same as the interest

rates borrowers would pay. Particular versions of the model differ according to how, if at all,

they limit variation in interest rates among borrowers.

Basic Model and Roles of Participants

Market competition would determine interest rates for both borrowers and lenders. Lenders

would charge the interest rates that borrowers agree to pay. The current federal loan guarantee

would remain, but the federal government would provide no other subsidies to borrowers or

lenders. Lenders could offer different interest rates to different students at different schools on

the basis of their evaluations of how default risks and servicing costs differ among students and

schools. Students or their representatives would be able to shop among lenders for the best

available interest rates, possibly using interest rate information that would become available over

the Internet. However, because students are often too inexperienced to shop for loans, schools

would be likely to shop on their behalf. In the market, schools would be likely to be able to
CHAPTER 6: MARKET-SET RATES

Page 56

negotiate better interest rates for students and to choose a limited set of lenders with whom to

conduct business.

Whether the student or the school does the shopping for the loan and loan terms could change the

loan terms actually provided to the student. It is logically possible that the school will have

concerns that do not line up exactly with the interests of the student. For example, ease of

administration and support for the schoolís lending operations may be more important to the

school than to the student. In contrast, the student may be more interested in the interest rate and

the ease of dealing with the lender after graduation.

The current mix of federal and state roles in operating the mechanisms could change. In the

simplest version of this approach, the federal government would no longer set the rate ceiling or

other terms and conditions of FFELP loans. However, because the federal guarantee would

remain, due diligence rules for servicing would still be required, and they would affect loan

terms and conditions. The role of the states need not change. State guaranty agencies and

secondary markets could continue to function.

The market-set rates model would require student borrowers, or schools acting on their behalf, to

be well-informed about the characteristics of loans available in the market. Without accurate and

timely information, students or schools would be unable to evaluate loans offered to them or

negotiate effectively with lenders. Schools or students would need information about loan terms

offered to all types of students, for all types of schools, and in all regions of the country. With

such data available, students and schools could compare their loan offers and rates with offers

and rates made in other circumstances. These comparisons would not eliminate all rate and

service differentials. However, such information would facilitate students or schools in finding

the best option.

Major Variations on the Model

The extent to which interest rates vary among borrowers could be limited in several ways, or it

might not be limited at all. One option would be to allow market competition to determine

interest rates without any restriction on the rates that lenders could charge. If the Congress

believed that this option was unacceptable because it would make loans unaffordable for some

borrowers, resulting in unacceptably high average borrower interest rates, or produce too much

variation in borrower interest rates, then it could choose one of three methods of limiting

variation in borrower rates. It could

designate a lender of last resort,

limit the extent to which a lender could offer different rates to borrowers presenting similar

risks and costs, or

provide an interest rate subsidy to all FFELP borrowers, which need not be constant.

The federal government could serve as a lender of last resort, using either FDLP, a newly

established lending program, or designated private lenders. The private lender or lenders would

have to be paid because the lenders would presumably not otherwise lend at the designated rate.
CHAPTER 6: MARKET-SET RATES

Page 57

The Congress would need to determine the interest rate that the lender of last resort would be

allowed to charge, decide on the compensation to be paid to the lender of last resort, and set

criteria for borrowers to be eligible to borrow from the lender of last resort.

Another option would be to limit variation in the interest rate or origination fees that a lender

could offer to a group of borrowers. The federal government could define groups of borrowers

by student or school characteristics that are associated with varying levels of servicing cost or

default risk. For example, borrower groups could be based on average loan balances, type of

degree sought, or type of school attended. The federal government would limit the interest rate

or origination fee differences that would be allowed within each group but would not restrict

these differences between groups. FHA imposes this type of limitation on the variation in

ìmortgage charge rates,î analogous to FFELP origination fees, among recipients of the home

mortgages it guarantees. Market competition determines the interest rates and fees on FHAguaranteed mortgages, and different borrowers pay different rates and fees. However, FHA

divides mortgages into groups on the basis of location and characteristics affecting prices and

charges, such as fees or costs. FHA limits the difference between the highest and lowest

mortgage charge rate within a group in any time period to 2 percentage points.

A final option would limit the rate level by setting a federal subsidy for borrowers for all FFELP

loans. Such a subsidy would lower the interest rate for all borrowers by the same number of

percentage points. It would also preserve borrowersí incentive to shop for the lowest interest

rates, since a borrower would always benefit if he or she could find a lower rate. Furthermore,

this subsidy could be uniform for all borrowers or could vary by the same student or school

characteristicsóaverage loan balances, type of degree sought, or type of school attendedóas

designated above. For example, borrowers in short-term programs or schools with high default

rates, who might face the highest rates in the marketplace, could receive larger subsidies than

those in other programs or schools, to try to ensure a more uniform rate for all borrowers.

COSTS, SAVINGS, AND EFFECTS ON SUBSIDIES

FOR PROGRAM PARTICIPANTS

Market-set rates are likely to reduce federal costs in the simplest version of the model, in which

government payments to lenders would be eliminated. Subsidies to borrowers would be reduced

in most versions of the model. Average borrower interest rates would probably rise in the short

run but could increase, decrease, or remain unchanged in the long run. However, interest rates

are likely to vary more among borrowers than they do today, increasing for some borrowers and

possibly declining for others; thus, federal cost savings might come at the expense of borrowers

who pay higher rates, potentially making some schools unaffordable for some borrowers. Lower

initial interest rates for the lowest-cost, lowest-risk borrowers might replace the discounts that

some lenders currently offer to those borrowers. A shift to market-set borrower interest rates in

FFELP would also be likely to necessitate a change in the method by which FDLP interest rates

were determined.

In the simple version of the model, federal FFELP costs under a system of market-set rates are

likely to be lower than they are now. Federal costs include the cost of the federal loan guarantee,
CHAPTER 6: MARKET-SET RATES

Page 58

payment of interest while borrowers are in school (for subsidized Stafford loans), and payments

to lenders to cover the difference between the lender interest rate and the maximum borrower

rate. By eliminating the federal governmentís payments of in-school interest and its payments to

lenders, the market-set rate model would lower federal FFELP costs. (The cost of the loan

guarantee would not change, assuming that the guarantee structure did not change and that these

program changes did not affect default rates.) If the federal government had to serve as lender of

last resort or pay private lenders to do so, or subsidize borrowers, then it would incur extra costs,

which would reduce or eliminate the federal savings from switching to market-set rates. If the

federal subsidies or lender-of-last-resort costs were great enough, federal costs for FFELP could

increase.

Market-set rates would eliminate all federal payments to lenders in the simplest version of the

model. Under most options, there would be no federal subsidies to borrowers. Subsidies to

borrowers would continue to exist only if the federal government chose to limit differences in

borrower interest rates, or reduce the rates for all borrowers, by paying a subsidy to all

borrowers. Eliminating the rate cap or making it less binding for all borrowers would be a major

change in federal policy, which historically has set the same rate cap for all borrowers.

In the short run, the interest rates that borrowers pay, on average, would be likely to be higher

than they now pay. In the long run, the average borrower rate could be higher than, lower than,

or the same as at present. In the simplest version of the model, in the short run, eliminating the

federal cap on borrower interest rates and federal subsidies to lenders would probably cause the

average borrower rate to rise. In variants of the model that included methods of limiting

borrower interest rates, borrower rates could increase by a lesser amount, or remain unchanged,

in the short run. However, the long-run effect on borrower rates in any version of the model

would depend on whether lender participation in FFELP increased or decreased. If lendersí

freedom to set interest rates induced entry by new lenders and increased participation by current

lenders, then those rates might fall. If some current lenders exited the FFELP and no new ones

entered, then borrower rates could increase.

Market-set rates would probably increase the variation in the interest rates different borrowers

pay, raising some borrowersí rates while lowering othersí. The increase in variation may not be

large, however, since the federal government would still guarantee 98 percent of the principal of

each loan. Currently, the legislatively set borrower interest rate cap limits the amount of

variation in borrower rates. The market-set rate model would allow some borrowersí rates to

exceed the current ceiling. Borrowers that lenders perceived as having high servicing costs or

high default risks (for example, those who had low loan balances or who attended schools with

high student loan default rates) could face higher rates. These borrowers could end up paying

interest rates exceeding the current ceiling. In the long run, interest rates for borrowers with low

servicing costs or low default risks could decrease, if market competition eventually caused their

average borrower rate to fall. In that event, low-cost, low-risk borrowers, who now receive

discounts that give them interest rates below the ceiling, could pay even less.

Low-cost, low-risk borrowers might pay lower up-front interest rates instead of receiving

discounts. Currently, lenders often give those borrowers interest-rate discounts after repayment
CHAPTER 6: MARKET-SET RATES

Page 59

begins. With increased competition at the front end of the loan, lenders might offer those

borrowers lower contractual interest rates, leaving less flexibility for rate discounts during

repayment. However, lenders might still offer discounts for good performance or for automatic

electronic payment if offering those discounts increased profits for lenders.

In addition to affecting FFELP borrower interest rates, a system of market-set rates would

probably require a change in the method of setting borrower interest rates in FDLP. Currently,

FDLP rates are based on FFELP borrower rates. If FFELP borrower rates were determined

through market competition, then they would probably vary more across borrowers and over

shorter periods of time than they do now. It would become more difficult to base FDLP rates on

FFELP borrower rates because of the increased variation in the latter. It would be possible to set

FDLP rates on the basis of an average of FFELP borrower rates over a designated period of

time.34 Alternatively, the Congress could set an FDLP interest rate independently of FFELP

borrower rates. This option, however, would be likely to make determining FDLP interest rates

at least partially a political decision and potentially set a ceiling for FFELP loans.

EFFECTS ON LENDER PARTICIPATION, LOAN

AVAILABILITY, AND SERVICE QUALITY

Market-set rates could give lenders a continuing incentive to reduce their costs. If student loan

markets are somewhat competitive, lower-cost lenders can offer lower rates and increase their

market shares and profits. In addition, lenders setting higher rates will lose customers unless

they are providing superior levels of service and other loan features attractive to borrowers.

They might reduce the quality of service or leave it unchanged but might have less incentive to

improve it than in the current system. Effects on lender diversity are uncertain. Some borrowers

would be likely to lose access to FFELP. This problem would be somewhat mitigated if there

were a lender of last resort. During a transition period, some borrowers who would ultimately

have access to FFELP loans could be temporarily unable to obtain them, while other borrowers

who would ultimately lose access might be able to borrow under FFELP.

Lendersí costs would also be likely to continue to decline after a market-set rate system was put

in place. If lenders had to compete for business from students or schools that wanted to obtain

low interest rates, then they would face a continuing incentive to cut interest rates. To cut

interest rates and maintain a sufficient profit to make it worthwhile for them to remain in FFELP,

lenders would have to reduce their financing, origination, or servicing costs. Because any lender

who could gain a cost advantage over competitors would gain borrowers at their expense, all

lenders would be under continuing pressure to keep costs low.

Market-set rates might reduce service quality or have no effect on it. The balance of competition

in the student loan market might shift toward price competition and away from service quality

competition. At present, FFELP lenders compete to a limited extent on the basis of price,

through discounts to preferred borrowers. They also compete on the basis of service quality.

Under market-set rates, lenders might place more emphasis on price competition. It is possible,

 

34The method chosen for setting the direct loan rate would also affect budget scoring for both programs.
CHAPTER 6: MARKET-SET RATES

Page 60

although not certain, that lenders would decrease their emphasis on service quality as they paid

more attention to price.

It is also possible, although not certain, that market-set rates would reduce service quality by

weakening long-term relationships between lenders and schools. At present, schools maintain

lists of ìpreferred lenders.î Financial aid officers become knowledgeable about the practices of

those lenders. Some schoolsí computer systems are programmed to deal with lenders on their

preferred lists. Since schools often serve as intermediaries between lenders and students, schoollender relationships can improve service quality if they help schools assist students in dealing

with lenders. In a system of market-set rates, schools might choose lenders on the basis of price

and sacrifice these long-term relationships with lenders. If students chose lenders directly, they

might not choose the lenders with which their schools previously had ongoing relationships.

However, it is also possible that students and schools would see value in lender-school

relationships and be unwilling to sacrifice these relationships to obtain slightly lower interest

rates.

The effect of market-set rates on lender diversity is uncertain. If lendersí freedom to set interest

rates attracted new lenders into FFELP in the long run, then lender diversity could increase.

Alternatively, with increased price competition, large lenders who could invest in the human

capital and servicing systems that would enable them to offer low interest rates might drive other

lenders out of FFELP and prevent new lenders from entering. Similarly, secondary market

lenders could be affected, if competition drove less efficient lenders and secondary markets out

of the market via mergers. However, consolidations of lenders and secondary markets are

already occurring in FFELP. It is possible that those consolidations would continue under a

system of market-set rates and that market-set rates would have no effect on them.

Without a lender of last resort or a substantial federal interest rate subsidy, some borrowers could

be priced out of the FFELP market. In a system of market-set rates, lenders would face

incentives to charge high interest rates to borrowers they saw as having high risks of default or

high servicing costs. For example, they would be likely to charge high rates to students in lowincome regions, those from low-income families, and those attending proprietary vocational

schools. Lenders would be likely to consider those kinds of students as presenting especially

high default risks. Similarly, they might offer higher rates to borrowers in short-term programs

or schools at which they are unlikely to end up with high loan balances, such as community

colleges. Since loan servicing costs are relatively fixed, borrowers with low loan balances are

more expensive to service on a per-dollar basis. If the interest rates that lenders were willing to

offer some students were so high that those students were unwilling to pay them, then those

students would not be able to obtain FFELP loans. Although the federal loan guarantee would

reduce the extent to which different students posed different risks to lenders, it might not be

sufficient to prevent some students from losing access to FFELP. A lender of last resort or a

substantial federal subsidy could eliminate this access problem.35

 

35Regulations restricting variation in interest rates lenders could charge might not eliminate the problem because

lenders might find it unprofitable to lend to the highest-risk or highest-cost students at any rate that the regulations

would permit.
CHAPTER 6: MARKET-SET RATES

Page 61

During a transition to market-set rates, access to FFELP loans could be reduced from its current

level but might differ from what it would be after lenders, schools, and students adjusted to the

new rate-setting system. Because lenders would charge the highest-risk and highest-cost

students rates that those students might not be willing to pay, those students could lose access to

loans. However, differences in interest rates and student access during a transition period need

not be the same as those that would ultimately exist in a system of market-set rates. Students, or

schools acting on behalf of students, might need time to develop expertise at shopping for low

interest rates. During a transition period, their lack of expertise might keep rates higher than they

would ultimately be, and some students could initially be priced out of FFELP. Lenders would

also need time to develop expertise in assessing the risks and costs of lending to different kinds

of students. The criteria they initially used to determine interest rate offers might not be the

same as those they would later use. Therefore, some students could be priced out of FFELP

during a transition period but regain access to the program later. Likewise, some students who

were able to obtain loans during the transition might later be priced out of the program. A lender

of last resort or substantial federal subsidy could eliminate access problems that arose during the

transition.

SIMPLICITY, REGULATORY BURDEN,

AND PROGRAM INTEGRITY

Eliminating most existing program regulations dealing with interest rates charged borrowers

would likely simplify FFELP for lenders but would place additional burdens on borrowers and

schools, and new regulations could make the program more complex for all participants.36 The

extent to which regulations become more complex or simpler will depend on program design

features dealing with the exact extent of interest rate variability permitted and the extent to which

borrower protection on servicing remain in place. In the simplest version of this model, the

federal government would no longer set maximum borrower interest rates, pay interest while

borrowers were in school, or pay subsidies to lenders. Eliminating these features of FFELP

would probably make the program simpler for lenders. However, borrowers and schools may

find the program more complex. In addition, the loss of access to loans, if it occurred, could

burden some students. Any new regulations to preserve participation of small lenders could

burden large lenders. New regulations designed to preserve both student access to loans and

student or school incentives to shop could burden various program participants. The nature of

those burdens depends on the type of regulation. For example, if the program limited the range

of rates that a lender was allowed to charge different students, then lenders would face an

additional burden. If students had to satisfy a complex set of criteria to be eligible to borrow

from a lender of last resort, then borrowers who had difficulty obtaining loans from other lenders

would face an additional burden.

Students, schools, and lenders would all have to adjust to changes in regulations and market

practices. The adjustments that would be required are probably greater than those that the other

 

36Even if regulations dealing with borrower rates were eliminated or modified, regulations dealing with servicing

loans could remain unchanged.
CHAPTER 6: MARKET-SET RATES

Page 62

models in this report require. If schools changed their preferred lender lists whenever lenders

changed their interest rates, then students could have to deal with multiple lenders, and financial

aid officers would have to deal with different lenders each year. This might require financial aid

officers to face the confusion and administrative burden of constant changes in procedures and

forms that different lenders required. The same results could occur if students rather than

schools choose lenders. The confusion and difficulties of dealing with multiple lenders each

potentially offering different interest rates and terms (unlike the present rates and terms that do

not vary by lender) might increase the attractiveness of FDLP to schools. Lenders would have to

determine their cost structures and provide mixes of prices and services that keep them attractive

to students or schools. Students or schools would have to learn how to choose lenders. Students

might also face difficulties dealing with multiple lenders. Guaranty agencies would have to deal

with more lenders per student than they do now. Finally, the procedures for consolidating loans

might need to change in order to accommodate the variety of interest rates and terms of FFELP

loans. The results of the analysis for the market-set rates model are summarized at a broad level

in table 13.

Table 13: Summary of Analysis for Market-Set Rates Model

Description of model,

including variations

 Lender and borrower interest rates would be set by market competition.

 Borrowers would pay the rates lenders charged, unless the model included

explicit subsidy for borrowers.

 Loans retain a federal guarantee.

 Options exist to limit variation in borrower interest rates

 Rate cap for students might be eliminated or less binding, representing a major

federal policy change.

Costs, savings, and effects

on subsidies for program

participants

 Federal costs could decline but could rise or remain unchanged under some

options.

 Costs will likely rise for some borrowers and fall for others.

 Average borrower costs would be likely to rise in the short run; long-run effect is

uncertain.

 Government payments to lenders and borrowers would be eliminated or

reduced under some options.

Effects on lender

participation, loan availability,

and service quality

 Lenders have continuing incentive to reduce costs.

 Service quality may decline or remain unchanged.

 Effect on lender diversity is uncertain.

 Loans would probably not be available to all students and schools and their

ability to negotiate could be limited unless ameliorative policies were adopted.

Simplicity, regulatory burden,

and program integrity

 All FFELP participants would bear a substantial burden of adjusting to a new

system.

 Borrowers or schools would have a greater burden to shop for loans.

 Eliminating some existing regulation would simplify FFELP for lenders, but new

regulations could burden all FFELP participants.
Page 63

CHAPTER 7

INCOME-CONTINGENT REPAYMENT

The Student Loan Reform Act of 1993 expanded the range of loan repayment options available

under the federal student loan programs. Of interest in considering market mechanisms in these

programs is the availability and use of the ICR plan in FDLP. Any of the proposed models for

introducing market mechanisms into FFELP could include an ICR option or requirement. Under

ICR, the amount of a borrowerís monthly loan repayment varies with income over time. Some

borrowers with low postgraduation incomes or high debt levels would make lower monthly

payments with ICR than with other loan repayment options. With the monthly installment

payment based on the borrowerís income, it is also far more difficult in theory for the borrower

to default. The availability of ICR expands options for student borrowers to choose educational

programs or careers that are less likely to provide a high income. Student borrowers who earn

less make lower monthly repayments and are therefore also relieved of some of the risk

associated with an uncertain future.

ICR DESIGN ISSUES COMMON TO MODELS

ICR design issues common to all market mechanism models include how borrowersí repayment

terms should be determined, whether the federal government or private lenders should hold ICR

loans, who should be able to choose or require ICR, and how borrowersí incomes should be

verified.

Repayment Terms Under FDLP ICR

Now and Alternatives

Any ICR plan must specify how a borrowerís loan repayments are to be determined. Under the

ICR option that now exists in FDLP, loan repayments depend in a complex way on income and

other factors. Some borrowers may have portions of their principal or interest forgiven.

Examples from other countries that use ICR illustrate alternative methods of determining

repayment obligations in an ICR system.

In FDLP, borrowers may choose an ICR option under which monthly payments depend on

income and, for some borrowers, loan principal and interest rate and marital status. Under this

option, the borrowerís monthly payment is the smaller of two amounts: (1) the amount the

borrower would repay annually over 12 years in the absence of ICR, multiplied by an income

percentage factor based on the borrowerís and spouseís adjusted gross income (AGI) and marital

status, or (2) 20 percent of the borrowerís income in excess of the poverty level. The ICR

repayment obligation is recalculated each year to reflect changes in the interest rate, income

percentage factor, and poverty level. Appendix IV explains the repayment formula in more

detail.
CHAPTER 7: INCOME-CONTINGENT REPAYMENT

Page 64

Under FDLPís ICR plan, the federal government subsidizes some borrowers by forgiving part of

their principal or interest payments. Two kinds of subsidies are available to ICR borrowers in

addition to those available to Stafford borrowers in general. First, if the borrowerís monthly

payment is less than the monthly interest accrued on the borrowerís loans, then the unpaid

interest is capitalized up to a limit of 10 percent of the original principal balance on each

individual loan. The federal government writes off any unpaid interest that exceeds this limit.

Second, the federal government forgives any unpaid loan balance remaining after 25 years in

repayment. This forgiveness includes any remaining unpaid principal, unpaid interest, or

charges on the borrowerís loans.

Other countries that use ICR in their student loan systems illustrate alternatives to the FDLP

method of determining ICR repayment obligations. For example, some countries have income

thresholds below which loan borrowers are not required to make any repayments. Once the

borrower has reached or exceeded the set threshold, payments are determined according a

percentage of income, as in Australia, or of income above the threshold, as in New Zealand. In

Sweden, payments are simply a percentage of total income, with no threshold. Loan forgiveness

provisions vary widely. For example, Sweden forgives all student loan debt that the borrower

has not repaid by age 65. New Zealand partially forgives interest payments for certain lowincome borrowers. Countries with ICR systems also vary as to whether ICR is voluntary or

mandatory. In some countries, such as Sweden, all borrowers use ICR. In New Zealand, ICR is

the default option but borrowers may choose to repay their loans at a faster rate than required

under ICR. In Australia, students indicate whether they wish to use ICR or pay their entire

obligation up front. Numerous and significant differences between loan programs run by other

nations make the relevance of these program features debatable.

ICR Loans Held by the Federal

Government or Private Lenders

Either the federal government or private lenders could hold ICR loans in FFELP. One option

that could be incorporated into all market mechanism proposals is to have the federal

government, rather than the FFELP lender, hold the loans of borrowers who have chosen the ICR

plan. For example, the government could buy at face value (ìparî) all privately held loans that

were being converted from a conventional repayment plan to ICR. If the federal government

initially held all FFELP loans (as under the loan sale proposal), then it could retain ICR loans

and sell only non-ICR loans. In either case, the federal government could use a loan servicing

contractor to service loans in the ICR plan. Borrowers could select ICR before or after entering

repayment.

Private lenders could hold FFELP ICR loans under any of the market mechanism proposals. If

lenders originated all loans, then they could continue to hold them or sell them to other lenders,

regardless of whether a borrower chose ICR. If the federal government initially held all FFELP

loans, then it could sell both ICR and non-ICR loans to private lenders. Privately held ICR loans

raise special issues related to the verification of borrower incomes. Financing subsidies to

borrowers could also differ between privately held ICR loans and publicly held ones. These
CHAPTER 7: INCOME-CONTINGENT REPAYMENT

Page 65

issues are discussed later in this chapter. An additional option would be for private lenders to

hold ICR loans but have them serviced by the government of its contractor.

Borrowers could elect to leave ICR, regardless of whether the federal government or private

lenders hold the loans. As with the current ICR program, the option of changing repayment

plans could be incorporated into ICR under any of the market mechanism proposals.

Choosing or Being Required to Use ICR

In the current FDLP, a standard (non-ICR) repayment schedule is the default option but any

borrower may choose to use ICR instead. Under a market mechanism approach, ICR in FFELP

could continue with this freedom of borrower choice. Another possibility would be to allow only

delinquent and defaulted borrowers to choose ICR as a last resort. If ICR were limited to

delinquent and defaulted borrowers, another option would be to allow the lender to put a loan

into ICR status. Alternatively, the federal government could mandate ICR for delinquent or

defaulted borrowers, for borrowers whose student loan debts were large in comparison with their

incomes, or even for all FFELP borrowers. A final possibility would be to make ICR the default

option for all FFELP borrowers but to allow borrowers to choose a standard repayment schedule

instead of ICR.

Income Verification

Regardless of whether the federal government or private lenders held ICR loans, the extent to

which the Internal Revenue Service (IRS) should be involved in the verification process is a

major policy decision that the Congress would face if ICR were included in FFELP. Income

information on borrowersí federal income tax returns filed with IRS may be more accurate than

income information that borrowers supply (such as pay stubs, bank statements, and borrowersí

own copies of their tax returns). If borrowers supplied income information to the holders of ICR

loans, then some borrowers might underreport their incomes, especially if the ICR plan includes

a future discharge of indebtedness. Even if loan holders required ICR borrowers to present

certified copies of their tax returns, fraud could still be an issue. Educationís Office of Inspector

General found that student aid applicants, even when required to provide a copy of their tax

returns as part of the Free Application for Federal Student Aid (FAFSA) verification process,

cannot always be relied on to provide accurate information.37 For these reasons, IRS

involvement in the verification process may be desirable. However, IRS has, in general, argued

that the use of tax return information for ìnon-tax collectionî purposes undermines public

confidence in the tax system and, therefore, reduces voluntary taxpayer compliance with tax

laws.

More specific policy decisions about IRS involvement in income verification depend on whether

the federal government or private lenders would hold ICR loans under FFELP. If the federal

 

37Education, Office of the Inspector General, Accuracy of Student Aid Awards Can Be Improved by Obtaining

Income Data from the Internal Revenue Service, ACN: 11-50001 (Washington, D.C.: Jan. 29, 1997).
CHAPTER 7: INCOME-CONTINGENT REPAYMENT

Page 66

government held the loans, then one possible method of verifying income would be the one

currently FDLPís ICR plan uses. In FDLP ICR, two methods of income verification are used:

IRS data-matching and borrower-supplied ìalternative documentationî of income. Alternative

documentation consists of a pay stub, dividend statement, or canceled check or, if none of these

is available, a signed statement that explains the borrowerís income sources and provides its

address. Alternative documentation of income is required for the first year a borrower is in

repayment and, for certain borrowers, for the second year. Otherwise, IRS data-matching is used

to verify income. Appendix IV explains the FDLP income-verification procedure in more detail.

If the federal government held FFELP ICR loans and if IRS information were used in verifying

borrowersí incomes, then a second policy issue might be whether or how federal contractors

involved in administering ICR should be able to obtain information from federal income tax

returns. Contractors now handle loan operations, such as origination and servicing. Education

requires FDLP ICR borrowers to sign a consent form giving contractors permission to obtain

information about their incomes from IRS.38 Either the Congress (through legislation) or

Education and Treasury (through regulation) may wish to consider whether a similar method of

borrower consent should be used for ICR in FFELP.

For the current FDLP ICR plan, Education and IRS have devised a system in which consent

forms are transmitted to IRS electronically for review. (See app. IV for details.) Education then

transmits to IRS the items of information to be verified for those taxpayers. Treasury estimates

that 100,000 consents are processed each year. Education and Treasury have been working

toward a possible statutory or regulatory solution to this paper-intensive approach. The separate

consent form is arguably a significant paperwork obstacle to borrowers completing the ICR

application process. In addition, the form itself may heighten borrower concern about the federal

use of tax return data.

If private lenders held ICR loans, then the main income-verification issue would be whether

lenders should be able to obtain borrower income information from IRS or should be required to

rely on income information that borrowers supply. As discussed above, borrower-supplied

information may be less accurate than IRS information. Some members of the lending

community have suggested that lenders could collect income information from FFELP ICR

borrowers and share it annually with Education. Education would then compare the self-reported

data with actual IRS tax return data through some type of data exchange to ensure that the selfreported income was accurate within a predefined tolerance. Treasury has stated that in order for

this to occur, either taxpayer consent or an amendment to the IRC would be necessary.

 

38The Internal Revenue Code authorizes Treasury to disclose information about FDLP ICR borrowersí identities, tax

filing statutes, and AGI to officers and employees of Education for the purpose of determining the appropriate ICR

amount (26 U.S.C. 6103(l)(13)). Because Education uses contractors to administer FDLP, these disclosures are

made on taxpayer consent forms filed with IRS. Subject to certain limitations, the Internal Revenue Code allows

Treasury to disclose a taxpayerís federal income tax return information to any person if the taxpayer requests this

disclosure (26 U.S.C. 6103(c)).
CHAPTER 7: INCOME-CONTINGENT REPAYMENT

Page 67

ICR VARIATIONS IN THE DIFFERENT

MARKET MECHANISM MODELS

ICR could be incorporated into any of the market mechanism proposals discussed in this report.

Some features of ICR would vary, depending on the market mechanism proposal chosen. In

particular, the federal acquisition of ICR loans could differ for some market mechanisms, federal

payments to private lenders that held ICR loans would exist in only one market mechanism, and

any subsidies to ICR borrowers would probably have to be financed differently for different

market mechanisms.

Federal Acquisition of ICR Loans

In all the market mechanism models except loan sales, if the Congress decided that the federal

government should hold FFELP ICR loans, then the federal government would have to buy from

private lenders all loans for which borrowers chose or were required to use ICR. In the loan sale

model, in which the federal government would originate all loans and then sell loans to private

lenders, it would not auction loans that were designated ICR loans. Under loan sales, if a

borrower chose or were required to use ICR after a private lender had bought his or her loan,

then the federal government would have to repurchase that loan from the lender.

Federal and Borrower Payments to Private

Lenders Holding ICR Loans

Under all the market mechanism models, if private lenders held ICR loans, then lenders would

receive the income-contingent payments that borrowers made. In addition, under adjustments to

the current system only, they would continue to receive a SAP, based on the difference between

the lender yield and the maximum borrower interest rate.

Financing Subsidies to ICR Borrowers

If private lenders held ICR loans, then the federal government might or might not reimburse

lenders for the costs of ICR borrower subsidies (that is, for uncapitalized interest and for loan

balances forgiven after 25 years). Under all market mechanism models, the federal government

would pay the costs of the subsidies if it reimbursed lenders for the costs of these subsidies.

However, a decision by the Congress not to require the federal government to reimburse lenders

for the costs of the subsidies could mean, depending on the market mechanism model, that

lenders, borrowers, or the federal government actually paid the costs of the subsidies.

Under adjustments to the current system, if the federal government reimbursed lenders for the

costs of borrower subsidies, then federal FFELP costs would be higher than if lenders received

no reimbursement. If the federal government did not reimburse lenders for the costs of borrower

subsidies, then FFELP lenders would pay for the subsidies. However, lender participation in

FFELP would probably be reduced, and loan availability might also be reduced.
CHAPTER 7: INCOME-CONTINGENT REPAYMENT

Page 68

Under the federal funding model, if lenders borrowed at a predetermined interest rate, then

lendersí costs would be higher if the federal government did not reimburse them for borrower

subsidy costs. Such a cost increase would be likely to reduce lender participation in FFELP,

reduce any discounts currently available to borrowers, and possibly reduce loan availability.

Under all auction models, including the auction variant of federal funding, whether the federal

government reimbursed lenders for the costs of borrower subsidies would not affect whether the

federal government actually paid those costs. Lendersí bids would depend on whether the

federal government reimbursed them for those costs. If it did not reimburse lenders, then

lendersí bids would reflect the increase in expected costs attributable to ICR. If loans (in the

loan sale model) or origination rights (in the origination rights auction or volume procurement

model) were grouped, bids would be lower for groups in which borrowers were more likely to

receive ICR subsidies. Alternatively, ICR loans or the right to issue ICR loans could be

auctioned separately from other origination rights. Under all auction models, the government

would bear the anticipated cost of ICR subsidies in the form of lower revenue from bidding

lenders. The net result could be higher or lower federal costs associated with privately held ICR

loans, depending on whether the private lenders operating expenses were higher or lower than

those of federally operated ICR.

Under market-set rates, if the federal government did not reimburse lenders for the costs of

borrower subsidies, then lenders would probably charge borrowers higher interest rates, which

would reflect the expected costs attributable to ICR. Therefore, borrowers would be likely to

bear the anticipated cost of ICR subsidies for privately held loans. The borrowers whom lenders

believed most likely to use ICR would bear the greatest share of the costs of the ICR subsidies.

Regulatory limits on the rates lenders could charge may reduce the availability of FFELP loans,

especially to borrowers whom lenders thought most likely to use ICR.
Page 69

 APPENDIX I

MANDATE FROM THE HIGHER

EDUCATION AMENDMENTS OF 1998

This appendix reprints section 801 of the Higher Education Amendments of 1998 (HEA), Pub.

L. No. 105-244.

 (a) Study Required.óThe Comptroller General and the Secretary of Education

 shall convene a study group including the Secretary of the Treasury, the

 Director of the Office of Management and Budget, the Director of the

 Congressional Budget Office, representatives of entities making loans under

 part B of title IV of the Higher Education Act of 1965, representatives of other

 entities in the financial services community, representatives of other

 participants in the student loan programs, and such other individuals as the

 Comptroller General and the Secretary may designate. The Comptroller

 General and Secretary, in consultation with the study group, shall design and

 conduct a study to identify and evaluate means of establishing a market

 mechanism for the delivery of loans made pursuant to such title IV.

 (b) Design of Study.óThe study required under this section shall identify not

 fewer than 3 different market mechanisms for use in determining lender return

 on student loans while continuing to meet the other objectives of the programs

 under parts B and D of such title IV, including the provision of loans to all

 eligible students. Consideration may be given to the use of auctions and to

 the feasibility of incorporating income-contingent repayment options into the

 student loan system and requiring borrowers to repay through income tax

 withholding.

 (c) Evaluation of Market Mechanisms.óThe mechanisms identified under

 subsection (b) shall be evaluated in terms of the following areas:

 (1) The cost or savings of loans to or for borrowers, including parent

 borrowers.

 (2) The cost or savings of the mechanism to the Federal Government.

 (3) The cost, effect, and distribution of Federal subsidies to or for participants

 in the program.

 (4) The ability of the mechanism to accommodate the potential distribution of

 subsidies to students through an income-contingent repayment option.

 (5) The effect on the simplicity of the program, including the effect of the plan
APPENDIX I: MANDATE FROM THE 1998 AMENDMENTS TO HEA

Page 70

 on the regulatory burden on students, schools, lenders, and other program

 participants.

 (6) The effect on investment in human capital and resources, loan servicing

 capability, and the quality of service to the borrower.

 (7) The effect on the diversity of lenders, including community-based lenders,

 originating and secondary market lenders.

 (8) The effect on program integrity.

 (9) The degree to which the mechanism will provide market incentives to

 encourage continuous improvement in the delivery and servicing of loans.

 (10) The availability of loans to students by region, income level, and by

 categories of institutions.

 (11) The proposed Federal and State role in the operation of the mechanism.

 (12) A description of how the mechanism will be administered and operated.

 (13) Transition procedures, including the effect on loan availability during a

 transition period.

 (14) Any other areas the study group may include.

 (d) Preliminary Findings and Publication of Study.óNot later than November

 15, 2000, the study group shall make the groupís preliminary findings,

 including any additional or dissenting views, available to the public with a

 60-day request for public comment. The study group shall review these

 comments and the Comptroller General and the Secretary shall transmit a

 final report, including any additional or dissenting views, to the Committee on

 Education and the Workforce of the House of Representatives, the

 Committee on Labor and Human Resources of the Senate, and the

 Committees on the Budget of the House of Representatives and the Senate

 not later than May 15, 2001.
Page 71

APPENDIX II

 LIST OF STUDY GROUP MEMBERS

APPOINTED BY EDUCATION AND GAO

Corye Barbour

Legislative Director

United States Student Association

Bill Beckmann

President and Chief Executive Officer

Student Loan Corporation

Mary F. Bushman

Vice President, Government Relations

AFSA Data Corporation

Kathy Cannon

Senior Vice President

Bank of America

Judy Case

Director of Financial Aid

University of Massachusetts Medical School

Rene R. Champagne

Chairman, President and Chief Executive Officer

ITT Educational Services, Inc.

Jacqueline Daughtry-Miller

Vice President, Student Loan Department

Independence Federal Savings Bank

Anthony P. Dolanski

Director, Sallie Mae Servicing

Sallie Mae, Inc.

Ivan Frishberg

Higher Education Project Director

U.S. Public Interest Research Group
APPENDIX II: STUDY GROUP MEMBERS

Page 72

Richard D. George

President and Chief Executive Officer

Great Lakes Higher Education Corporation

Jonathan Gruber

Department of Economics

Massachusetts Institute of Technology

Michael H. Hershock

President and Chief Executive Officer

Pennsylvania Higher Education Assistance Agency

D. Bruce Johnstone

Department of Higher and Comparative Education

University at Buffalo

State University of New York

James C. Lintzenich

President and Chief Executive Officer

USA Group

Claire J. Mezzanotte

Senior Director, Structured Finance, Asset Backed Securities

Fitch IBCA, Inc.

David Mohning

Director of Student Financial Aid

Vanderbilt University

Deborah Mott

Senior Vice President, Corporate Finance

Ferris, Baker Watts, Incorporated

Barmak Nassirian

American Association of Collegiate Registrars and Admissions Officers

Chalmers Gail Norris

Executive Director

Utah Higher Education Assistance Authority

Richard H. Pierce

President and Chief Executive Officer

Maine Education Services
APPENDIX II: STUDY GROUP MEMBERS

Page 73

Susan L. Pugh

Director, Office of Student Financial Assistance

Indiana University

Marilyn B. Quinn

Executive Director

Delaware Higher Education Commission

Robert A. Scott

President

Adelphi University

Patricia Smith

American Association of State Colleges and Universities

Paul S. Tone

Senior Vice President, Industry and Government Relations

UNIPAC

Laurie Wolf

Director, Enrollment Management

Des Moines Area Community College

Paul W. Wozniak

Managing Director

PaineWebber Incorporated

DESIGNATED BY FEDERAL AGENCIES

Nabeel Alsalam

Principal Analyst

Congressional Budget Office

Barbara Bovbjerg

Director, Education, Workforce, and Income Security Issues

U.S. General Accounting Office

Robert Cumby

Former Deputy Assistant Secretary, Office of Economic Policy

U.S. Department of the Treasury

Maureen McLaughlin

Deputy Assistant Secretary, Office of Postsecondary Education

U.S. Department of Education
APPENDIX II: STUDY GROUP MEMBERS

Page 74

Lorenzo Rasetti

Program Examiner

Office of Management and Budget
Page 75

APPENDIX III

TECHNICAL ASPECTS OF AUCTION DESIGN

Several of the policy options we reviewed in this report, particularly those in chapters 3 and 4,

involve some sort of auction mechanism for setting the terms on which student loans are

originated. The purpose of this appendix is to review the relevant theoretical and empirical

literature on auctions.

IDEAL CONDITIONS FOR AUCTIONS TO WORK

Standard theoretical treatments of auctions in the economic literature generally assume that the

objective of the party conducting the auction is pecuniaryóthat is, that a successful auction is

one that provides the most favorable price quotations by bidders.39 Bidders are likely to make

more attractive bids, other things being equal, when the following conditions are present: a large

number of bidders, easy entry and exit conditions for bidders, as much relevant information as

possible available to bidders, and the existence of secondary markets. However, in many

practical situations, the state of the market deviates from the ideal conditions described above.

For example, as we noted in chapter 1, the student loan market has been characterized by the

concentration of much of the business in the hands of a few large lenders.

The competitiveness of a market can affect the success of auctions, but auctions themselves can

influence the competitiveness of the market. In the short term, auctions either may make the

market more competitive or may have no effect on competition. They may increase competition

by enabling new participants to enter the market on relatively equal terms with existing

participants. Alternatively, auctions may have no effect on competition if entry into the market

is so expensive that no new participants are willing to enter. In the long term, it is possible that

auctions will gradually reduce competition and, in the case of FFELP, increase federal costs,

although how likely this outcome is cannot be known.

The current student loan market, however, may not be competitive enough to enable auctions to

produce savings for the federal government. This may be because a few large lenders dominate

the student loan market and it is costly for new lenders to enter the market. The dominant

lendersí influence on the winning bids could conceivably lead to FFELP costs that are as high as

or higher than current costs. Lenders might also collude in setting their bids. The relatively

small number of lenders in the market would make collusion easier.

The student loan program is distinguished by several nonpecuniary policy objectives, such as

encouraging participation by small lenders, maximizing access by student borrowers, and

maximizing familiesí choices of postsecondary education options.

 

39As we noted in chapter 3, in the context of the student loan program, this could be defined in one of several ways:

the interest rate offered by bidders, a markup over a reference rate such as a T-bill rate or the CP rate, or a price to

be offered by bidders. Unless otherwise noted, the discussion in this appendix pertains to any pecuniary outcome.
APPENDIX III: TECHNICAL ASPECTS OF AUCTION DESIGN

Page 76

OPTIONS FOR AUCTION DESIGN

There are various ways of structuring the auction process. We review several of the variants that

have been used in financial markets or that have been proposed for the student loan program.

Where appropriate, we note aspects of auction design that might be significant when the auction

is being conducted under less than ideal conditions. Although most of the available theory and

evidence pertains to the implications of auction designs for pecuniary outcomes, we also note the

implications of auction design for nonpecuniary policy objectives. This list is by no means

exhaustive. Although we indicate whether a particular auction design may be more or less

conducive to attaining certain objectives than another auction design, we do not generally answer

the question of whether auctions as such are superior to nonauction methods of setting interest

rates and other terms for student loans.

Uniform Versus Multiple Prices

In an auction for multiple identical items, where bidders can bid on different quantities of the

item, competitive bids state the amount and price desired and are ranked from the highest to the

lowest price. Bids are accepted at successively lower prices until the desired level of funds has

been raised or all items have been sold. In a uniform-price auction, all winning bidders then pay

the same priceóthe cut-off price.40 By contrast, in a multiple-price auction, all accepted bids are

filled at the price that each bidder bid, so some wining bidders pay more than others.

Treasury recently made a transition from multiple-price auctions to single-price auctions in its

auctions of Treasury securities. A Treasury official told us that the uniform-price auction was

expected to produce benefits, from Treasuryís point of view, in that it would encourage more

bidders to participate in bidding by reducing the importance of specialized knowledge regarding

market demand and the information costs associated with its collection. It expected that the

concentration of bidders would decline and that there would be more revenue to the Treasury.

Its analysis of data from the initial experience with single-price auctions lends modest support

for these predictions.

Single Versus Multiple-Round Auctions

Rather than selling items one at a time, a large set of related items can be auctioned

simultaneously, with the auctioning continuing for multiple rounds until the best possible price is

attained for all items. FCC uses multiple-round auctions for some of its auctions of licenses.

The auction closes when all bidding activity has stopped on all licenses. The principal advantage

of a multiple-round auction is the information that it provides bidders about the value other

bidders place on a license. This information increases the likelihood that licenses will be

assigned to the bidders that value them the most and will generally yield more revenue than

auctions where there is much uncertainty about common factors that affect the value of a license

to all biddersóthat is, who bid and how much was bid. In a multiple-round auction, bidders

 

40A variant of this technique involves accepting the second highest bid.
APPENDIX III: TECHNICAL ASPECTS OF AUCTION DESIGN

Page 77

need not guess about the value the second highest bidder places on the license because bidders

have the opportunity to raise their bids if they are willing to pay more than the current high

bidder.

Multiple-round bidding is also more likely than single-round bidding to be perceived by

participants and observers as open and fair. Auction theory shows that multiple-round bidding

tends to increase revenue by reducing the incentive for bidders to be overly cautious during

bidding while trying to avoid the winnerís curseómeaning the highest bidder would bid too

much and regret its purchase. Multiple-round bidding provides information about other biddersí

estimates of common information, thus reducing biddersí incentive to bid cautiously to avoid

falling victim to the winnerís curse and regretting their purchases.

An auction that has a single round of bidding is faster than one with multiple rounds, and the bid

evaluation process is simpler. Also, a multiple-round auction may be more vulnerable to

collusion than a single-round auction and an auction in which each bidder pays a different price

could be either more or less susceptible to collusion than one in which all bidders paid the same

price.

Sealed Bid Versus Open Outcry Auctions

In a sealed-bid auction, each bidder submits a single bid. The bids are then all opened at once

and the winner is determined. By contrast, in an open-outcry auction, bidders submit bids

publicly and then have the opportunity to revise their bids in light of other bids. Open-outcry

auctions are generally not used in financial markets. A Treasury official told us that for Treasury

auction, it was important to minimize event riskóthat is, the risk that market conditions will

change while the auction is ongoing. An open-outcry auction for Treasury securities might

increase this risk.

Auction Frequency

In a potential auction in FFELP, whether for loan origination rights or for loans that have already

been originated, how frequently auctions would be held would be an important decision. FFELP

costs could be higher the more frequently auctions were held. Because there would be some

costs to conducting each auction, the total administrative costs of auctions would be higher the

more frequently auctions were held. Similarly, the cost to lenders of bidding in auctions would

be higher the more frequently auctions were held, which could reduce the number of bidders.

More frequent auctions could also result in fewer bidders because some lenders would not find it

worthwhile to enter the FFELP market if they could not be sure of remaining in it for a long

time. With less competition among lenders, federal payments to lenders could be higher.

However, there are also reasons why FFELP costs could be lower with more frequent auctions.

Because lower-cost lenders can outbid those with higher costs, lenders would have a greater

incentive to reduce their costs the more frequently auctions were held. Therefore, federal

payments to lenders could be lower with more frequent auctions. In addition, lenders might

increase their profits during the time between auctions if they were able to reduce their costs
APPENDIX III: TECHNICAL ASPECTS OF AUCTION DESIGN

Page 78

during that time. The federal government would capture more of these profit increases and could

therefore make lower payments to lenders the more frequently auctions were held. Furthermore,

more frequent auctions reduce lendersí risk that the interest payments they would receive would

be out of line with their cost of funds. Therefore, more frequent auctions could make origination

rights more valuable to lenders, reducing federal payments to them. Finally, more frequent

auctions could make it more difficult for a few lenders to become entrenched as perennial

auction winners. Thus, auction winners could face more competition at each auction. This

competition could lead to lower federal payments to lenders.

Lender participation could be either higher or lower the more frequently auctions were held.

Because the cost to lenders of bidding in auctions would be higher the more frequently auctions

were held, more frequent auctions could mean fewer bidders. Small lenders might be especially

sensitive to the costs of bidding. However, because more frequent auctions reduce lendersí risk

that the interest payments they would receive would be out of line with their cost of funds, they

could make origination rights more valuable to lenders, inducing more lenders to participate.

Also, more frequent auctions could make it more difficult for a few lenders to become

entrenched as perennial auction winners. Thus, past auction winners could face more

competition at each subsequent auction.

Frequent auctions could impose substantial burdens on lenders, students, and schools. Because

participating in auctions would cost lenders both money and time, more frequent auctions would

be more burdensome to lenders. Because both students and schools value the ability to deal with

a single lender, more frequent auctions could impose a greater burden on them by disrupting

long-term student-lender and school-lender relationships. Less frequent auctions could have a

negative effect on service quality. Lenders whose rights to originate loans were secure for many

years might pay less attention to service. Students might then become confused about their

repayment responsibilities and the default rate might rise. However, less frequent auctions could

also improve service. Students value the ability to borrow from a single lender. Having this

ability could make it easier for them to keep track of and repay their debts, thereby reducing the

default rate. The more frequently auctions were held, the more likely it would be that a student

would have to change lenders, especially if each auction had only one winning lender per school.

This effect of auction frequency on service quality could be eliminated in several ways, though.

Each student could be allowed to remain with one lender throughout his or her educational

program, even if a different lender subsequently won origination rights at his or her school, or

students who had more than one lender could retain the right to consolidate all their loans. Less

frequent auctions could also improve service quality by facilitating long-term relationships

between lenders and schools. The more frequently auctions were held, the more likely it would

be that a school would have to change lenders, especially if each auction had only one winning

lender per school.

Grouping

It is possible that auctioning origination rights or loan volume for small groups of schools would

produce higher federal FFELP costs than auctioning rights or volume for larger groups or

conducting auctions without grouping schools. However, there is no information available to
APPENDIX III: TECHNICAL ASPECTS OF AUCTION DESIGN

Page 79

enable us to determine how likely this outcome would be. If the per-student cost of originating

loans declines as the number of students served increases, then it is less expensive for each

lender to serve a large number of students than to serve only a few students. Under these

conditions, total lender costs are lower when there are a few lenders, each of which serves many

students, than when there are many lenders, each of which serves a few students. Therefore,

federal payments to lenders would be greater when each of a large number of auction winners

served a small number of students than when each of a small number of winners served many

students. If schools were bundled into small groups when auctions were held, then it is possible

that the auctions would produce a large number of winning lenders, each of which would serve

relatively few students. This outcome could be less likely if schools were bundled into large

groups or if schools were not grouped at all. Thus, federal payments to lenders could be higher

the larger the number of school groups. For example, federal payments to lenders could be

greater if schools were grouped by state than if origination rights for all FFELP-eligible schools

were auctioned as a single package.

Likewise, it is possible that FFELP costs would be higher if multiple lenders were permitted to

serve each school than if there were only a single lender for each school. Once again, there is no

information available to enable us to determine the likelihood of this outcome. As the previous

paragraph showed, it is possible that federal payments to lenders would be greater if each of a

large number of auction winners served a small number of students than if each of a small

number of winners served many students. If many lenders were allowed to serve students at

each school, then there could be a large number of winning lenders, each of which served

relatively few students. This outcome could be less likely if only one lender were allowed per

school. Federal payments to lenders could be greater with multiple lenders per school than with

a single lender per school.

How schools were grouped together in the auctions would be likely to affect the distribution of

federal payments to lenders. If schools were not grouped or if the characteristics of each group

of schools resembled those of FFELP-eligible schools as a whole, then the distribution of those

payments would probably be similar to what it is at present. However, if schools in each group

were similar to one another but different from those in other groups, then lenders would bid more

for the right to originate loans in the groups they perceived as more desirable (for example, those

with higher per-student loan amounts and lower default rates) than for the right to originate in

ìless desirableî groups. Federal payments to lenders who won origination rights in the ìless

desirableî groups would then be greater than federal payments to lenders who won rights in the

ìmore desirableî groups. The resulting pattern of unequal federal payments to lenders would

give the federal government better information about the costs of lending to students at different

schools, but in so doing it could also lead to an erosion of political support for FFELP. A similar

pattern of unevenly distributed federal payments to lenders would likely result if lenders were

allowed to define their own groups of schools when they bid. If lenders defined their own

groups of schools, they would probably group schools according to such characteristics as perstudent loan amounts and default rates.

Students in low-income regions, from low-income families, or attending proprietary vocational

schools could lose access to loans if Education grouped similar schools together or allowed
APPENDIX III: TECHNICAL ASPECTS OF AUCTION DESIGN

Page 80

lenders to define their own groups of schools. In a volume procurement auction, those types of

students could lose loan access if winning lenders were allowed to choose the students to whom

they would lend. Lenders would be likely to consider those kinds of students as presenting

especially high default risks. If they were allowed to, some lenders might refuse to lend to

students with those characteristics or to bid on groups of schools that served such students. If

similar schools were grouped together or if lenders were permitted to group schools themselves,

then groups of schools that lenders perceived as serving students with high risks of default (for

example, schools with very high student loan default rates) might attract no bids. In a volume

procurement auction in which winning lenders were permitted to choose their borrowers, lenders

might refuse to lend to students at those schools.

Ability to Pay

Auctions that involve payments to a government entity by a successful bidder for specified

rights, as opposed to offering an interest rate, would require rules to ensure that bidders were

able to pay the amounts they bid. Without such rules, nonserious bidders could distort

competition. Other federal auctions provide examples of rules that could be adopted in an

origination rights auction. EPA requires each bidder in its sulfur dioxide emission allowance

auctions to send a certified check or letter of credit to cover its bid before the auction, or else to

specify a method of electronic transfer or other payment method. (This rule is feasible only for

sealed-bid auctions, in which each bidder submits a single bid.) FCC requires bidders in its

wireless spectrum auctions to submit refundable deposits to cover the cost of placing bids. A

final option, not used in any federal auction, is to require all potential bidders to show some

evidence of their ability to pay. One way of implementing this option is to use FFELP eligibility

criteria as evidence of ability to pay. Another alternative is to require FFELP-eligible lenders to

pass additional ability-to-pay tests before allowing them to participate in the auction.

Federal costs could depend on whether winning bids are payable in full immediately after the

close of the auction or whether a schedule of installment payments is allowed. Installment

payments enable small bidders to participate more easily. Small bidders would have to come up

only with a down payment rather than with the full purchase price, enabling bidders with less

funding to compete with better funded large bidders. However, allowing loan purchasers to pay

in installments could result in winning bidders not paying off the installments. When FCC

allowed some spectrum auction winners to pay their bids in installments, it experienced many

defaults by auction winners. This raised a related issue of who owns the auctioned item (student

loans) if the purchaser declares bankruptcy. In the case of wireless spectrum rights FCC

auctioned, bankruptcy of winning bidders has left the disposition of the auctioned item to be

determined by a bankruptcy court. Solving this issue with respect to student loan packages

before implementation will enable Education to reclaim and resell such loans in subsequent

auctions.

Small Bidders

Some federal auctions use several methods of ensuring small biddersí access. In its auctions of

federal debt, Treasury allows small buyers not to participate in the auction and to agree in
APPENDIX III: TECHNICAL ASPECTS OF AUCTION DESIGN

Page 81

advance to buy a limited, pre specified amount of debt at the price that emerges from the auction.

(Of course, only a small minority of buyers could use this option. If many buyers decided to use

it, then the auctions would have few bidders and would not work properly.) Treasury also

imposes a 35 percent limit on the market share of any winning bidder. FCC offers bidding

credits to small bidders. In addition, FCC formerly allowed auction winners to pay their bids in

installments, but this policy resulted in many defaults by auction winners. Independent of its

annual auction, EPA gives electric power plants some sulfur dioxide emission allowances for

free.41 In the early years of its auctions, EPA also sold allowances at a fixed price outside

auction. However, the price it set turned out to be much higher than the market price, and it later

abandoned this practice.

Evidence from the FCC wireless spectrum auctions suggests that small-bidder protections can

make auctions more competitive. In some early auctions, FCC gave preferential treatment to

certain categories of bidders (such as women-owned and minority-owned businesses) for certain

types of licenses. This policy intensified bidding competition among the nonpreferred bidders.

At the same time, preferred bidders bid more for the licenses that were subject to the preferences

than nonpreferred bidders would have been willing to pay for the same licenses. The preferences

increased auction revenues.

Commercial Paper Versus Treasury Rates

FFELP costs could be lower if the maximum borrower interest rate were based on the CP rate

than if it were based on the 91-day T-bill rate. Under current law, the maximum borrower

interest rate is based on the 91-day T-bill rate and the lenderís cost of funds is based on the CP

rate. The relationship between the 91-day T-bill rate and lendersí cost of funds is relatively

unstable. For this reason, federal payments to lenders that are based on the CP rate are more

valuable to lenders than federal payments that are based on the 91-day T-bill rate, for loans made

at the same predetermined interest rate. A convenient way of setting a predetermined lender

interest rate would be to set it equal to the borrower interest rate. Thus, if the borrower rate were

based on the CP rate, lendersí bids would be more favorable to the government than if the

borrower rate continued to be based on the 91-day T-bill rate. FFELP costs would be lower if

the basis for the borrower rate were changed to the CP rate.

 

41In addition to protecting small lenders, free distribution of some student loan origination rights before

auction could be a method of phasing in origination rights auctions.
Page 82

APPENDIX IV

DETAILS ON INCOME-CONTINGENT

REPAYMENT IN FDLP

THE RATIONALE FOR ICR

ICR gives borrowers the opportunity to repay student loans based on their income. One analyst

has stated that current economic conditions place a greater burden on borrowers than conditions

of previous eras did. Low inflation means that todayís graduates and borrowers will pay back, in

real terms, as much as 40 percent more than student loan borrowers who graduated in the 1970s

and 1980s. Graduates of earlier eras benefited from paying back their loans in cheaper dollars.

Current borrowers cannot depend on inflation to reduce their ìrealî debt burden. However,

todayís graduates may have higher inflation-adjusted postgraduation incomes than graduates of

the 1970s and 1980s. We are unable to determine whether todayís graduates face higher debt

burdens relative to their incomes than graduates of earlier eras. However, if todayís graduates do

face higher debt burdens than graduates of the 1970s and 1980s, and if it is believed that todayís

graduates should have the same debt burdens as graduates of those earlier decades, then a

properly designed and administered ICR plan can be justified as one way to reduce the burden

for todayís graduates. ICR allows some borrowers with low incomes or high debt burdens to

maintain a good credit rating by making lower monthly payments than they would have to make

under a standard repayment schedule. With the monthly installment payment based upon the

borrowerís income, it is also far more difficult in theory for the borrower to default. The

availability of ICR also expands the educational and occupational options for student borrowers.

It may be especially valuable for some borrowers who are in the early stages of their careers.

DATA ON ICR

The Student Loan Reform Act of 1993 expanded the range of loan repayment options available

under the federal student loan programs. Of interest to the study group on market mechanisms in

the student loan programs is the use of the various repayment plans available in FDLP, especially

the ICR plan. The use of the various repayment plans varies significantly by whether the loan

was a consolidation loan. Thus, we are providing an analysis of overall ICR usage in the Direct

Loan program as well as ICR usage among consolidation borrowers.

All Loans in Repayment

Nearly 2.7 million borrowers have loans in repayment under FDLP. They have loan amounts

totaling nearly $34 billion.42 Of the total loan amount, 31 percent is subsidized Stafford loans,

17 percent is unsubsidized Stafford loans, 11 percent is PLUS loans, and 41 percent is

consolidation loans.

 

42All information is as of May 31, 2000.
APPENDIX IV: DETAILS ON INCOME-CONTINGENT REPAYMENT IN FDLP

Page 83

Of the total amount in repayment,

56 percent is being repaid through the standard repayment plan,

20 percent is being repaid through the graduated repayment plan;

12 percent is being repaid through the extended repayment plan, and

2 percent is being repaid through ICR.

Roughly half of the loans being repaid under the ICR option require payments that are less than

the interest due on the loan. See tables 14 and 15.

Table 14: Direct Loan in Repayment by Loan Type

Loan Number of

borrowers

Percent of

total

borrowers

Principal balance

outstanding

Loan amount Average

loan amount

Percent

of total

loan

amount

Subsidized 1,501,329 56% $9,627,369,029 $10,431,517,693 $6,948 31%

Unsubsidized 932,386 35 5,861,802,639 5,694,855,988 6,108 17

PLUS 372,453 14 3,335,602,873 3,788,560,419 10,172 11

Consolidation 709,786 26 13,447,855,619 14,070,935,315 19,824 41

Totala 2,684,031 100% $32,272,630,160 $33,985,869,415 $12,662 100%

a

Unduplicated borrower count.

Table 15: Direct Loans in Repayment by Plan

 Repayment plan Number of

borrowers

Percent of

total

borrowers

Principal balance

outstanding

Loan amount Average

loan amount

Percent

of total

loan

amount

Standard 1,944,060 72% $17,315,051,937 $18,884,768,619 $9,714 56%

Graduated 402,876 15 6,757,482,096 6,729,516,982 16,704 20

Extended 149,703 6 3,981,172,966 4,116,109,476 27,495 12

Income contingent

repayment

193,289 7 4,041,457,111 4,049,233,342 20,949 12

Payments

greater than or

equal to interest

101,725 4 2,033,145,308 2,057,503,793 20,226 6

Payments less

than interest

91,564 3 2,008,311,803 1,991,729,549 21,752 6

Alternative plan 10,740 0 177,466,051 206,240,996 19,203 1

Totala 2,684,031 100% $32,272,630,160 $33,985,869,415 $12,662 100%

a

Unduplicated borrower count.

Consolidation Loans in Repayment

As shown in table 14, consolidations are more than 40 percent of the Direct Loan repayment

portfolio by loan amount. Education tracks this closely, as it allows borrowers to consolidate

defaulted loans for the purpose of obtaining an income contingent repayment arrangement.

Defaulted loans that are not being rehabilitated through the Direct Loan income contingent
APPENDIX IV: DETAILS ON INCOME-CONTINGENT REPAYMENT IN FDLP

Page 84

repayment or another reasonable and affordable plan are normally pursued and collected by

collection agencies contracted by Educationís Debt Collection Service (DCS).

Nearly 710,000 borrowers have consolidation loans in repayment totaling more than $14 billion

in original loan amounts. Almost all (95 percent) of the $14 billion in original loan amounts are

ìregularî consolidation loans. The remaining 5 percent represent loans previously held by DCS.

See table 16.

Of the total consolidation amount in repayment (table 17)

29 percent is being repaid through the standard repayment plan,

27 percent is being repaid through the ICR plan.

22 percent is being repaid through the graduated repayment plan, and

20 percent is being repaid through the extended repayment plan.

Roughly half of the loans being repaid under ICR require payments totaling less than the interest

owed on the loan. See tables 16 and 17.

Table 16: Source of Direct Consolidation Loans in Repayment

Consolidation

type

Number of

borrowers

Percent of

total

borrower

count

Principal balance

outstanding

Loan amount Average

loan

amount

Percent

of total

loan

amount

Regular

consolidation

loans

598,715 84% $12,762,306,108 $13,362,649,377 $22,319 95%

Defaulted loans

formerly held

by DCS

112,135 16 684,081,869 706,738,859 6,303 5

Totala 709,786 100% $13,446,387,978 $14,069,388,236 $19,822 100%

a

Unduplicated borrower count.

Table 17: Direct Consolidation Loans in Repayment by Plan

Repayment plan Number of

borrowers

Percent

of total

borrower

count

Principal

balance

outstanding

Loan amount Average

loan

amount

Percent

of total

loan

amount

Standard 301,817 43% $3,729,080,437 $4,145,517,660 $13,735 29%

Income contingent

repayment

182,178 26 3,816,246,780 3,834,087,757 21,046 27

Payments less

than interest

87,383 12 1,923,399,764 1,936,038,142 22,156 14

Payments

greater than or

equal to interest

94,795 13 1,892,847,016 1,898,049,615 20,023 13

Graduated 137,190 19 3,053,074,468 3,101,952,324 22,611 22

Extended 84,028 12 2,730,481,991 2,852,202,918 33,943 20

Alternative plan 5,337 1 117,197,409 135,216,042 25,336 1

Totala 709,786 100% $13,446,081,085 $14,068,976,702 $19,821 100%

a

Unduplicated borrower count.
APPENDIX IV: DETAILS ON INCOME-CONTINGENT REPAYMENT IN FDLP

Page 85

Of the loans being repaid through income-contingent repayment (see the 193,289 borrowers in

table 15). Ninety-four percent are consolidation loans (see the 182,178 borrowers in table 17).

Of the consolidation loan amounts previously held by DCS, 11 percent are in ICR. Of the

regular consolidation loan amounts, not previously held by DCS, 28 percent are in ICR. See

tables 18 and 19.

Table 18: Direct Consolidation Loans in Repayment by Plan: Defaulted Loans Formerly Held

by DCS

Repayment

plan

Number of

borrowers

Percent of

total

borrowers

Principal balance

outstanding

Loan amount Average

loan

amount

Percent

of total

loan

amount

Standard 63,550 57% $318,715,398 $343,082,099 $5,399 49%

Graduated 29,748 27 216,876,576 216,141,878 7,266 31

Income

contingent

repayment

11,778 11 80,719,328 77,778,778 6,604 11

Extended 6,905 6 66,899,517 68,730,851 9,954 10

Alternative plan 10 0 40,742 45,933 4,593 0

Totala 112,135 100% $683,251,561 $705,779,539 $6,294 100%

a

Unduplicated borrower count.

Table 19: Direct Consolidation Loans in Repayment by Plan: Regular Consolidation of

Non-DCS Loans

Repayment

plan

Number of

borrowers

Percent of

total

borrowers

Principal

balance

outstanding

Loan amount Average

loan

amount

Percent of

total loan

amount

Standard 238,397 40% $3,409,473,808 $3,801,485,419 $15,946 29%

Graduated 77,204 13 2,663,424,434 2,783,316,598 36,051 21

Income

contingent

repayment

107,603 18 2,835,914,828 2,885,506,253 26,816 22

Extended 170,798 29 3,735,395,565 3,756,175,778 21,992 28

Alternative plan 3,523 1 89,756,731 103,761,954 29,453 1

Totala 598,715 100% $12,733,965,367 $13,330,246,002 $2,265 100%

a

Unduplicated borrower count.

ICR Usage Under FDLP

Although the ICR option appears to be more expensive for many borrowers over the full

repayment term than, for example, the standard repayment plan, no ICR borrower ìoverpaysî

interest because the current plan has been established without an internal cross-subsidy.

Analyses of possible repayment options, as well as contemporary repayment calculators that are

provided to aid borrowersí choices among various repayment plans, are typically described in

total dollars rather than in terms of the net present value of those dollars. This can make ICR

seem to be more expensive for borrowers than it really is. Some observers believe that this

illusory high-interest cost of ICR has discouraged financial aid administrators from urging
APPENDIX IV: DETAILS ON INCOME-CONTINGENT REPAYMENT IN FDLP

Page 86

borrowers to consider choosing it. Also, these analyses and repayment calculators at best can

only assume, and cannot predict, a borrowerís future income. Such projections have typically

specified the historical income growth for college graduates (on average, 5 percent annually).

However, ICR is more valuable to borrowers with a flatter income trajectory. The fact that ICR

usage has not approached initial projections does not mean that ICR should be discarded. While

the currently operational ICR plan may in fact be relatively unattractive to many borrowers,

financial aid administratorsí poor familiarity with it has certainly affected its take-up rate.

MONTHLY PAYMENT CALCULATION

FOR LOANS IN ICR

The monthly payment calculation under ICR is the lesser of

the principal balance and AGI based calculation or

20 percent of the borrowerís discretionary income. These two calculations are explained

below.43

Principal Balance and AGI-Based Calculation

The monthly payment is the amount the borrower would repay annually over 12 years, using

standard amortization multiplied by an income percentage factor based on the borrowerís or

coupleís AGI and whether the borrower is single or married and head of the household:

12-year standard amortization =

 (principal balance)(monthly interest rate)/[1 (monthly interest rate + 1)-n].

The monthly interest rate is equal to the annual interest rate divided by 12, and n is the number of

months remaining in the repayment term.

For this calculation, the principal balance is the original principal balance plus any capitalized

interest when the borrower first entered repayment. This amount remains static except for the

following situations:

1. Reporting new disbursements, disbursement adjustments, and cancellations. The principal

balance is adjusted to reflect these changes.

2. A new loan is received after the new loan has entered repayment. In this situation, the

principal balance is the principal balance of the new loan when the loan first entered

repayment plus any capitalized interest when the borrower first enters repayment plus the

outstanding principal balance on the existing loans (including capitalized interest) plus

outstanding accrued interest, collection charges, late charges, and any other charges.

3. Borrowers request joint repayment. In this situation, the principal balance is recalculated on

the basis of the borrowerís combined outstanding principal balance when the borrower enters

 

43See also ìExamples of the Calculations of Monthly Repayment Amounts,î published annually in the Federal

Register, most recently at 65 Fed. Reg. 34,006 (25 May 2000).
APPENDIX IV: DETAILS ON INCOME-CONTINGENT REPAYMENT IN FDLP

Page 87

joint repayment plus any capitalized interest when the borrower first enters repayment plus

the outstanding principal balance on the existing loans (including capitalized interest) plus

outstanding accrued interest, collection charges, late charges, and any other charges.

4. For purpose of the annual recalculation of the payment amount when new income

information is received, after periods in which a borrower makes payments that are less than

interest accrued on the loan. In this situation, the principal balance is the highest outstanding

principal balance (including amounts capitalized) calculated for the borrower while paying

under the ICR plan if this amount is higher than the original principal balance when the loan

first entered repayment, plus any capitalized interest.

The monthly payment calculation is principal based and AGI based monthly payment = (12-year

standard amortization * income percentage factor).

The income percentage factor is obtained from a table published annually by the Secretary in the

Federal Register.

44 If the borrowerís exact AGI is not found in the table, the income percentage

factor is obtained by linear interpolation between the next higher and next lower AGIs. The

linear interpolation method calculates the income percentage factor on the basis of intervals

between the incomes and income percentage factors on the table.

20 Percent of the Borrowerís

Discretionary Income

The borrowerís discretionary income is calculated on the basis of poverty guidelines provided by

the U.S. Department of Health and Human Services (HHS): discretionary income = AGI 

poverty guideline. Thus, the monthly payment calculation is discretionary income monthly

payment = (discretionary income * 0.20)/12.

Treatment of Married Borrowers

Not in Joint Repayment

For a married borrower to be eligible for ICR, the borrowerís income information and the

borrowerís spouseís income information are required, even if the spouse files a separate tax

return. Thus, both spouses are required to sign the IRS consent form. In addition, both spouses

are required to provide the same required income type, AGI, or alternative documentation of

income. If both spouses have direct loans and are in joint repayment, the servicer refers to the

borrower who has the most recent in-school period to determine income type.

If the borrower is separated from the borrowerís spouse, the borrower is not required to provide

the spouseís income. The borrower is required to send the servicer a self-certifying statement

that indicates the change in marital status. If the borrower is separated and the borrower filed a

joint income tax return, the borrower may submit alternative documentation of income for only

the borrower.

 

4465 Fed. Reg. 34, 007 (25 May 2000).
APPENDIX IV: DETAILS ON INCOME-CONTINGENT REPAYMENT IN FDLP

Page 88

Treatment of Married Borrowers

in Joint Repayment

Married borrowers may choose to repay their loans jointly under ICR. The decision to repay

jointly under ICR does not make each borrower liable for the otherís direct loan debt. Joint

repayment is used as a method to determine the borrowersí monthly repayment amounts. In

order to be eligible, both borrowers are required to request joint repayment on the Repayment

Plan Selection Form. The payment amount is based on the borrowersí combined outstanding

direct loan debt and the borrowersí combined income when the servicer calculates the

borrowersí joint repayment amount. The borrowersí individual payment amount is determined

so that each payment amount is proportionate to each personís level of debt. When payments are

applied in any joint repayment situation, they should be applied to interest on both borrowersí

accounts before they are applied to principal on either account. This helps avoid negative

amortization on either account. Obviously, if payments are not high enough to cover interest on

both accounts, there will be negative amortization. In cases in which both spouses choose joint

repayment and the loans are serviced at different servicers, one of the borrowerís loans will be

transferred.

If the servicer holds the loans of only one borrower and the borrower is selecting ICR for the first

time and wants to repay jointly, the servicer should wait until the spouseís loans are transferred

before calculating the joint repayment amount. Therefore, the borrower should be put on interest

billing, even if the servicer has income information for borrower and spouse. The borrower

should be left on interest billing until the spouseís loans are transferred.

Married borrowers may select joint repayment, even if they filed their taxes separately. The ICR

plan does not assume that a borrowerís AGI is proportionate to his or her debt. A joint payment

amount is calculated on the basis of the combined AGI and combined debt amounts. The

borrower receives a bill for the portion of the joint payment amount that is proportionate to the

borrowerís individual debt.

ALTERNATIVE DOCUMENTATION OF INCOME

The servicer is required to collect alternative documentation of income for the first year a

borrower is in repayment and for certain borrowers for the second year.45 All married borrowers

must submit alternative documentation of income for their spouses, unless the borrower is

separated from the borrowerís spouse. If the borrower has been in repayment for more than a

year, the servicer must determine whether the AGI data or alternative documentation of income

should be used to calculate the ICR monthly repayment amounts.

 

45Documentation supporting the borrower's income can be in the form of a pay stub, a dividend statement, or a

canceled check. If these types are not available, the borrower can provide a signed statement that explains each

income source and provides its address. If the borrower provides the servicer with other forms of supporting

documentation, the servicer determines whether the documentation is acceptable at its own discretion, with guidance

from Education's On-Site Monitor. Supporting documentation of alternative documentation of income cannot be

older than 90 days.
APPENDIX IV: DETAILS ON INCOME-CONTINGENT REPAYMENT IN FDLP

Page 89

The servicer collects alternative documentation of income from borrowers if the borrowerís AGI

from IRS would be likely to reflect any period of time in which the borrower was in school. If

AGI data do not represent an in-school period, the servicer uses the AGI data from IRS to

calculate the monthly payment amount. If the borrower receives an in-school deferment, the

servicer does not consider the time of the in-school deferment as an in-school period. In

situations in which the borrower has multiple loans with the servicer, if any of the loans require

alternative documentation of income, the borrower is required to provide alternative

documentation for all the loans.

If the borrower is not required to submit alternative documentation of income, the servicer

calculates the borrowerís monthly payment amount using the borrowerís AGI data from IRS.

However, the servicer collects alternative documentation of income in situations in which IRS

cannot provide the servicer with valid income information or if the borrowerís reported AGI

does not reasonably reflect current income. The servicer accepts the borrowerís alternative

documentation for the following situations:

the borrower has lost or changed employment or is undergoing some other special

circumstances,

the borrower did not file a sufficiently recent tax return,

IRS provided income information but not currently enough to determine the payment

amount, or

IRS did not provide AGI data during the first AGI solicitation and the borrower did not

request the servicer to re-solicit IRS.

In addition to these situations, the servicer can use alternative documentation of income from the

borrower even when IRS is processing a request for AGI data or if AGI data are received from

IRS. However, alternative documentation of income cannot be submitted or solicited solely to

reduce the amount of time a borrower is assigned ICR interest-only monthly payments. The

guideline is to be used only if the alternative documentation most accurately reflects the

borrowerís current ability to repay the loan. If the servicer has both current AGI and alternative

documentation of income, the servicer uses the alternative documentation of income to calculate

the monthly repayment amount, unless the borrower requests otherwise.

If a borrower and the borrowerís spouse have chosen to repay their Direct Loans jointly, the

servicer refers to the spouse who most recently left in-school status in order to determine

whether AGI or alternative documentation of income should be solicited.

ANNUAL INCOME INFORMATION RENEWAL

Each year, the servicer renews the borrowerís income information, either by soliciting AGI data

from IRS with the taxpayerís consent or by receiving updated alternative income information

from the borrower. The servicer begins the annual income renewal process at the end of August.

The servicer does not request updated income information if the servicer has received income

information from the borrower within the past 6 months. For example, if the borrower entered
APPENDIX IV: DETAILS ON INCOME-CONTINGENT REPAYMENT IN FDLP

Page 90

repayment under ICR in March 1999, the servicer would not have renewed the borrowerís

annual income until August 2000.

If the borrowerís loans require renewal of income information, the servicer must determine

whether the borrower is required to submit alternative documentation of income or whether AGI

data from IRS can be used. Valid AGI data cannot reflect an in-school period. If AGI data

reflect an in-school period, the servicer uses alternative documentation of income to recalculate

the monthly payment.

Renewal for Borrowers Who Require AGI

At the end of August each year, the servicer attempts to solicit IRS for AGI data for the borrower

and spouse. If the servicer cannot obtain the AGI data, the servicer asks the borrower to submit

alternative documentation of income. Alternative documentation is acceptable to recalculate the

payment amount if the AGI data are not obtained from IRS or if the AGI data do not accurately

reflect the borrowerís current income. Once the servicer receives updated income information,

the servicer recalculates the borrowerís monthly payment amount. After the recalculation, the

servicer discloses the borrowerís new monthly payment amount.

If the servicer does not receive updated income information from IRS, or the alternative

documentation of income form and supporting documentation from the borrower by the end of

the calendar year, the servicer removes the borrower from the ICR plan. The servicer reverts the

borrowerís loans to the standard repayment plan, or to the borrowerís previous repayment plan if

the borrower switched to ICR from another repayment plan.

Renewal for Borrowers Who Require

Alternative Documentation of Income

For borrowers required to submit alternative documentation of income, the servicer asks at the

end of August each year for the alternative documentation of income form and supporting

documentation for income renewal purposes. The servicer uses the AGI data from IRS to verify

the borrowerís previous yearís alternative documentation of income information.

If the servicer does not receive the form and supporting documentation from the borrower by the

end of the calendar year, the servicer removes the borrower from the ICR plan. The servicer

reverts the borrowerís loans to the standard repayment plan or to the borrowerís previous

repayment plan if the borrower switched to the ICR plan from another repayment plan.

IRS Consent Form

Before the servicer is able to solicit AGI data from IRS, the borrower and the borrowerís spouse

must provide the servicer with a valid and signed IRS Consent to Disclosure of Tax Information

form. A married borrower is not eligible for ICR without an IRS consent form with both

spousesí signatures and IRS validation of the form. When the servicer receives the form, the
APPENDIX IV: DETAILS ON INCOME-CONTINGENT REPAYMENT IN FDLP

Page 91

servicer ensures that the borrower and spouse have correctly completed it. If the form is

incomplete, the servicer either sends an imaged copy of it with a new consent form or retrieves

the original consent form and sends it to the borrower and spouse to complete. The borrower and

spouse must either complete a new consent form in its entirety and submit it to the servicer or

complete the original consent form and submit it to the servicer.

Once the servicer receives a completed IRS consent form, the servicer images the borrowerís

IRS consent form and passes the image to IRS within 3 business days. If the form is invalidó

for example, if IRS receives the image of the form more than 60 days after the date when the

borrower signed the formóIRS rejects it. If IRS rejects the form, the servicer requests the

borrower to submit an updated form.

When IRS initially validates the form, the form is valid for 5 tax years. The 5 tax years are

defined on the IRS consent form. Any subsequent renewals of the forms are also valid for 5 tax

years.

Solicitation for IRS Consent Form Renewals

IRS consent form renewals are solicited in December of the year following the last covered tax

year indicated on the form. For example, at the end of December 2000, the servicer has to begin

the renewal cycle for all IRS consent forms that expired after the 1999 tax year. If the servicer

does not receive a new IRS consent form from the borrower, the servicer requests an IRS consent

form at least two additional times before the end of June. If the borrower does not provide an

updated form, the servicer does not solicit updated AGI data in August. The servicer removes

the borrower from the ICR plan the December following the initial renewal attempt if the

borrower does not provide the servicer with an updated IRS consent form and if updated income

information is not received.

If the borrower voluntarily revokes the IRS consent form, the servicer immediately removes the

borrower from the ICR plan. If the borrower does not choose a new repayment plan, the servicer

notifies the borrower that the servicer placed the borrower on the standard repayment plan.

Treatment of Married Borrowers

A married borrower is required to have his or her spouseís consent authorizing IRS to disclose

tax information for the purpose of determining the borrowerís AGI. The servicer requires both

spouses to sign the IRS consent forms in order for a married borrower to participate in the ICR

plan. Both spouses must sign the IRS consent form, even if the couple filed a joint tax return.

Both signatures are required for all married borrowers, unless they are separated.

Soliciting AGI Data From IRS

The servicer solicits IRS for AGI data once a month. The servicer solicits the AGI data from

IRS for a particular borrower either when initial or renewal AGI data are required. Depending

on the AGI data sent by IRS, the following three situations could occur:
APPENDIX IV: DETAILS ON INCOME-CONTINGENT REPAYMENT IN FDLP

Page 92

IRS mismatch. IRS is unable to recognize the borrowerís or spouseís Social Security

number or name as provided by the servicer.

No AGI data. The borrower or spouse did not file a tax return the previous year covered by

the IRS consent form, or IRS provided outdated (or invalid) AGI data, because sufficiently

current data were not available.

The servicer receives sufficiently current AGI data. IRS provides the borrowerís or spouseís

current AGI data.

If IRS cannot provide the servicer with AGI data because of a mismatch, no AGI data are

available, or IRS sent outdated AGI data, the servicer only resolicits IRS for AGI data on the

borrowerís request. (The borrower is permitted to request that the servicer resolicit IRS for AGI

data at any time.) If IRS cannot provide income information, the servicer requests alternative

documentation of income from the borrower. When the servicer receives valid AGI data from

IRS, the servicer calculates the borrowerís monthly payment amount on the basis of the AGI.

Eligible AGI Data and Alternative Documentation

 for Borrowers Entering ICR

AGI data used to calculate the repayment amount must be current data. Prior or next-prior

calendar year AGI data (or both, for a married borrower and spouse) from IRS are acceptable if

received before August 31 for borrowers entering ICR who are required to provide AGI data.

For information received after August 31, the servicer accepts only prior-year AGI data from the

IRS. For example, 1998 or 1999 AGI data are acceptable if the servicer received the information

from IRS before August 31, 2000. If the servicer received the information after August 31,

2000, only 1999 AGI data were acceptable. If the borrower submits alternative documentation

of income, the only requirement is that the supporting documentation not be older than 90 days.

If married borrowers have income information from two different tax years, the servicer

designates the most current tax year to the income data.

Substitution for AGI Data

The servicer can accept a signed tax return with accompanying required documentation (for

example, W-2 forms or 1099 forms) from the borrower as proof of AGI data, if the servicer

cannot obtain the data from IRS. A signed tax return from the borrower cannot be considered

alternative documentation of income but may be used temporarily to calculate the borrowerís

monthly payment. If the servicer receives a signed tax return from a borrower, the servicer

attempts to recollect AGI data from IRS, using the signed tax return as proof that valid AGI data

exist for the borrower. If the servicer continues not to be able to obtain AGI data from IRS, the

servicer collects alternative documentation of income from the borrower to recalculate the

borrowerís monthly payment amount.
Page 93

APPENDIX V

 CALL OPTIONS AS A MECHANISM

 FOR DETERMINING NET LENDER YIELDS

Competitive forces in the market could help establish lender yield on loans and remove any

ìexcessî lender profits through the inclusion of a ìcall optionî on all new FFELP loans. The call

option would give the federal government the right to ìbuyî the FFELP loan within a specified

time period at a predetermined price (ìexercise priceî) set by legislative formula. The exercise

price would be set when the loan originates and would include consideration for a lenderís cost

in making the loan.

Within the specified time period, the government would auction the call option (the right to buy

the loan). FFELP lenders willing to pay the highest positive value to the government for the

option would receive the right to purchase the loan at the predetermined exercise price. The

government would receive the bid price on the option. If lenders were unwilling to bid a positive

value for the option, the federal government could purchase the loan at the exercise price or the

originator would keep the loan.

The call option model uses competitive secondary market forces to determine the value of a loan.

In determining whether and how much to pay for the call option, buyers review the expected

value of the loan (including special allowance payments, interest payments, and so on) relative to

the exercise price. When the expected value exceeds the exercise price, potential buyers would

be likely to bid positive amounts for the option.

Assume solely for illustration that origination costs were 1 percent of the loan amount. The

exercise price would be 101 percent of the face value of the loan and would just compensate the

originator for expenses. If the estimated income from the loan for the time it would be held were

worth more to the originator, or to other potential loan holders, than 101 percent of the face

value, then the option would have a positive value. The governmentís selling the option would

recoup those excess returns.

EFFECT ON PROGRAM STRUCTURE

Under this mechanism, most aspects of FFELP could remain unchanged. As is generally true of

the other models discussed in the body of the report, the federal government could provide

special allowance payments if deemed desirable as an addition to the lendersí return from a

maximum statutory student interest rate, and loans would remain guaranteed lenders. Lenders

would originate and service loans, and schools and borrowers could continue to choose their loan

originator. Additionally, loan originators could continue to compete for loan volume through

decreased interest rates and fees to students.
APPENDIX V: CALL OPTIONS AS A MECHANISM FOR DETERMINING NET LENDER YIELDS

Page 94

EFFECT ON BORROWERS

Financial benefits to students would remain unchanged or might increase under this model. It is

unlikely that benefits to borrowers would decrease, because concessions by lenders would be a

way of getting additional business; they would not be required to bid in advance for the

additional loans. The concession to borrowers would diminish the likelihood that they would

have to bid for the option to retain the loan.

The model could permit differential concessions to student borrowers but would not require

differential student rates to ensure loan availability. Availability of loans to all borrowers could

be assured in one of several ways: (1) The special allowance payments and interest rates would

provide a return adequate to service the most-expensive-to-service loans, (2) The government

could exercise the options on loans expensive to service and resell the loans at a loss, or (3) This

model could be supplemented (as suggested for other models discussed above) by a lender of last

resort or administrative requirements on FFELP lenders.

In a completely private exchange market, all options would not be sold for the same price, even

apart from discounts to students. Because some loans are cheaper to service than others, as

discussed earlier in this report, it would be expected that options on these loans would sell at a

higher price. Where the government is on one side of the transaction, it would be desirable to

bundle options by loan characteristic in order to allow for price variations to parallel these cost

variations. The same issues of design of option bundles would emerge as would arise in the

rights auction model. The possibility of private transactions and bundling of government sales

could mean that, unlike the current system in which special allowance payments provide a onesize-fits-all gross return, this option model could produce more efficient incentives of all types of

loans, without necessitating excess net returns for cheap-to-service loans.

BUDGETARY EFFECT

While it is unclear whether the government would realize any budgetary savings under this

model, federal costs are not expected to increase. Any potential excess lender profits after the

exercise date of the options would either be provided to students in the form of discounts or

recouped by the federal government in the option price.

EFFECT ON LENDERS

The model would likely decrease or maintain existing lender returns in the aggregate. It is

unlikely that overall lender returns would increase. Rather, if bundling of options by loan

characteristics could be done effectively, the model would foster an environment where income

would more closely match the characteristics of the loan. Loans with higher servicing costs

(lower estimated value) would demand lower call option prices.

The originator of a loan might have a slight advantage in bidding on the options, because he or

she would not bear the burden of exercising the options and loading the loans on his or her own,

different loan servicing system. Combined with existing arrangements through which lenders
APPENDIX V: CALL OPTIONS AS A MECHANISM FOR DETERMINING NET LENDER YIELDS

Page 95

essentially extend a line of credit to students for their course of study at a particular school, this

advantage would tend to keep a studentís loans with a given servicer. This would be efficient for

both servicer and student. The existing possibilities for loan consolidation also need not be

disturbed in this model.

MODEL CONSIDERATIONS

One key component of this program would be the call option exercise priceóthat is, the price at

which the government would have the right to acquire the loans. It should be established near

the cost to originate student loans. If the exercise price were too low, loan originators would not

participate. If the exercise price were too high, there would not be bidders for the options. The

government would be required either to let them expire (leaving loans with the originators, who

might earn an excess return) or to exercise the option and resell the loans at a loss (albeit,

probably a small loss unless the error on the exercise price was quite large).

The costs related to loan origination are very similar among all student loans, regardless of

delinquency or balance. Measuring the cost of origination would require obtaining information

that is readily available about certain fixed and variable costs. The origination allowance built

into the exercise price could be a fixed amount of dollars per loan plus a percentage of the

borrowerís principal balance. Because many originators of student loans are not the ultimate

holders, contracts with secondary marketers could also provide a source of information on

origination costs. In contrast, when the Congress (or its designee) is evaluating the net return

associated with a given SAP, it must measure a wide range of lender costs: servicing costs over

the likely 10-year life of loans, the effects of differing loan balances, the likelihood of default

costs, and the likelihood that loans will be prepaid or consolidate. It should be much easier to

determine the market cost of originating student loans than to determine the market rate of return

for loans over their life, taking these other costs into account.

Another key design decision involves determining the call option availability period (the time

when the option can be exercised). Lender uncertainty regarding the option could be

considerably reduced if the option first became effective near the time when originators now

most frequently sell many student loans. This might be just as the loan entered repayment.

Alternatively, the effective period for the option might be set earlier, if it were thought that a

substantial portion of any excess profits on loans were received early in the life of the loan. In

either case, it would seem desirable for the option to have a fixed expiration date, without an

excessively long window in which it could be exercised.
Page 96

APPENDIX VI

ADDITIONAL AND DISSENTING VIEWS

FROM RENE CHAMPAGNE

This appendix presents an additional and dissenting view submitted by study group member

Rene Champagne in accordance with section 801(d) of the Higher Education Amendments of

1998.

Received by e-mail December 12, 2000.

I am particularly concerned with any proposal that attempts to segregate federal student

loans by type of student or by type of institution because of the inherent opportunity for

discrimination provided under such formulas. Title IV programs have been created by

Congress to insure equal access to postsecondary education for all students regardless of

race, ethnic background, gender or income level assuming the student met certain

eligibility standards applied uniformly to all students. The same holds true for

institutions. Congress has made it very clear that they will not tolerate the segregation of

institutions reflected but their support of Historically Black Colleges, Career Colleges

and Schools and Community Colleges as well as traditional four-year institutions. I fear

segregation by student type and institution type as contained in certain proposals borders

on ìredliningî and therefore must be avoided. ìBlendedî portfolios must continue to be

used in the future to insure that all students are properly afforded equal access to the

institution of their choice.
Page 97

APPENDIX VII

ADDITIONAL AND DISSENTING VIEWS

FROM MICHAEL HERSHOCK AND RICHARD PIERCE

This appendix presents an additional and dissenting view submitted by study group members

Michael Hershock and Richard Pierce in accordance with section 801(d) of the Higher Education

Amendments of 1998.

January 16, 2001

Dear Reader:

Attached is a paper entitled ìToday's Competitive Loan System Is Already Filled with

Market Mechanisms,î prepared in our capacity as Members of the Market Mechanisms

Study Group. We were assisted in the preparation of the paper by Harrison Wadsworth

of the Education Finance Council.

We have requested that this paper be appended to the report of the study group because

we believe that the paper presents a viewpoint that is not thoroughly explored in the body

of the study group report. It is our hope that this paper will assist readers in better

understanding the market forces currently at work in the Federal Family Education Loan

Program.

The presentation of this paper is not intended as a dissenting view, nor should its

presence in the report's appendix be interpreted as representing any particular

characterization of the study group report.

Michael H. Hershock Richard H. Pierce

President and CEO President and CEO

Pennsylvania Higher Education Maine Education Services

Assistance Agency
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM MICHAEL HERSHOCK AND RICHARD PIERCE

Page 98

Today's Competitive Loan System Is Already Filled With

Market Mechanisms

A proposal prepared for the Study Group On

Market Mechanisms In Federal Student Loan Programs

Prepared by: Richard H. Pierce

President and CEO

Maine Education Services Corp.

Michael H. Hershock

President and CEO

Pennsylvania Higher Education Assistance Agency

Harrison M. Wadsworth

Deputy Executive Director

Education Finance Council

May 5, 2000
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM MICHAEL HERSHOCK AND RICHARD PIERCE

Page 99

Today's Competitive Loan System Is Already Filled With Market Mechanisms

We recommend that one of the three or more systems of market mechanisms

included in the General Accounting Office/Department of Education report to Congress

under Section 801 of the Higher Education Amendments of 1998 should be the current

student loan system. The current system involves intense competition for business

among thousands of private organizations, with additional competition from state

government agencies and the federal Direct Loan program.

Under any scenario that preserves the basic mission of the Higher Education Act,

Congress will always be involved in setting prices for at least some segments of

borrowers. We believe the alternative is unacceptable ó reducing access to higher

education for students. Today's prices are ceilings, which Congress could lift if it

wished. Given the level of competition, prices of loans for most borrowers might not

rise. Prices for some categories of borrowers probably would ó such as borrowers

attending high-default schools with low loan balances. Any federally supported student

loan system will always have intensive Congressional oversight. No system is perfect.

Imperfection will always invite attempts at improvement by lawmakers and

administrators.

Market mechanisms currently exist in every aspect of the FFEL Program.

Loan origination: Lenders compete to offer schools the fastest, most efficient,

most reliable origination of loans. Students demand this, and school financial aid

administrators in turn also demand the best quality service. Loan delivery must be

accomplished within hours of the receipt of an application. Anything more will send

students and schools elsewhere. A characteristic of the FFEL Program is that there are

many alternatives. Once a school has entered direct lending, the only choice if there

are service problems is to convert to FFELP, a process that requires the school to

forsake the investment it has made in systems that process direct loans. The federal

government should not take steps to make FFELP more like direct lending, winnowing

participation down to a few huge players offering basically the same products, leaving

schools and borrowers with few choices.

Loan Servicing: Private lenders must follow due diligence procedures in

servicing loans or they lose the 98% federal guaranty. Some lenders, such as EFC

members, only exist to make student loans. If they displease students and schools,

they will be out of business. Even in large diverse lending organizations, the student

loan department is usually a specialized area where the jobs of its employees depend

on success in student lending.

In addition, a number of financial considerations motivate lenders of all types to

provide top quality service, in addition to the necessity of complying with federal

regulations. Lenders not only lose 2% of their principal when loans default. They also
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM MICHAEL HERSHOCK AND RICHARD PIERCE

Page 100

have cash flow issues, because they have to keep repaying their investors whether or

not they are receiving payments on the underlying loans. When a loan defaults, there is

a delay before insurance is paid, causing cash flow problems that, if severe, could

cause a default on bond payments. Bond issues are structured with reserves and other

methods to make a default highly unlikely for the majority of an issue. This brings a

high rating from credit rating agencies, reducing borrowing costs. Low borrowing costs

translate to low interest rates, lots of competition for business, including borrower

benefit programs for students and their families. One of the key factors that rating

agencies check is the track record of the company that will service the student loans

that form the collateral for a securities issue.

High quality loan servicing holds a rank of highest importance in the federally

backed loan programs. The penalties for problems are severe. Borrowers are tracked

down and punished by seizure of income tax refunds, wage garnishment, lawsuits, loss

of professional licenses and destruction of credit ratings. Bankruptcy usually doesn't

help since a student loan generally cannot be discharged. Schools face bad publicity at

a minimum and closure at a maximum if their students' default rates rise too high.

Guaranty agencies lose money at increasing rates if their borrowers' default rates rise

too high. The Education Department and Congress face the wrath of the public and a

potential loss of confidence in the loan programs if default losses rise again, like they

did in the late 1980's. In other words, everyone involved in the loan program has an

incentive to make sure that if a loan does default, it is not because of servicing

problems. There are strong incentives to do everything possible to avoid loan defaults

and to cure them if they do default.

Liquidity: As loan volume has grown in recent years, there never has been a

problem with finding adequate funds for college. A healthy secondary market for loans

ensures liquidity in the student loan market. That means that funds are available at

reasonable cost. As it has become apparent that the FFEL Program will survive and

grow, more investors, including international investors, have been willing to invest in

student lending. This is good for American students. It shows the health of the loan

program. It is something that should be encouraged. Proposals that disrupt the system

or cause uncertainty and instability will result in reduced interest in investing the tens of

billions of dollars needed every year to finance student loans. At a minimum, this loss

of liquidity will increase lending costs, meaning more money will go into paying off

bonds, leaving less for improvements in technology and for borrower benefits.

Subsidies for Borrowers: Subsidies from various sources are in place to help

reduce borrowers' costs. As a result, student loans are some of the lowest cost loans

available anywhere. The federal government has put a ceiling on interest rates and

capped that ceiling to make sure they stay low. The government lowers rates further by

paying interest for borrowers at various times. Lower-income borrowers have their

Stafford Loan interest paid while in school and during periods of deferment. All

borrowers, including parents, are guaranteed that their interest payments will not rise

above a low level, no matter what the Federal Reserve does. These caps have saved

borrowers millions of dollars. Recent Stafford Loan borrowers have a portion of their
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM MICHAEL HERSHOCK AND RICHARD PIERCE

Page 101

interest costs ó 0.5 percentage point ó paid by the government at all times. On top of

that, interest payments are deductible from federal income taxes for many borrowers.

The combination of subsidies leaves a net interest cost for subsidized Stafford loans of

less than 4% ó the lowest-cost consumer loans available. On top of that, most

borrowers can reduce their costs even further thanks to lender-offered borrower benefits

programs. The system is set up to keep borrowing costs as low as possible.

Access: Much of the discussion of market mechanisms in the student loan

programs and of ways to set interest rates seems to ignore the fundamental purpose of

the federally backed student loan programs ó to ensure that all Americans have a way

to pay for higher education. A corollary purpose of the programs, also important, is to

keep the cost of borrowing as low as possible. There are various philosophical points of

view about borrowing. Some, including many in other countries, believe that the nation

should provide a higher education to all who wish it or all who qualify. For many years,

the state of California followed that policy, not charging tuition to in-state residents

attending state universities, although significant "fees" were charged. Others believe

that governmental assistance to pay for higher education should be concentrated on

students with the greatest need. Another approach treats assistance as a reward for

students who demonstrate merit. Policy in the United States has included all three

approaches, with need-based aid the predominant approach since 1965. Increasingly

in recent years, states and schools have put resources into merit-based grant aid. But

the loan programs have always been either based on need or open to all, without regard

to grades or other merit factors. Given the trend towards merit-based grants, the FFEL

Program will become more critical to ensuring that every American can pay for college.

Whether this trend changes or not, this country will need a large loan program for the

foreseeable future.

Summary and Conclusions: Experimentation with massive restructuring of the

FFEL Program could threaten its viability. Any major changes must be weighed

against the strength of the existing program. The best decision for Congress may be to

do nothing rather than continuing the turmoil that has kept program participants on edge

for the past 10 years. Constant upheaval is costly and eventually wears down loan

providers, financial aid administrators, and others who are involved in the loan

programs. Competitive pressure and the technological revolution of the 1990's have

brought significantly reduced borrowing costs for students, their families and taxpayers.

This is a good thing. It should be encouraged.

Competition with direct lending is no longer a central issue for lenders, although

the competition with FFELP does seem to be a major concern for schools in the Direct

Loan Program. Lenders are much more focused on doing battle in the marketplace with

their FFELP competitors.

Currently, the largest lenders are increasing market share. Still, the smaller state

and regional lenders serve to provide alternatives to the big national companies,

keeping prices low and service high. Many times they are able to meet local needs and

provide specialized service to schools thanks to longstanding relationships. This allows

customization of products to fit the needs of particular schools, particular students and
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM MICHAEL HERSHOCK AND RICHARD PIERCE

Page 102

particular states. It would be a mistake to encourage development of an effective cartel

or oligopoly by altering the loan program so that only the largest participants remain

viable.

Beware of arguments about competition being ìunfair.î Such statements always

suffer from tunnel vision -- only looking at one of many factors that affect the

competition. For example, should it be considered unfair for an organization to have

access to interest-free funds? Is it unfair for one company to be able to offer its student

loan customers other financial products that a competing company (or program) cannot

offer? Probably not.

Student loan programs should not be dumbed down, with the federal government

picking the lowest common denominator for loan programs and forcing everyone else to

reduce their services and raise their prices to that level. The program should remain

flexible enough to encourage excellence, innovation and the use of the latest

technology.

Market mechanisms already dominate the way prices are set and services are

provided in today's FFEL Program. Any study of market mechanisms should include a

look at how competition works in today's program, which is effectively delivering $22

billion in new loans this year while servicing a $150 billion portfolio with increasing

efficiency and decreasing defaults.
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM PAUL TONE AND RICHARD PIERCE

Page 103

APPENDIX VIII

ADDITIONAL AND DISSENTING VIEWS

FROM PAUL TONE AND RICHARD PIERCE

This appendix presents an additional and dissenting view submitted by study group members

Paul Tone and Richard Pierce in accordance with section 801(d) of the Higher Education

Amendments of 1998.
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM PAUL TONE AND RICHARD PIERCE

Page 104
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Page 105
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Page 106
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Page 107
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Page 108
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM PAUL TONE AND RICHARD PIERCE

Page 109
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM PAUL TONE AND RICHARD PIERCE

Page 110
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM PAUL TONE AND RICHARD PIERCE

Page 111
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM PAUL TONE AND RICHARD PIERCE

Page 112
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM PAUL TONE AND RICHARD PIERCE

Page 113
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM PAUL TONE AND RICHARD PIERCE

Page 114
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM PAUL TONE AND RICHARD PIERCE

Page 115
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM PAUL TONE AND RICHARD PIERCE

Page 116
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM PAUL TONE AND RICHARD PIERCE

Page 117
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM PAUL TONE AND RICHARD PIERCE

Page 118
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM PAUL TONE AND RICHARD PIERCE

Page 119
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Page 126
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM PAUL TONE AND RICHARD PIERCE

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APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM PAUL TONE AND RICHARD PIERCE

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APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM PAUL TONE AND RICHARD PIERCE

Page 129
APPENDIX VIII: ADDITIONAL AND DISSENTING VIEWS FROM PAUL TONE AND RICHARD PIERCE

Page 130



	
		

	
		
	




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Page 131

APPENDIX IX

PUBLIC COMMENTS FROM THE

CAREER COLLEGE ASSOCIATION

March 15, 2001

Mr. Gene Kuehneman

Senior Economist

U.S. General Accounting Office

441 G Street, NW

Room 5928

Washington, DC 20548

RE: Alternative Market Mechanisms for the Student Loan Program

Dear Mr. Kuehneman:

The Career College Association (CCA) is pleased to provide its comments on the draft report,

Alternative Market Mechanisms for the Student Loan Program. The Career College Association

is a voluntary trade association representing 850 schools, institutes, colleges, and universities

which educate students for careers in a wide variety of fields including allied health, computer,

hospitality, electrical and automotive, paralegal, and business office administration. Our

members provide programs ranging from short-term diploma programs to associate, bachelors

and masters degrees. The educational institutions in our sector educate almost 30% of the

technically trained employees and serve a critical role in preparing our current and future work

force.

GENERAL COMMENTS

CCA recognizes the delicate balance in establishing lender yields on student loans between

guaranteeing access to sufficient loan capital for all students and keeping borrower costs and the

Federal program costs at a minimum. This issue dominated the consideration of the Higher

Education Amendments of 1998, and its budget implications placed significant constraints on the

ability to expand borrower benefits such as reducing loan origination fees. CCA encourages the

study group to identify ways to move this yield-setting process out of the political arena and

allow market forces to regulate this balance.

Our major concern in examining the potential models put forth by the study group is ensuring

that all students have uninterrupted access to student loan funds at the lowest possible costs of

borrowing. In the current loan system, some loans are more profitable than others. Lenders have

a market bias toward large, high-balance loans because the servicing costs are roughly equal to

that of smaller balance loans in absolute terms, but represent a smaller percentage of the yield
APPENDIX IX: PUBLIC COMMENTS FROM CAREER COLLEGE ASSOCIATION

Page 132

received on the loans, making the servicing costs per dollar lent significantly lower for high

balance loans. Additionally, loans made to students in longer programs are more profitable

because interest is allowed to be capitalized, and in addition the serialization of loans in a single

account increases the borrowerís account balance. Thus, a real potential for discrimination and

denial of access to funds exists even in the current program for students who take out smaller

loans for shorter academic programs. This potential could be amplified by a change to a marketbased model.

Adequate safeguards to ensure uninterrupted access must be included in all models. It is also

important to ensure that students who borrow smaller balances for shorter programs, many of

whom are among the neediest students served by the programs, do not pay higher interest rates

and loan fees than students borrowing larger amounts or who are enrolled in long-term programs.

To achieve this result, uniform terms and conditions for all students must remain as a

fundamental policy requirement for the student loan programs.

SPECIFIC COMMENTS

The following are some of our specific concerns over the various models under consideration:

Incremental adjustments model ó CCA believes that there is a potential for a degradation of

service quality as well as access problems under this model if it used to reduce lender yield too

substantially. This incremental approach relies too much on Congress to establish acceptable

yields. If yields are set too low, this could result in serious disruption in financing for students.

Loan origination rights model ó This model also has potential for causing serious disruptions

in access to loan originations. We also have concerns given the experience of the Health

Education Assistance Loan (HEAL) program in using this type of model, and believe that it

would make it difficult for students and families to predict their borrowing costs into the future.

Loan Sale ó This model would mitigate much of the access risk by providing universal

originations of loans, similar to the Direct Loan program. However, it is unclear how loans

would be sold after origination, how the loans would be guaranteed, and what choice, if any, the

borrower would have in deciding who purchased or serviced their loan. We also have concerns

over the servicing quality of loans purchased by the lowest bidder.

Federal Funding ó This model seems to have little potential effect on the delivery of student

loans and is not truly a market-based mechanism. However, as in the first model, it has the

potential for disruption in access if Congress uses lendersí reduced cost of funds to lower yields

below what is acceptable to lenders.

Market-Set Rates ó This model has the most potential for discriminatory effects and

ìredliningî implications. CCA does not support any model which would result in unequal

borrower rates and benefits at differing institutions because it would disproportionately

discriminate against the neediest students currently served by the programs. Such a model would

likely result in lenders charging the neediest borrowers the highest rates for student loans. Any
APPENDIX IX: PUBLIC COMMENTS FROM CAREER COLLEGE ASSOCIATION

Page 133

market-rate model should not allow for the differentiation of loan terms and conditions by

borrower type, loan balance, or type of institution.

Income Contingent Repayment ó This model also seems to have little potential effect on the

delivery of student loans. CCA would be supportive of expanding the benefits of Income

Contingent Repayment presently available only to Direct Loan borrowers to all borrowers to

help them better manage their repayment obligations relative to their income.

Thank you for the opportunity to comment on the draft proposal.

Sincerely,

Nancy B. Broff

General Counsel
Page 134

APPENDIX X

PUBLIC COMMENTS FROM

CBA, NCHELP, AND SLSA

By E-Mail and Fax

March 19, 2001

Public Comments on MMSL Draft Report

c/o Mr. Gene Kuehneman, Senior Economist

US General Accounting Office

441 G Street, NW, Room 5928

Washington, DC 20548

Dear Mr. Kuehneman:

The undersigned welcome the opportunity to comment on the draft report entitled

ìAlternative Market Mechanisms for the Student Loan Programî. We recognize that the draft

report represents the results of a huge undertaking by the General Accounting Office and the

Department of Education (as well as the other government agencies that participated in preparing

the draft). Overall, the draft report presents a fair comparison of the proposals reviewed.

Accordingly, our comments will be limited to a couple overarching observations, together with a

handful of comments on statements in the body of the draft report which, in our view, are

inaccurate or lack support.

As a general matter, we do not believe the draft gives sufficient credit to the success of

the current Federal Family Education Loan Program (the ìFFELPî). Since 1965, the FFELP has

made higher education affordable for over 40 million Americans. Access to FFELP loans is

universal. Similarly, we not believe the draft report recognizes the market features that are

currently thriving in the FFELP. There currently is intense competition in the FFELP, with the

result being not only lower interest costs to students, but first class service as well (competition

in the area of service quality is a feature of the FFELP that would be absent in the case of many

of the market mechanism models analyzed in the report). We know that it was decided that the

Study Groupís report would not contain specific recommendations on future courses of action.

But let us say loud and clear, we do not believe the draft reportís analysis on any of the models

studied justifies dramatic changes to the current program.

We also believe, in general, that the report minimizes the transition costs to any new

system. We believe that implementation of many of the models would create substantial

disruption. This disruption would adversely affect schools and students as well as FFELP

participants. A related concern is that under the various models change would be forced upon

the FFELP community but not the Federal Direct Loan Program. It should be obvious that if one

program were to undergo a dramatic overhaul, many schools would seek the stability of the
APPENDIX X: PUBLIC COMMENTS FROM CBA, NCHELP, AND SLSA

Page 135

alternative program not being changed. This would be unfair to those schools and students who

participate in the FFELP, as well as to those involved in the delivery of FFELP loans.

A final comment relating to the Direct Loan Program deserves mention. As noted above,

we do not believe the draft report adequately recognizes the success of the FFELP. The draft

report, on the other hand, goes overboard in praise of the Direct Loan Program. We draw your

attention in particular to the discussion on pages 22 and 23. The draft seems to give the Direct

Loan Program credit for the substantial reduction in the default rate on student loans. This is

disingenuous. The decline in the default rate in the FFELP, by far the largest student loan

program, is the result of intense efforts by FFELP participants, actions by both the Congress and

the Department of Education, and the strong economy. The draft report also mentions that the

Direct Loan Program gives schools a customer service emphasis (implying that the FFELP does

not). The draft fails to note that the Departmentís own surveys have consistently shown that

customer satisfaction with the FFELP is higher than with the Direct Loan Program. We also take

issue with statements that attribute budget savings to the Direct Loan Program. The

Departmentís Inspector General has concluded that ìif administrative and subsidy costs are

added together, at any point in time FFELP or FDLP total costs may be greater given prevailing

market conditions.î U.S. Depít of Education, Office of the Inspector General, Study of Cost

Issues: Federal Family Education Loan Program/Federal Direct Loan Program (March 1999, p.

9).

As mentioned above, we are limiting our comments on the discussion sections of the

draft report to those select areas where we believe the discussion is significantly off base. In

Chapter 3 (Loan Origination Rights Auction), the draft states that auctions have the potential to

reduce FFELP costs. See page 37 (and Table 10). We note that this is only true if there are

substantial excess profits in the FFELP, a qualification that is acknowledged later. See page 38.

We do not believe there are excess profits in the FFELP, and note that the return on assets on

FFELP loans is lower than that for alternative loan products. The statement on page 38 that the

rights auction conducted for the Health Education Assistance Loan Program created savings to

the federal government is incorrect because the Federal government did not receive any proceeds

from the auction and did not benefit from any interest reductions. Furthermore, the widespread

dissatisfaction among schools with the HEAL auction program is not adequately discussed (it is

only alluded to in a footnote on page 41). The draft report states that ì[a]uctions could either

reduce the quality of service or have no effect on it.î See page 40 (and Table 10). This statement

is based on the conclusion that ì[a]uctions might shift the balance of competition toward price

competition and away from service competition.î We do not believe there is any question that

service quality would deteriorate and believe the draft report should be more definitive on this

point. Because all competitive energy would be focused on the auction, it is also likely that

lenders would eliminate current borrower benefits, thus increasing borrower costs. We believe

this should be mentioned in the analysis. Finally, we note that the draft report states that ìsome

school representativesî stated that schools and students value the ability to deal with a single

lender (which relationships would be jeopardized by an auction system). See page 44. We

believe this opinion is common among schools.

With respect to Chapter 4 (Loan Sale), there is a statement that this model would entail

adjustment burdens on lenders. The adjustment will adversely affect schools (particularly
APPENDIX X: PUBLIC COMMENTS FROM CBA, NCHELP, AND SLSA

Page 136

FFELP schools) and borrowers as well. Also, both borrowers and schools would lose the ability

to choose their lender. The draft report states that under the loan sale model there would be no

need to pay the in-school interest subsidy. See page 46. We did not understand that under this

model borrowers would be required to pay interest while they are in school. There also is a

statement that under this model ìborrower costs are unlikely to change much.î See page 49 (and

Table 11). For the same reason noted in the previous paragraph, it is likely that borrower costs

would rise as lenders eliminate borrower benefits. Since service quality will also deteriorate, the

statements on this point should be more definitive. See page 50 and Table 11.

With respect to Chapter 6 (Market-Set Rates), we believe the description of the proposal

is in some respects inaccurate. For example, the draft states that under this model there would be

no subsidies to the borrower other than the guaranty. There is no reason why the government

could not continue to subsidize in-school interest. The report also states that lenders might

reduce the quality of service or leave it unchanged. In our view, lenders likely would be

incentivized to increase service quality, since service quality would remain a criterion on which

schools and students choose their lenders. Finally, the report states that adjustment challenges

would be greater under this model than under the others. We disagree. The adjustment required

to implement the models discussed in Chapters 3, 4 and 5 would at least be as great, if not

greater.

We appreciate the opportunity to provide comments on the draft report. We would be

happy to elaborate on any of these comments if you so desire. Finally, we commend the valuable

contributions of the public members of the Study Group. We believe the balance evidenced

throughout the report reflects in many respects the thoughtful advice they provided.

Consumer Bankers Association (CBA)

National Council of Higher Education Loan Programs, Inc. (NCHELP)

Student Loan Servicing Alliance (SLSA)

Cc: Barbara Bovbjerg, GAO

 Maureen McLaughlin, Department of Education
Page 137

APPENDIX XI

PUBLIC COMMENTS FROM FINAID PAGE

Received by e-mail on March 7, 2001.

Dear Mr. Kuehneman,

I noticed in your draft report, Alternative Market Mechanisms for the

Student Loan Program (http://www.gao.gov/mmsl/comments.htm), Appendix IV,

page 93, that you wrote:

Analyses of possible repayment options, as well as contemporary

repayment calculators that are provided to aid borrowers choices among

various repayment plans, are typically described in total dollars rather

than in terms of the net present value of those dollars. This can make

ICR seem to be more expensive for borrowers than it really is. Some

observers believe that this illusory high-interest cost of ICR has

discouraged financial aid administrators from urging borrowers to

consider choosing it.

The FinAid site provides a repayment calculator for the ICR program that

does include net present value calculations. You can find the calculator at

 http://www.finaid.org/calculators/icr.phtml

You will notice that it not only has more features than the ICR calculator

available on the US Department of Education web site, but is also more

accurate. I am not aware of any other repayment calculators for the ICR

program. Approximately 150 people a week use our ICR calculator.

I am also writing to draw your attention to a report by Prof. Phil Schrag

of Georgetown University Law School (schrag@law.georgetown.edu). His report

analyzes the ICR program in depth, identifying several possible reasons why

it is underutilized and giving suggestions for improving the program. I

highly recommend reading his report.

Mark Kantrowitz

Publisher, FinAid and EduPASS

A FastWeb Student Resource Site

---------------------------------------------------------------------------

Mark Kantrowitz, Publisher FinAid!

FinAid Page, LLC The SmartStudent Guide to Financial Aid

PO Box 81620 http://www.finaid.org

Pittsburgh, PA 15217 1-412-422-6189 (fax)

 mailto:mkant@finaid.org 1-412-422-6190 (voice)
Page 138

APPENDIX XII

PUBLIC COMMENTS FROM

 NATIONAL STUDENT LOAN PROGRAM
APPENDIX XII: PUBLIC COMMENTS FROM NATIONAL STUDENT LOAN PROGRAM

Page 139
Page 140

APPENDIX XIII

PUBLIC COMMENTS FROM

OKLAHOMA LENDER ADVISORY COUNCIL

Received by e-mail on March 6, 2001.

Public Comments on MMSL Draft Report

c/o Mr. Gene Kuehneman, Senior Economist

US General Accounting Office

441 G Street, NW, Room 5928

Washington, DC 20548

The Oklahoma Lender Advisory Council, Inc. (OLAC, Inc.), consisting of lenders,

servicers and secondary markets participating in the Oklahoma lending community, is

submitting the following comments in response to the Draft Report on Alternative Market

Mechanisms for the Student Loan Program.

According to the draft overview, the central reason for the study, mandated by Congress,

was to determine ways of gathering more credible information on which to base lender

yield. Section 801 of the 1998 Amendments to the Higher Education Act (HEA)

mandated the study of alternative market mechanisms.

Surprisingly, none of the models described in the alternative market mechanism report

seriously address ways of gathering more credible information on which to base lender

yield. Instead, models described appear to have great potential for causing interruption to

the delivery of loan funds and services to students by virtue of the degree of radical

change required by the respective models.

The current model for delivery of loan funds to students and the objectives and integrity

of the FFEL program are functional and intact; therefore why change them? Among the

federal Title IV programs, citizens clearly depend most heavily on the FFEL program to

fund post-secondary educational goals. A close look shows that only a small percentage

of the cost of the program is realized as revenue for the lenders; the vast majority of

funding that runs this program is reinvested into the program. To de-stabilize the program

in any way, particularly in the ways described by at least four of the market mechanism

models in this draft report, would be to risk access to higher education for many and to

defer or deny educational goal attainment for many others currently relying on this

program.

Model 1, Adjustments to the Current System, appears to be least problematic of the five.

This model protects the current competition-based model, which we believe is in the best

interest of the borrower. This model also offers the least disruption to the delivery of

loan funds and services to student consumers.
APPENDIX XIII: PUBLIC COMMENTS FROM OKLAHOMA LENDER ADVISORY COUNCIL

Page 141

Model 2, Loan Origination Rights Auction, could create some of the same problems that

were created during the last stages of the now defunct HEAL program. Students could

not rely on continuity of service, lender relationship or even funding availability. Use of

loan consolidation to solve the problem of multiple loans with multiple lenders, is not in

the best interest of all students. Last, schools are put in the uncomfortable position of

soliciting lenders.

Model 3, Loan Sale, could deter lender participation, reduce the quality of customer

service to students, and increase liability for the federal government and thus for the

taxpayer. Timely fund appropriation for this popular program would also become a new

issue.

Model 4, Federal Funding, creates similar concerns as those stated for the Loan Sale

Model. In addition, we believe it would also create chaos, uncertainty and student access

problems.

Model 5, Market-set Rate, creates a very serious concern for student access, would

require a lender of last resort, puts lenders in an adversarial position with their customers,

could cause serious problems for schools where loans were not readily available for their

students and creates disruption.

OLAC, Inc. does not want the perceived need for a new way of determining lender yield

to jeopardize a strong viable program designed to facilitate the education of our citizens.

We believe models 2 through 5 would indeed jeopardize FFELP whereas Model 1

appears to be least problematic.

The current lender yield formula, based on the Commercial Paper (CP) index, is working

adequately; therefore, why change it? No market-based mechanism is perfect nor will any

formula or financial instrument fulfill all of the important financial objectives of the

program forever. However, recently, Congress helped encourage continued lender

participation with its legislation of the current (CP index) mechanism. OLAC, Inc. would

like to see the current formula remain in place as long as feasible.

Sincerely,

Oklahoma Lender Advisory Council, Inc.

Oklahoma Lender Advisory Council, Inc. Members

Arvest Bank

BancFirst

Bank of Oklahoma

Bank One Education Finance Group

Chase/Education First Marketing
APPENDIX XIII: PUBLIC COMMENTS FROM OKLAHOMA LENDER ADVISORY COUNCIL

Page 142

Citibank Student Loan Corporation

Citizens Bank of Edmond

Educational Funding Services, Inc.

Key Bank, USA

Lincoln National Bank

Local Oklahoma Bank

NHELP Marketing

Oklahoma Guaranteed Student Loan Program

Oklahoma Student Loan Servicing

Rockwell Bank

Sallie Mae

Stillwater National Bank

Tinker Federal Credit Union

UMB Bank
Page 143

APPENDIX XIV

PUBLIC COMMENTS FROM PHILIP SCHRAG
APPENDIX XIV: PUBLIC COMMENTS FROM PHILIP SCHRAG

Page 144
Page 145

APPENDIX XV

PUBLIC COMMENTS FROM

PATRICIA SMITH, STUDY GROUP MEMBER

Received by e-mail on March 15, 2001.

I submit the following comments on the draft report Alternative Market Mechanisms for

the Student Loan Program by ED and GAO, released January 18, 2001.

1. The options analyzed in the report fairly reflect those discussed by the Market

Mechanisms Study Group, mandated by Congress in the 1998 Amendments to the Higher

Education Act.

2. The material on income-contingent repayment (ICR) in Chapter 7 and Appendix IV is

very useful. It provides a clear analysis of policy and operational aspects of ICR that are

not generally available except through the Code of Federal Regulations or unpublished

Department of Education data. As the report notes, there is broad lack of understanding

about the ICR program, which causes some unwarranted hostility in the community.

This lack of information discourages the use of ICR in cases in which it would be

appropriate, thereby working to the detriment of some borrowers, particularly those

whose incomes are persistently low after leaving school. It also provides a good analysis

of the current role of IRS in ICR, and options for income verification if ICR is to be

expanded to the Federal Family Education Loan Program (FFELP). All this material

should be retained in the final report.

3. I recommend clarification of one sentence on p. 93 of the draft, in the first sentence

under ICR Usage in FDLP. The sentence now reads, ìAlthough the ICR option appears

to be more expensive for many borrowers over the full repayment term than, for example,

the standard repayment plan, no ICR borrower ëoverpaysí interest (unless the plan has

been established with an internal cross-subsidy).î This sentence should make clear that

there is no internal cross-subsidy under current regulations.

4. The ìcallî option, proposed by the Department of Treasury in Appendix V, is a useful

addition to the report, should be retained in the final report, and is worthy of further

exploration in the future. On p. 102, it specifically addresses the following recurrent

concern:

ì...unlike the current system in which special allowance payments provide a onesize-fits-all gross return, this option model would produce more efficient

incentives for provision of all types of loans, without necessitating excess net

returns for cheap-to-service loans.î

The draft report, in describing this option, also notes on p. 101, ìUnder this mechanism,

most aspects of the current FFELP could remain unchanged.î
APPENDIX XV: PUBLIC COMMENTS FROM PATRICIA SMITH, STUDY GROUP MEMBER

Page 146

5. The Federal budget disadvantage of a one-size-fits-all gross return to lenders should be

stated more prominently in the final report: Overview, the Chapter 1 Background, and

any executive summary produced later. The Background makes only one brief statement

regarding this problem on p. 19 when discussing the special allowance payment (SAP).

During Study Group discussion of options, however, it appeared to be very difficult to

retain all of the following advantages of the current FFELP for students and institutions if

one eliminated the current ìone-size-fits-all gross returnî to lenders.

Students now have the benefit of interest rates set by Congress that are the same for

all borrowers, whether high risk or low risk.

Guaranteed student loan volume is driven by the demand of eligible students, not an

annual decision by Congress or the Executive Branch. Eligible lenders can make

guaranteed loans to all eligible students attending institutions participating in the

FFELP who apply for a loan. Eligible lenders have an entitlement to the federal

guarantee and special allowance payments.

Lenders must compete for market share. Institutions and borrowers can choose

among lenders on the basis of lenders' service without regard to any annual limit on

how much each lender has the right to lend in FFELP.

Under the current legislative structure, the FFELP is a mandatory program, does not

require an annual appropriation of either loan capital or subsidy, and does not

compete for funding with the discretionary student aid programs.

Thank you for the opportunity to comment on this report.
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APPENDIX XVI

PUBLIC COMMENTS FROM

 TEXAS GUARANTEED STUDENT LOAN CORPORATION
APPENDIX XVI: PUBLIC COMMENTS: TEXAS GUARANTEED STUDENT LOAN CORPORATION

Page 148
APPENDIX XVI: PUBLIC COMMENTS: TEXAS GUARANTEED STUDENT LOAN CORPORATION

Page 149
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GLOSSARY

Basis Risk

A lenderís risk that the basis of the interest rate at which he or she borrows to finance a loan and

the basis of the interest rate that he or she receives from the loan will not move in tandem.

Borrower

The person responsible for repaying a loan who has signed and agreed to the terms in the

promissory note.

Budget Scoring

The process of estimating the budgetary effects of pending and enacted legislation and

comparing them to limits set in the budget resolution or legislation. Scorekeeping tracks data

such as budget authority, receipts, outlays, the surplus or deficit, and the public debt limit. For

purposes of the congressional budget process, the budget committees and CBO are responsible

for scoring legislation in relation to the levels set by the Congress in budget resolutions and the

Budget Enforcement Act.

Capitalization

The addition of unpaid interest to the principal of a loan. Capitalizing interest increases the

principal amount of the loan and the borrowerís total cost of the loan.

Collection Cost

The cost the government incurs and charges to the borrower when collecting a delinquent or

defaulted loan.

Commercial Paper

Short-term, unsecured promissory notes, issued primarily by corporations, with maturities up to

270 days. Many companies use commercial paper to raise cash for current transactions, and

many find it to be a lower-cost alternative to bank loans.

Consolidation

The combination of multiple loans into a single new loan to simplify loan repayment. Also

known as refinancing.

Debt Burden

The ratio of a borrowerís loan payments to the borrowerís income.

Default

Defined in FFELP as the borrower's continuous delinquency or failure to make a payment for

270 days in the case of a loan repayable in monthly installments or 330 days in the case of a loan

repayable in less frequent installments. If the delinquency persists for 270 days, the holder will

file a default claim with the guarantor. The guarantor will review the claim to ensure that the

account has been serviced (that minimal due diligence has been followed) according to

regulatory requirements. If the holder is able to prove that the account has been serviced
GLOSSSARY

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properly, the guarantor will purchase the loan from its holder. The guarantor, in turn, will

request reimbursement through its reinsurance agreement with the Secretary of Education.

Deferment

A period during which borrowers do not need to pay a loanís principal and, for subsidized

Stafford loans, the federal government pays interest. Borrowers are eligible for a deferment

during unemployment, while going on to further postsecondary education, and under certain

other conditions.

Dependent Student

A student who does not meet the criteria for being classified as independent. See Independent

Student.

Due Diligence

Compliance standards prescribed by federal regulations that govern loan making, disbursement,

and servicing in the FFEL program. For example, due diligence in loan collection servicing

requires that in the event of a delinquent loan, a lender shall engage in at least the collection

efforts described in federal regulations.

Event Risk

The risk that market conditions will change during an auction.

Forbearance

Permitting the temporary cessation of payments, allowing an extension of time for making

payments, or temporarily accepting smaller payments than were previously scheduled. A lender

may grant forbearance of payments of principal and interest, according to conditions specified by

federal regulations, for up to a year at a time if both the borrower or endorser and an authorized

official of the lender agree to the forbearance in writing.

Government-Sponsored Enterprise

A financial institution, established by federal law but privately owned and directed, that operates

in the private sector capital market.

Income Percentage Factor

A factor that corresponds to a borrowerís adjusted gross income as shown in the income

percentage factor table in a notice published annually by the Secretary of Education in the

Federal Register.

Income Threshold

An income level below which loan borrowers are not required to make repayment.

Independent Student

Student who, by meeting certain regulatory criteria, is presumed to receive no financial support

from parents. A student is considered independent if he or she is: at least 24 years old, a

graduate or professional student, a veteran of the U.S. armed forces, married, or has dependents
GLOSSSARY

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other than a spouse. A financial aid administrator may also classify a student as independent

under special circumstance, even if none of these criteria are met.

Interest

An expense of borrowing money that is calculated as a percentage of the amount borrowed.

Interest Spread

The difference between a lenderís yield and its funding costs (costs related to capital acquisition

and interest expenses).

Lender of Last Resort

A lender who lends to borrowers who are unable to obtain loans from other lenders.

Lender Yield

The face value of the lenderís interest rate on an FFELP loan, set in legislation as the CP rate

plus 1.74 percentage points when the student is in school or during other nonrepayment periods

and 2.34 percentage points when the student is in repayment.

Loan Volume

The dollar amount or number of loans committed. It may be reported in thousands or millions of

dollars.

Margin

A market-based add-on to a market rate. A margin can be negative, and it changes on the basis

of market conditions and the creditworthiness of the borrower.

Market Mechanism

An interaction of buyers and sellers, in which prices or interest rates are established on the basis

of the amounts of money buyers are willing to pay or sellers are willing to accept.

Markup

An amount to be added to a reference rate to determine the new derived rate.

Match Funding

Lenders matching the basis of the interest rate at which they borrow to finance a loan with the

basis of the interest rate that they receive from the loan. If they are able to do so, then changes in

the interest rate affect their costs and revenues identically and do not affect their net profits. If

their funding costs and their revenues are based on different interest rates and those rates do not

move in tandem, then their net profits could fluctuate. Hedging reduces or eliminates these

fluctuations.

Multiple-Price Auction

An auction in which all accepted bids are filled at the price that each bidder bid.
GLOSSSARY

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Multiple-Round Auction

An auction in which a set of related items is auctioned simultaneously, with the auctioning

continuing for multiple rounds until the best possible price is obtained for all items.

Negative Amortization

A gradual increase in loan debt that occurs when the monthly payment is insufficient to cover the

interest due, and the balance owed continues to increase because unpaid interest is capitalized.

Open-Outcry Auction

An auction in which bidders submit bids publicly and then have the opportunity to revise their

bids in light of other bids.

Operating Expense

An expense incurred by a guaranty agency, such as salary and costs for travel, computer

hardware and software, equipment, rent, and supplies and contractor costs.

Origination Fee

A fee charged and deducted from the proceeds of an FFEL program loan before the loan is

disbursed. It offsets some of the administrative costs of loan processing. It must not exceed the

maximum rate established by law. This fee is deducted from the interest and special allowance

the federal government pays the lender. Generally, lending institutions pass this fee on to

borrowers when loans are made.

Present Value

The value today of a stream of payments in the future, discounted at the prevailing interest rate.

According to the regulations of the Federal Credit Reform Act of 1990, the cost of a direct loan

to the government is the net present value (when the direct loan is disbursed from the financing

amount) of estimated cash flowsóthat is, loan disbursements, repayment of principle, interest

repayment. For loans made, guaranteed, or modified in fiscal year 2001 and thereafter, the cash

flow estimated for each year (or other time period) is discounted by using the interest rate on a

marketable zero-coupon Treasury security with the same maturity from the date of disbursement

as that cash flow.

Principal Balance

The amount owed on a loan or loans at any given time. It may include capitalized interest.

Promissory Note

A legally binding contract between a lender and a borrower that contains the terms and

conditions of the loan, including how and when it must be repaid.

Proprietary School

A postsecondary institution that is operated for profit.

Reference Rate

An interest rate on a cash market instrument used, or referred to, in a formula for calculating

another rate.
GLOSSSARY

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Repayment Period

The period during which a borrower is responsible for repaying his or her loan. For Stafford

loans, this period begins on the day after the last day of the grace period. For PLUS and SLS

loans, this period begins on the day the loan is fully disbursed. The maximum standard

repayment period is 10 years, not including any authorized deferment or forbearance periods.

Risk

Lendersí risks in FFELP include

Interest rate risk or basis risk. The risk that changes in interest rate levels and the spreads

among different interest rates increase the volatility of returns, reduce returns, or create

losses.

Political or regulatory risk. The risk that a program might be affected by unexpected

legislative or regulatory changes.

Credit risk. The risk of loss from borrower delinquencies or defaults, which is almost but not

completely ameliorated by guaranty agencies and the federal reinsurance guarantee.

Servicing risk. The risk of mistakes and errors that may occur when servicing a loan can

create credit risk for the lender because improper servicing can void the federal guarantee on

student loans.

Sealed-Bid Auction

An auction in which each bidder submits a single bid and then all bids are opened at once.

Secondary Market

Financial institutions that purchase student loans from lenders and provide liquidity to the

student loan market.

Securitization

Selling debt securities to investors with groups of loans serving as collateral for the debt.

Single-Price Auction

See Uniform-Price Auction.

Single-Round Auction

An auction in which an item or a set of items is auctioned off with one single-round of bidding.

Special Allowance Payment

A quarterly payment the government makes to FFELP lenders when lender yield exceeds the

maximum borrower rate.

Uniform-Price Auction

An auction in which all successful bidders pay the same price, even if they submitted bids at

different prices.

U.S. Treasury Bill

A negotiable debt obligation issued by the U.S. government and backed by its full faith and

credit. The shortest term, regularly offered Treasury debt securities are 91-day T-bills.