BACKGROUND

PAPER State Profits on Tax-Exempt

Student Loan Bonds:

Analysis and Options

March 1980

Congress of the United States

Congressional Budget Office
STATE PROFITS ON TAX-EXEMPT STUDENT LOAN BONDS:

ANALYSIS AND OPTIONS

The Congress of the United States

Congressional Budget Office

PREFACE

In 1979 states began earning unexpected profits from taxexempt bonds that they had issued to raise funds for loans to

college students. This paper, prepared at the request of Chairman

Al Ullman of the House Committee on Ways and Means, analyzes the

source of these profits and provides a background for analyzing

various proposals to reduce them. In accordance with CBO's

mandate to provide objective analysis, the report offers no recommendations.

Cynthia Francis Gensheimer of the Tax Analysis Division

prepared the report under the direction of James M. Verdier.

David Longanecker, Alfred Fitt, Robert Reischauer, Janice

Grassmuck, and others in the Congressional Budget Office provided

valuable suggestions and comments. Donna Richard prepared the

tables in the appendix. Patricia H. Johnston edited the manuscript, and Linda Brockman and Shirley Hornbuckle typed it.

Many people outside of the Congressional Budget Office gave

generously of their time and assistance. Those who carefully

reviewed and provided valuable comments on drafts include Bruce

F. Davie, Benjamin Cohen, John deClue, David Reicher, and Loren

Carlson. Several people at the Office of Education and the

Student Loan Marketing Association provided statistical data. The

directors of student loan bond programs across the country were

extremely helpful in providing information on their programs.

Alice M. Rivlin

Director

March 1980

iii

CONTENTS

Page

PREFACE ill

SUMMARY ix

CHAPTER I. INTRODUCTION 1

CHAPTER II. PROGRAM OPERATIONS 3

Participants in Student Loan Bond Process ... 3

Issuers of Student Loan Bonds 3

Student Eligibility 4

Sallie Mae 5

Administration 5

Acquisition of Student Loans . . 5

Servicing 6

Federal Insurance and Reinsurance of

Student Loans 7

Profitability 7

Yield on Loans 7

Profits Accruing to State and Local

Governments 9

Volume of Student Loan Bonds 14

Volume to Date 14

Potential Volume 15

Federal Costs of Student Loan Bonds 18

CHAPTER III. LEGISLATION AFFECTING STUDENT LOAN BONDS ... 21

Tax Treatment of Student Loan Bonds for

Arbitrage Purposes ... 21

Education Legislation Affecting Student Loan

Bond Profits 22

Pending Proposals to Restructure Student

Loan Programs 24

Continued
CONTENTS (Continued)

Page

CHAPTER IV. OPTIONS 27

Take No Action 28

Lower Special Allowance for Student Loans

Financed by Tax-Exempt Bonds 30

Fixing the Special Allowance At Bond

Issuance 33

Recalculating the Special Allowance for

All Loans Each Quarter 35

Federal Cost Reduction 37

Impose Usual Arbitrage Restrictions on

Student Loan Bonds 40

Tax Interest on Student Loan Bonds 44

Withdraw Federal Insurance from Loans

Financed with Tax-Exempt Bonds 46

Specify Permissible Uses of Surplus Funds ... 49

Conclusion ..... 50

APPENDIX. CASH FLOW ANALYSIS OF EXPECTED PROFITS FROM

TWO STUDENT LOAN BOND ISSUES 55

vi
TABLES

Page

SUMMARY

TABLE. FEDERAL SAVINGS FROM PROPOSALS TO LIMIT PROFITS

ON STUDENT LOAN BONDS xiv

TABLE 1. SPECIAL ALLOWANCE RATES, 1969-1979 10

TABLE 2. YIELD ON STUDENT LOANS COMPARED TO THE NET

INTEREST COST OF STUDENT LOAN BONDS, 1970-1979. . . 13

TABLE 3. STUDENT LOAN BOND ISSUES BY STATES, 1966-1980 ... 16

TABLE 4. PROJECTIONS OF VOLUMES OF ANNUAL ISSUES OF STUDENT

LOAN BONDS 19

TABLE 5. CURRENT LAW PROJECTIONS OF FEDERAL COSTS OF

STUDENT LOAN BONDS 20

TABLE 6. FEDERAL SAVINGS FROM PROPOSALS TO CUT SPECIAL

ALLOWANCE 38

TABLE 7. FEDERAL SAVINGS FROM PROPOSALS TO LIMIT PROFITS

ON STUDENT LOAN BONDS 42

TABLE 8. RANKING OF OPTIONS BY THEIR EFFECTS ON FEDERAL

COST AND AVAILABILITY OF STUDENT LOANS 51

APPENDIX TABLES

TABLE A-l. NORTH DAKOTA CASH FLOW PROJECTIONS, 1979 SERIES

A STUDENT LOAN REVENUE BONDS . 58

TABLE A-2. WISCONSIN CASH FLOW PROJECTIONS, 1979 SERIES

A STUDENT LOAN REVENUE BONDS 59

vii

SUMMARY

Through the interaction of rising interest rates and recent

tax and education legislation, a growing number of state and local

governments are accumulating millions of dollars in unanticipated

profits through the federally subsidized guaranteed student loan

program. In the aggregate, states could accumulate between $300

million and $450 million in profits over fiscal years 1980-1985.

Student loan bonds are issued to provide students better

access to loans. For a number of years, the federal government

has induced commercial lenders to make student loans voluntarily,

by offering them interest subsidies (a "special allowance") and

insurance against student default. Even with these inducements,

however, commercial lenders have been unwilling to lend to all

student applicants because of the high cost of servicing student

loans. As a result, some students have had trouble finding banks

willing to lend to them, and an increasing number of states has

responded by issuing student loan bonds and then relending the

proceeds to students.

States and localities raise money by issuing bonds at low,

tax-exempt interest rates and use the proceeds to buy or make

federally guaranteed student loans at significantly higher

interest rates, paid in large part by the federal government.

Although the interest costs of nearly all student loan bond

authorities were under 7 percent in 1979, for example, the yield

they received on student loans fluctuated between 11 and 16 percent. The profits accruing to the bond issuers is the difference

between the yield on student loans and the level of associated

expenses—interest on the bonds and administrative costs. Lenders

receive 7 percent interest paid by the federal government until

students leave school and by students thereafter. In addition,

lenders receive special allowance payments from the federal

government. The special allowance rate is recalculated each

quarter and averaged 6.5 percent in 1979.

ix

58-650 0-80- 2
Volume and Cost of Student Loan Bonds

Eighteen states and the District of Columbia have issued the

bonds to date, and ten others may do so for the first time in

1980. The volume of student loan bonds issued each year has been

increasing rapidly and will probably continue to do so, unless the

Congress enacts legislation affecting the bonds. About $1.4 billion in student loan bonds has been issued to date, including

about $100 million issued in 1977, $300 million in 1978, and $600

million in 1979. It is likely that between $900 million and $2.3

billion of student loan bonds will be issued in 1985.

The federal revenue loss from the tax exemption of interest on

these bonds will amount to approximately $90 million in fiscal

year 1981 and between $160 and $290 million in 1985. In addition,

the federal government makes special allowance payments on student

loans financed by the bonds. These payments will cost between

$80 million and $100 million in 1981 and between $115 million and

$220 million in 1985.

Tax and Education Legislation Affecting Student Loan Bonds

Federal law generally prohibits states from issuing taxexempt bonds at low interest rates and investing the proceeds at

much higher yields. Profits that arise in this way are called

"arbitrage." In the Tax Reform Act of 1976, the Congress made an

exception to this rule for issuers of student loan bonds. For

arbitrage purposes, the special allowance part of the return on

student loans is not counted in determining the yield on the

investments made with bond proceeds. The Tax Reform Act of 1976

imposed no restrictions on state and local government use of

profits derived from student loan programs.

It is this tax legislation that has allowed state and local

governments to make profits from student loan bonds. At the time

the Tax Reform Act of 1976 was enacted, the portion of the return

on student loans that was excluded from arbitrage yield calculations (the special allowance) was capped under the education laws

at 3 percent. Subsequent higher education legislation changed the

way the special allowance is calculated and removed its ceiling.

The state profits come directly out of the special allowance, and

the special allowance has increased dramatically over the past few

years. In the fourth quarter of 1979, for example, the special

allowance rate was 9 percent. Since the special allowance is paid

directly by the federal government to the lenders, the state prox
fits from student loan bonds come directly from the federal

government.

The large increase in the popularity of student loan bonds

has been spurred by the large increase in student demand for

loans in the last two years. The interest rate students are

charged on their loans has been held steady at 7 percent.

Although 7 percent loans were not a bargain when that interest

rate was initially set, soaring interest rates have made them an

excellent borrowing opportunity, and loan demand has increased

correspondingly. More importantly, perhaps, the Middle Income

Student Assistance Act, enacted in 1978, made all students,

regardless of family income, eligible for in-school interest subsidies on their loans. This increased the demand for the loans by

students from upper-income families.

Drafters of the 1976 Tax Reform Act had no reason to envision

these changes in higher education legislation. Likewise, it is

unlikely that drafters of the higher education legislation realized the effects their actions would have on the profitability of

what were then relatively small-scale student loan bond programs.

All student loan programs must be reauthorized before October

1, 1980 and several proposals under consideration would affect

student loan bonds. Under one approach, a two-tier student loan

structure would be established. First, students would be eligible

for federally financed basic loans, in amounts based on need.

Second, independent students and parents of dependent students

would be eligible for supplemental loans which would be financed

by commercial lenders, schools, and nonprofit state authorities.

These supplemental loans would be similar to the loans now made by

student loan bond authorities. If the Congress takes this

restructuring approach, student loan authorities would be able to

issue bonds for supplemental loans, but they would probably not

issue as large a volume of bonds as under an extension of current

law.

Options

There are a number of alternatives open to the Congress concerning student loan bonds, including cutting back one or another

of the federal subsidies now received by student loan bond authorities and thereby reducing their federally supported profits. The

available options include:

xi
o Taking no action.

o Reducing the federal interest subsidy (special allowance)

on loans financed with tax-exempt bonds.

o Imposing usual arbitrage rules on student loan bonds,

o Taxing interest on student loan bonds.

o Withdrawing federal insurance from bond-financed loans,

o Requiring that surpluses be invested in student loans.

Taking No Action. There are two arguments for taking no

action on student loan bonds at this time. First, since interest

rates are now at unusually high levels, the profits states are now

earning may be only temporary. The special allowance payments

are tied to the 91-day Treasury bill rate, and if this rate

declines sharply, state profits will dry up.

Second, the profits states are allowed to make from student

loan bonds can be viewed as an inducement from the federal government to encourage the states to issue bonds and thereby make student loans more broadly available. The surpluses would then

represent the cost of using this method to increase loan availability. The question then would be whether there are other, less

costly ways of providing the same expanded loan availability.

Reducing the Federal Interest Subsidy on Loans Financed With

Tax-Exempt Bonds. Currently, tax-exempt authorities receive the

same federal interest subsidies (special allowances) and guarantees on student loans that commercial lenders receive. In

addition, they receive a federal subsidy because they raise funds

at tax-exempt rates much lower than the interest rates private

lenders must pay. The two kinds of lenders get the same gross

yield on their loans, but the costs of private lenders exceed the

costs of tax-exempt bond authorities. By reducing the federal

interest subsidy on student loans held by bond authorities, the

Congress could equalize the net return on student loans held by

tax-exempt authorities and private lenders. In this way, most

surpluses would be eliminated, but states could continue to issue

student loan bonds. This option would save the federal government

a cumulative total of between $200 million and $350 million in

special allowance payments from fiscal year 1981 to 1985 (see

Summary Table).

xii
Imposing Usual Arbitrage Rules on Student Loan Bonds*

Another way of reducing the yield on the student loans held by

tax-exempt bond authorities would be to require the authorities to

rebate to the federal government part of the federal interest

subsidy on the loans. This could be done by amending the Internal

Revenue Code's arbitrage rules on student loan bonds to make these

bonds subject to the same rules as other tax-exempt bonds. In

this way, nearly all profits of student loan bonds could be

eliminated, and federal costs could be reduced a total of between

$170 million and $300 million from fiscal years 1981 to 1985 (see

Summary Table).

Taxing Interest on Student Loan Bonds. Instead of reducing

the profitability of student loan bonds by lowering the yield on

the loans, the Congress could do so by raising their costs. It

could do this by taxing interest on the bonds, or, as will be discussed in the next section, by withdrawing federal insurance from

the loans.

Depending on the extent to which taxing interest on student

loan bonds would push up the costs of these programs, this option

could cause a cutback in bond issuance arid hence in student loan

availability. There would almost certainly be a cutback in bond

issuance during the transition period in which states restructured

their bonds and found new markets for them.

Not only would this option reduce federal costs the most, but

it would also have the advantage of bringing the student loan

program entirely under the jurisdiction of the Department of

Education, where it can be reviewed in conjunction with other

education programs. The Summary Table shows total savings of

between $480 million and $830 million from 1981 to 1985. It

would, however, be a departure from past policy for the Congress

to tax interest on bonds which serve a public purpose. In general, the Congress allows these bonds to be tax-exempt, but

restricts their profitability by limiting the yield on investments

made with bond proceeds.

Withdrawing Federal Insurance from Bond-Financed Loans.

If student loans financed with tax-exempt bonds were not federally

insured, the costs to states of student loan bond programs would

increase for two reasons: (1) because states would no longer be

reimbursed for losses on defaulted loans, and (2) because the

interest rate on student loan bonds would be pushed up by

investors demanding higher returns as compensation for the

xiii
SUMMARY TABLE. FEDERAL SAVINGS FROM PROPOSALS TO LIMIT PROFITS ON

STUDENT LOAN BONDSa (By fiscal year, in millions

of dollars)

Cumulative

Five-Year

1981 1982 1983 1984 1985 Totalb

If annual bond issues

remain 20 percent of

annual loan originations

Give states a special

allowance equal to

half the special

allowance of commercial lenders, with

no floor

Impose usual arbitrage rules on student loan bonds

23 38 44 49 53 208

19 32 35 40 45 171

Tax interest on student loan bonds

Withdraw federal

insurance from loans

financed with taxexempt bonds

49 74 99 119 138 479

8 17 23 29 35 112

The estimates are based on CBO's projections of interest rates

and are made on the assumption that no changes would affect

bonds issued before 1980 or loans made from the proceeds of

those bonds. The estimates are based also on the assumption

that none of the options would cause a reduction in bond

xiv
SUMMARY TABLE (Continued)

Cumulative

Five-Year

1981 1982 1983 1984 1985 Totalb

If annual bond issues

as a percent of annual

loan originations increase 5 percentage

points each year

Give states a special

allowance equal to

half the special

allowance of commercial lenders, with

no floor 32 56 72 88 104 352

Impose usual arbitrage rules on

student loan bonds 27 49 59 75 94 303

Tax interest on

student loan bonds

Withdraw federal

insurance from loans

financed with taxexempt bonds

67 112 163 214 269

10 24 36 49 64

826

182

issuance. To the extent that reductions do occur, federal

costs would be further reduced.

b. Details may not add to totals because of rounding.

xv
increased risk of bond default. In order to reduce the riskiness

of student loan bonds, states could pledge their full faith and

credit to the bonds. Some states might, however, be hesitant to

lend their support to the programs in this way.

Removing federal insurance from student loans held by taxexempt bond authorities could raise the costs of some states1

student loan bonds so high that they would no longer be willing to

issue the bonds. This could be true, for instance, for states

that currently do the best job of lending to high-risk students

who have trouble obtaining loans from commercial banks. The

states that continued to issue student loan bonds would have an

incentive to lend to students who were good credit risks. Since

these students should have the best access to loans from commercial banks, the broadened loan availability provided by student

loan bonds would be diminished under this option. As shown in

the Summary Table, this option would save the federal government a

total of between $110 million and $180 million in the five-year

period 1981-1985.

Requiring That Surpluses Be Invested in Student Loans. There

are currently no restrictions on state use of surplus funds.

Student loan bond issuers could be required to invest their surpluses in student loans. This requirement, however, would not

necessarily ensure that those funds would not ultimately be

deposited in state general purpose accounts. The new student

loans would be income-producing assets owned by the states. Unless the Congress drafted a comprehensive set of regulations,

states could deposit that income in their general purpose

accounts, along with the proceeds of sales to the Student Loan

Marketing Association.

xvi
CHAPTER I. INTRODUCTION

The Congress established the guaranteed student loan program

in the Higher Education Act of 1965. Initially, the federal role

was limited to laying ground rules for the program, insuring

lenders against student default, and providing in-school interest

subsidies to students from families with annual incomes below

$15,000. All students attending college at least half-time were

eligible for the loans. Virtually all guaranteed student loans

(GSLs) were made by commercial lending institutions, mostly by

banks.

The interest rate charged students was originally set very

close to the prime commercial lending rate—the rate banks charge

their best customers. When inflation began to push up interest

rates in 1969, the Congress instituted a system of special allowances, quarterly payments from the federal government to lenders

designed to bring the total yield (student plus federal government

share) on student loans up to the yield on other investments banks

could make. The Congress realized that very few student loans

would be made unless lenders received a competitive yield on them,

since the GSL program relied on the voluntary participation of

commercial lenders.

The incentives offered by the GSL program—interest subsidies

and loan guarantees—may or may not be sufficient to induce

private lenders to accommodate all students seeking assistance.

Private lenders in some states have met the demand for loans

better than those in others. In every state, some groups of

students can obtain loans more easily than others. First-year

students, minorities, students living in rural areas, and students

without established banking relationships are among those who

often have difficulty getting loans from banks. Moreover, during

periods of high interest rates, all students may have less access

to loans, as banks prefer to use their diminished deposits to lend

to long-standing commercial customers.

Despite the relatively high gross yield on student loans (now

about 16 percent), many banks do not like to make them. Compared

to other loans, collections on student loans are costly. The

average size of a student loan, $2,000, is much smaller than the

58-650 0-80- 3
average size of other loans, and it is often difficult to keep

track of the whereabouts of students during the ten years or so of

their indebtedness. Even though the federal guarantee on student

loans makes them less risky than most commercial loans, it may

still be costly for banks to apply and wait for reimbursement in

the case of default.

In the past few years, a growing number of states have issued

tax-exempt bonds to finance federally guaranteed student loans,

because they felt that commercial banking institutions were not

meeting the needs of all deserving students. By issuing taxexempt bonds, states can tap national capital markets and bring

additional money for student loans within their borders. About

$270 million in student loan bonds was issued in 1978 and $600

million in 1979. Combined, these amounts represent about 60

percent of the total $1.4 billion of student loan bonds issued

since 1966, the year in which they first appeared.

States will receive millions of dollars in unanticipated

profits from the bonds as a result of rising interest rates

coupled with recently enacted tax and education legislation.

State authorities that issue tax-exempt bonds to finance student

loans are entitled to exactly the same federal interest subsidies

and guarantees that private lenders get. As explained above, the

rationale behind the special allowance is to keep the return on

student loans competitive with the return on other banking investments. When state authorities, which can raise funds by issuing

bonds at low, tax-exempt interest rates and which do not have to

pay income taxes, receive this same gross yield on student loans,

they earn substantial profits. Normally, states are prohibited

from borrowing at low, tax-exempt interest rates and investing the

proceeds at significantly higher yields, but the Congress made an

exception to these so-called "arbitrage" rules for student loan

bonds.

Chapter II presents background information about both student

loan bond programs and student loans themselves, explains how

issuers of student loan bonds are able to accumulate surpluses,

and estimates the magnitudes of those surpluses. Chapter III

gives the legislative history of the provisions making the profits

possible and discusses pending proposals to restructure the

federal student loan program and the effect these proposals would

have on student loan bonds. Chapter IV presents several options

for Congressional consideration that would reduce the profitability of student loan bonds.
CHAPTER II. PROGRAM OPERATIONS

When states* issue student loan bonds, they borrow money from

bond purchasers and relend that money to students. The states

receive a stream of interest and principal payments from the students and from the federal government as the students pay off

their loans, and use that money to pay the interest and principal

they owe the bondholders. In essence, the students borrow from

the bondholders, and the states act as middlemen, just as banks in

general act as middlemen matching depositors (lenders) and

borrowers.

PARTICIPANTS IN STUDENT LOAN BOND PROCESS

The participants in student loan bond programs are the agencies that issue the bonds and administer the programs; the students who receive loans from the agencies; the Student Loan

Marketing Association (Sallie Mae), which buys some student loans

from the agencies; the investors who purchase the bonds; and the

federal government, which subsidizes the programs. The federal

government's role is developed later in this paper. The bondholders are primarily commercial banks, life insurance companies,

and individual investors in high-income tax brackets. The other

participants—bond issuers, students, and Sallie Mae—are

described briefly in this section.

Issuers of Student Loan Bonds

States, state authorities, and nonprofit corporations have

issued student loan bonds. State authorities are established by

state legislatures or governors, and are usually restricted by

state law in the volume of bonds they may have outstanding.

Federal law requires that private, nonprofit corporations that

1. For brevity, the terms states or state authorities and

agencies will be used throughout the paper to mean state

authorities and state and local nonprofit corporations that

issue student loan bonds.
issue tax-exempt student loan bonds be established by a state or

local government exclusively to acquire federally guaranteed

student loans. Nothing in federal law precludes a local government from issuing student loan bonds directly, but none have done

so to date.

Student Eligiblity

Student loan authorities buy and make only guaranteed student

loans (GSLs), so students receiving loans from the authorities

must meet both the eligibility criteria of the national guaranteed

student loan program and the criteria established by the individual states.

Nationally, any student attending college or graduate school

at least half time is eligible to receive a guaranteed student

loan. The Middle Income Student Assistance Act (MISAA), enacted

in the fall of 1978, effectively opened up the guaranteed student

loan program to all students, regardless of family income. Before

MISAA was enacted, students from families with incomes exceeding

$25,000 a year were eligible to receive guaranteed student loans,

but their loans bore 7 percent interest from the day they were

made, instead of starting 9 to 12 months after the student left

school as they did for lower-income students and as they now do

for all students. All undergraduate students are now eligible for

GSLs of up to $2,500 per year, as long as the total amount of

their indebtedness is under $7,500. Graduate students may borrow

up to $5,000 per year, up to a total of $15,000 (including

indebtedness from undergraduate school).

In addition to the federal eligibility criteria, state higher

education loan authorities impose residency requirements. All

state agencies will make loans to state residents attending

schools in their state. Some will also lend to state residents

attending out-of-state schools or to out-of-state residents

attending in-state schools or to both.

Some student loan authorities aim for total accessibility—

that is, they would like to be able to sell enough tax-exempt

bonds to finance all guaranteed student loans made in their

respective states. Those states generally impose no eligibility

requirements other than residency.

Other student loan authorities view their role as "lenders of

last resort." They gear their lending to students who cannot
obtain loans from commercial lenders or to areas in the state

where private lenders are reluctant to make student loans.

Authorities operating under this principle sometimes require

students to submit certificates of loan denial from private

lenders. In at least one state (Texas), students must meet a

needs test based on family income in order to receive loans from

the state.

Sallie Mae

Most states that issue student loan bonds intend to hold the

student loans until the students pay them off. A few loan

authorities pay Sallie Mae fees out of their bond proceeds for

Sallie Mae's promise to buy student loans from the authorities at

the authorities' option at specified prices and dates. In some

cases, states issue short-term bonds, usually of three-year

maturity, and plan to sell their complete portfolio to Sallie Mae

at the end of the three-year period. In most cases, however,

states make these arrangements with Sallie Mae to guard against

future problems. For instance, if loan repayments were slower

than anticipated, an authority could find itself short of cash

when its bonds became due. In that case, the authority might want

to be able to sell loans to Sallie Mae and use the proceeds of the

sale to redeem the bonds. As another example, a state might want

to sell loans to Sallie Mae if it wanted to make new student loans

at a time when it would be undesirable to enter the bond market

because tax-exempt interest rates were high. In that case, the

state might want the option of selling the loans in its portfolio

to Sallie Mae and using the proceeds of the sale to make new

student loans.

ADMINISTRATION

Acquisition of Student Loans

States that issue student loan bonds use the proceeds not

only to finance new student loans, but also to purchase outstanding loans from commercial banks.

2. Sallie Mae is a U.S.-chartered, private corporation, whose

purpose is to increase the liquidity and availability of

student loans through secondary market and warehousing

operations.
Financing New Student Loans* Even when states use the

proceeds of their bonds to make only new student loans, they

usually contract with private lending institutions to process the

loan applications and make the loans to students; the private

institutions then sell the loans to the states. Students who get

loans in this way apply for them in much the same way they would

apply for student loans financed by commercial banks. The

financial aid office at their school usually informs them of their

eligibility for the loans and tells them at which banks they may

place applications.

Several states have in-house loan application processing

offices and do not work through private lenders. In these states,

although students must apply directly to the state lending agency,

they can usually pick up the application forms from the financial

aid office at their school.

Purchasing Old Student Loans. Many states set aside all or a

portion of their loanable funds to buy student loans from the

portfolios of banks, credit unions, and savings and loan associations. These loans may have been made several years previously.

In most cases, the states buy existing student loans only if the

commercial lenders agree at least informally to make new student

loans.^

Servicing

As soon as a state has acquired student loans, it begins to

receive interest payments on the loans. Collecting the payments

is called servicing a loan. Just as most of the states work

through private lenders to acquire their student loans, most of

them hire private lenders or servicing companies to service their

loans. As noted earlier, servicing student loans is expensive

compared to servicing other loans. Since the cost of servicing a

loan doesn't vary much with the size of the loan, the small value

of student loans ($2,000 on average) makes them costly to service

for that reason alone. In addition, they are of long duration

(usually about ten years) compared to other small loans, and it is

often difficult, and expensive, to keep track of mobile students

3. Federal law and regulations do not require commercial lenders

to use the proceeds of sales to bond authorities to make

additional student loans.
and recent graduates for that length of time. The annual cost of

servicing student loans usually ranges between 1.5 percent and 2

percent of loan principal, compared to usual costs of between 1/4

percent and 3/8 percent of loan principal for servicing home

mortgages, for instance.

Federal Insurance and Reinsurance of Student Loans

Student loans held by state authorities are all insured

directly or indirectly by the federal government against student

default, death, bankruptcy, and disability. In response to

federal financial incentives and pressure from private lenders,

about 40 states have established guarantee agencies to insure

student loans for lenders for 100 percent of principal and

interest. The guarantee agencies are in turn reimbursed by the

federal government, at rates varying between 80 and 100 percent,

depending on the state's claims rate.

In states that have not yet set up guarantee agencies, student

loans held by state authorities are federally insured for 100

percent of principal and interest. These loans are called

Federally Insured Student Loans (FISLs). Loans guaranteed first

by a state guarantee agency are called guarantee agency loans.

FISL and guarantee agency loans make up the broad category of

guaranteed student loans.

PROFITABILITY

The profitability of student loan bonds depends on the

difference between the yield on the loans and the level of associated expenses—interest on the bonds and administrative costs.

Major factors affecting profit levels are the method by which the

yield on student loans is determined and the profits allowed by

federal law. This section explains how the yield on student loans

is determined and what restrictions federal law imposes on profitability. It also shows the historical relationship between the

yield on student loans and the interest rate on student loan

bonds, and gives examples of profits expected by two 1979 issuers

of student loan bonds.

Yield on Loans

Students' Interest Payments. Terms on the loans are essentially the same under both the FISL and guarantee agency loan pro-
grains. Students do not have to pay interest or begin repaying

their loans until 9 to 12 months after they leave school. Until

that time, the federal government pays the lender the 7 percent

student's share of interest on the loan—called interest subsidy

payments. Lenders are not allowed to charge students more than

7 percent interest on the loans.

Special Allowance Payments. Because a 7 percent return would

not be sufficient to induce commercial lenders to make student

loans, the federal government makes supplemental interest

payments, called special allowance payments, to institutions that

make student loans. State and local authorities that finance

student loans by selling tax-exempt bonds qualify for special

allowance payments just as other lenders do.

Special allowance payments are calculated each quarter by a

formula intended to reflect market interest rates. The rate of

the special allowance is 3.5 percentage points less than the

prevailing bond-equivalent rate on 91-day Treasury bills, rounded

up to the nearest one-eighth of 1 percent.^ When the special

allowance is added to the 7 percent interest paid by the student

(or the federal government), the gross return to the lender comes

to 3.5 percentage points above the bond-equivalent rate on 91-day

Treasury bills.^

4. The federal government pays interest also for up to three years

after graduation if the student is in the Armed Forces, Peace

Corps, or Vista, and for up to one year if the student is

unemployed.

5. The bond-equivalent rate is calculated using slightly different conventions than those used to calculate the Treasury bill

rate. One of the differences is that the bond-equivalent rate

is based on a 365-day year, instead of a 360-day year. If an

investor bought a $100, 91-day Treasury bill for $99.50, for

example, the Treasury bill rate would be 1.978 percent, and

the bond equivalent rate would be 2.016 percent. The bondequivalent rate always works out to be slightly higher than

the Treasury bill rate.

6. Student's 7 percent interest rate + special allowance rate = 7

+ [T bill rate - 3.5] = T bill rate + 3.5.
Table 1 shows the special allowance rates paid from 1969 to

1979. The procedure for calculating the rate has changed since

special allowance payments were first instituted in the Federal

Emergency Insured Student Loan Act of 1969. The rationale for

changing the rate has always been to keep the return on student

loans competitive with the return on other investments available

to banks.

Until December 1976, the rate of the special allowance was

determined by a committee consisting of officials from the Department of Health, Education, and Welfare, the Treasury Department,

and the Office of Management and Budget. The formula relating the

special allowance to the Treasury bill rate was established in the

Education Amendments of 1976 (P.L. 94482). The formula itself has

remained unchanged since then, but initially the annual average

rate of the special allowance was limited to 3 percent. The 3

percent ceiling was increased to 5 percent effective October 1,

1977, and the ceiling was removed effective September 30, 1979.

Profits Accruing to State and Local Governments

Federal Tax Law. In general, state and local governments are

prohibited by federal law from investing the proceeds of taxexempt bonds in securities with "materially higher" yield than the

interest rate on the bonds. If these governments do earn

materially higher yields on these investments, the profits are

called arbitrage, and the bonds are called arbitrage bonds.

Section 103(c) of the Internal Revenue Code defines and generally

prohibits arbitrage bonds. The Tax Reform Act of 1976 amended

this section, however, so that special allowance payments "are

not to be taken into account ... in determining yields on

student loan notes" for arbitrage purposes.

The arbitrage rules and regulations affect nearly all issuers

of tax-exempt bonds. For instance, there are rules exempting

"reasonably required" reserve accounts and temporary investments

from arbitrage restrictions. The Internal Revenue Service and

private bond attorneys spend a great deal of time and effort

interpreting the arbitrage rules and dealing with alleged abuses.

With minor exceptions, there are no federal restrictions on

the purposes for which states may use surplus funds. Since one of

this paper's options is to specify permissible uses of surplus

funds, this issue is discussed in Chapter IV.

58-650 0-80- 4
TABLE 1. SPECIAL ALLOWANCE RATES, 1969-1979 (In percents)

Quarter Ending

Special

Allowance Rate

September 30, 1969

December 31, 1969

March 31, 1970

June 30, 1970

September 30, 1970

December 31, 1970

March 31, 1971

June 30, 1971

September 30, 1971

December 31, 1971

March 31, 1972

June 30, 1972

September 30, 1972

December 31, 1972

March 31, 1973

June 30, 1973

September 30, 1973

December 31, 1973

March 31, 1974

June 30, 1974

September 30, 1974

December 31, 1974

March 31, 1975

June 30, 1975

2.000

2.250

2.000

2.250

2.000

1.500

1.000

1.250

1.250

0.750

0.750

0.750

0.750

0.750

1.000

1.750

2.500

2.500

2.250

3.000

3.000

3.000

2.250

1.500

continued

Size of Profits, The difference between the yield on student

loans and the interest rate on student loan bonds is now generally

large enough to generate millions of dollars of profits—revenues

in excess of costs—for a bond issuer over the course of the

fifteen years or so of a bond issue. In the aggregate states

could accumulate between $300 million and $450 million in profits

from student loan bonds over the six-year period 1980-1985. The

magnitude of the profits depends mostly on the size of the bond

10
TABLE 1. (Continued)

Special

Quarter Ending Allowance Rate

September 30, 1975 2.250

December 31, 1975 1.875

March 31, 1976 1.250

June 30, 1976 1.500

September 30, 1976 1.875

December 31, 1976 1.500

March 31, 1977 1.250

June 30, 1977 1.500

September 30, 1977 2.250

December 31, 1977 2.875

March 31, 1978 3.125

June 30, 1978 3.250

September 30, 1978 4.125

December 31, 1978 5.625

March 31, 1979 6.250

June 30, 1979 4.000

September 30, 1979 6.625

December 31, 1979 9.000

SOURCES: State of North Dakota, Official Statement for Student

Loan Revenue Bonds of 1979 (July, 1979), p. 1-4; and

Virginia Education Loan Authority, Official Statement for

Guaranteed Student Loan Program Revenue Bonds Series of

1980A (January 1980), p. 14.

issue, but also on the interest rate on the bonds, the level of

special allowance payments, and the administrative efficiency of

the authority. Other things being equal, profits will be larger

the lower the interest rate on the bonds, the higher the level of

special allowance payments, and the lower the costs of running the

authority.

The level of profits for a bond issue of any given size and

administrative cost depends then on the difference between the

return on student loans and the net interest cost of the bonds.

Since this difference changes each quarter when the special allow11
ance is recalculated, it is difficult to predict the level of

profits that any one bond issue will generate. The return on

student loans can never fall below 7 percent (the return corresponding to a zero percent special allowance), and it can range

upward from 7 percent to whatever level is generated by adding 3.5

percentage points to the bond-equivalent rate on 91-day Treasury

bills. By contrast, the net interest cost of the bonds is customarily fixed at the time the bonds are issued. The difference

between the return on the loans and the net interest cost of the

bonds, therefore, fluctuates with the Treasury bill rate.

States that sold student loan bonds several years ago, when

interest rates were low compared to current rates, have been

paying low, fixed interest rates on their bonds but have been

enjoying increasingly higher yields on their student loans. Their

programs are generating surpluses that the issuers never expected.

On the other hand, if states were to issue long-term, fixed

interest rate bonds when interest rates were above 7 percent,

there would always be a possibility that they would run into difficulty making their scheduled payments of interest and principal

on the bonds. This could happen if interest rates dropped dramatically so that the yield on the loans fell short of the interest

rate of the bonds. States can take steps to protect themselves

against that event, however. These measures are described in

Chapter IV.

Table 2 indicates the approximate spreads between yields on

student loans and interest rates on student loan bonds since

1970. Column 4 shows the spread that existed at the time the

bonds were issued. Column 5 shows the average spread that states

are now working with. The numbers in Column 5 are the differences

between the current yield on student loans (16 percent) and the

fixed interest rates on bonds issued between 1970 and 1979.

States that issued student loan bonds in 1975, for instance, are

now working with a spread of 10 percentage points, compared to a

spread of 11 percentage points for bonds issued in 1972. These

spreads should not be equated to surpluses. The rates at which

surpluses are accumulated are the spreads minus administrative

expenses.

Examples. An analysis of the cash flow projections prepared

by two 1979 issuers of student loan bonds, North Dakota and Wisconsin, appears in the Appendix. The results of the analysis,

12
TABLE 2. YIELD ON STUDENT LOANS COMPARED TO THE NET INTEREST COST

OF STUDENT LOAN BONDS, 1970-1979 (In percents)

Average Net

Yield on Interest Cost

Student of Student

Annual Spread

Between Yield

On Student Loans

and Average Net

Interest Cost of

Student Loan Bonds

Spread Between

Current 16% Yield

on Student Loans

and Average Net

Interest Cost of

Student Loan Bonds

Issued in the

Year

(1)

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

Loans3

(2)

8.9

8.1

7.7

8.9

9.8

9.0

8.5

9.0

11.1

13.5

Loan Bonds"

(3)

6.0

5.2

5.0

4.9

5.6

6.0

5.3

4.8

6.0

6.4

[(2) - (3)]

(4)

2.9

2.9

2.7

4.0

4.2

3.0

3.2

4.2

5.1

7.1

Indicated Yeard

(5)

10.0

10.8

11.0

11.1

10.4

10.0

10.7

11.2

10.0

9.6

SOURCE: State of North Dakota, Official Statement for Student Loan

Revenue Bonds of 1979 (July 1979), p. 1-4; and Virginia

Education Loan Authority, Official Statement for Guaranteed Student Loan Program Revenue Bonds Series of 1980A

(January 1980), p. 14; Blyth Eastman Paine Webber and

state higher education officials.

a. The yield on student loans is the sum of the 7 percent paid by

the student or the federal government and the special allowance payment made by the federal government, calculated as an

annual average. b« In any given year, the average net interest cost (NIC) of

student loan bonds is the average of tlie NICs of bonds issued in

that year, weighted byissue $ize. c. Current yield on student loans is the rate (16 percent) that

applied from October 1 to December 31, 1979.

States1 interest costs are generally fixed as of the year their

bonds were issued, \>ut the return on their investments fluctuates from quarter to quarter. This column shows the difference

between the current return on student loans (16 percent), and

the interest costs corresponding to bonds issued between 1970

and 1979. States that issued student loan bonds in 1975, for

instance, are now working with a spread of 10 percent, whereas

states that issued bonds in 1972 are working with a spread of 11

percent.

d.

13
which serves as an illustration of the basic concepts explained in

the previous section, are summarized briefly below.

North Dakota, for instance, expects to realize profits of $16

million—$5 million in present-value terms'—by 1996 from $79

million of bonds issued in the summer of 1979. Over a 17-year

period, Wisconsin expects profits totaling $8.5 million—$4 million in present-value terms—from its $40 million bond issue in

the summer of 1979.

These estimates may be low, because the state authorities

base their cash flow projections on what seem to be conservative

estimates of future special allowance rates, and the profit

figures reported above are based on the states1

 assumptions."

Assuming instead that the special allowance rate remains an even 5

percent, North Dakota would receive profits of $25 million—$8

million in present-value terms, and Wisconsin would receive profits of $15 million—$8 million in present-value terms.

VOLUME OF STUDENT LOAN BONDS

Volume to Date

Eighteen states, four local authorities in Texas, and the

District of Columbia have sold bonds to finance guaranteed student

7. Present-value discounting is a procedure used to assign a

value to funds that will be received at specific future

dates. It is designed to take into account the fact that the

promise of funds in the future is less valuable than having

the money presently in hand, both because of the risk that the

money will not actually be received in the future, and because

it is possible to earn interest on money presently in hand.

8. Both Wisconsin and North Dakota, for example, project special

allowance rates of only 2.8 percent after 1983. Under the

current formula for calculating the special allowance, that

corresponds to a 91-day Treasury bill rate of 6.3 percent. If

instead, the 91-day Treasury bill rate is 8.5 percent, the

current formula will produce a special allowance rate of 5

percent.

14
loans.y

 Ten other states—California, Colorado, Georgia, Indiana,

Iowa, Mississippi, Ohio, Vermont, Tennessee, and West Virginia—

are considering issuing revenue bonds for student loans.

Table 3 lists the annual dollar volume of student loan bond

issues of each state from 1966 to 1979. About $1.4 billion in

student loan bonds has been issued to date, with $270 million

issued in 1978 and $600 million issued in 1979.

Potential Volume

The potential volume of annual student loan bond issues is

associated closely with the annual volume of guaranteed student

loan originations (newly made loans). In fact, if states chose to

use bond proceeds only to make new student loans and not to

purchase existing loans from banks, then the absolute limit of

annual bond issues would about equal the annual volume of loan

originations.^

Projections of student loan originations, then, serve as a

useful guide in making projections of the level of future bond

issuance. The volume of student loan bond issues has been

increasing as a percentage of student loan originations, from 10

9. Two of those states, Florida and New Mexico, are no longer

issuing student loan bonds. Florida has sold all of its loans

to Sallie Mae and has no firm plans to issue additional

student loan bonds, although there is some interest there in

establishing a nonprofit corporation to issue bonds and

purchase student loans from banks. New Mexico restructured

its student loan program when it created a state guarantee

agency and now uses the proceeds of state severance taxes to

make student loans. If the state decides to sell revenue

bonds in the future, its legislature would first have to enact

new authorizing legislation.

10. To reach this limit, of course, student loan bonds would have

to preempt all other sources of guaranteed student loans.

Total bond issues would be somewhat greater than total loan

originations, since, on average, only about 85 percent of the

bond proceeds are used to make student loans. The remaining

15 percent is invested in reserve accounts or used to pay the

costs of issuing the bonds.

15
TABLE 3. STUDENT LOAN BOND ISSUES BY STATES, CALENDAR YEARS 1966-

1980 (In millions of dollars)

1966-

State 1970 1971 1972 1973 1974 1975

Arkansas — — — — — —

California13

Coloradob

District of

Columbia — — — — — —

Florida — — — 8.0 — 10.0

Georgiab

Illinois

Indianab

Iowab

Kansas — — — —

Kentucky

Michigan — — — — — —

Minnesota — — — -- 29.4 18.0

Mississippi — — — — — —

Nebraska — — — — — —

New Mexico — 4.9 7.7 4.6 5.3 4.3

North Carolina — — 16.7 3.0

North Dakota

Ohiob

Oklahoma — — — 0.7 2.9 3.0

South Carolina — — — — 5.0

South Dakota — — — — — —

Tennesseeb

Texas 103.0 12.5 20.0 10.0 15.0 11.0

Texas Local

Authorities0 — — — — — —

Utah

Vermontb

Virginia — — — — —

West Virginiab

Wisconsin — — — — — —

Total 103.0 17.4 44.4 26.3 57.6 46.3

Cumulative

Totald 103.0 120.4 164.8 191.1 248.7 295.0

SOURCE: Compiled by the Congressional Budget Office from Student

Loan Marketing Association data and data supplied by individual states.

a. These are very rough, informal Sallie Mae estimates.
TABLE 3. (Continued)

Arkansas

California15

Colorado15

District of

Columbia

Florida

Georgia15

Illinois

Indiana15

Iowab

Kansas

Kentucky

Michigan

Minnesota

Mississippi15

Nebraska

New Mexico

North Carolina

North Dakota

Ohiob

Oklahoma

South Carolina

South Dakota

Tennessee15

Texas

Texas Local

Authorities0

Utah

Vermont15

Virginia

West Virginia15

Wisconsin

Total

Cumulative

Totald

1976

—

—22.0

—

37.2

6.1

17.0 — .

3.0

—

~_

18.0

—

::

—

103.3

398.3

1977

—

—12.5

—

27.0

37.0

—4.3

— —

2.0

—

_

16.0

20.0

— —

—

118.8

517.1

b. May issue student loan bonds for

c. Texas local authorities include

1978

7.5

—

25.9

21.0

22.0

38.3

21.6

19.0

— •—

2.5

10.0

__

10.0

——

16.5

75.0

269.3

786.4

the

the

1979

—

—

—

40.0

30.0

42.0

100.0

47.9

—

20.0

78.5

10.0

23.9

52.1

—

35.0

47.4

35.0

40.0

601.8

1388.2

Estimates

1980a

10.0

100.0

30.0

30.5

30.0

20.0

50.0

30.0

—75.0

50.0

55.0

10.0

40.0

—25.0

80.0

15.0

—50.0

20.0

—

—75.0

35.0

60.0

10.0

900.5

2288.7

first time in 1980.

higher education authorities of Abilene, Central Texas, North Texas, and South Texas.

The cumulative total is larger than the volume of bonds outstanding because some of the bonds have been retired.
percent in 1977 to 20 percent in 1979. The volume of guaranteed

student loan originations has itself also been increasing rapidly,

from a total of about $2 billion in fiscal year 1978 to about $3

billion in fiscal year 1979.

Table 4 shows two estimates of growth paths for annual issues

of student loan bonds. Although the paths can be only educated

guesses, the evidence at hand suggests that the realized path will

lie somewhere between these two. The lower path assumes that bond

issues will remain at 20 percent of loan originations, and the

upper path assumes that bond issues will continue to increase as a

percentage of loan originations by five percentage points a year,

leveling off at 50 percent of loan originations in 1984.^ Growth

along the upper path would displace at least some private lending

to students.

Student loan bond issues, thus, are likely to total between

$770 million and $960 million in fiscal year 1980 and between $900

million and $2.3 billion in fiscal year 1985. The state-by-state

estimates of 1980 volume listed in the last column of Table 3

total $900 million, midway between these 1980 volume projections.

FEDERAL COSTS OF STUDENT LOAN BONDS

The major federal costs of student loan bonds stem from

direct outlays for the special allowance and revenue foregone

because interest on the bonds is not subject to federal income

taxation. Five-year projections of these costs are shown in Table

5 for both low- and high-path bond volume. The cost of the

special allowance on bond-financed loans will be between $80

million and $100 million in 1981 and will grow to between $120

million and $220 million in 1985. The revenue loss caused by

tax-exemption of interest on the bonds will be between $80 million

and $100 million in 1981 and between $160 million and $290 million

in 1985. These revenue loss calculations are based on the

assumption that each billion dollars of outstanding tax-exempt

11. The projections of loan originations are the Congressional

Budget Office's projections based on current law. If the

Congress enacts legislation changing the guaranteed student

loan program, these estimates would have to be revised.

18
TABLE 4. PROJECTIONS OF VOLUMES OF ANNUAL ISSUES OF STUDENT LOAN

BONDS (By fiscal year, in millions of dollars)

Bond Volume 1980 1981 1982 1983 1984 1985

If annual bond issues

remain 20 percent of

annual loan originations 770 860 880 890 900 900

If annual bond issues as

percent of annual loan

originations increase 5

percentage points each

year 960 1,290 1,540 1,790 2,030 2,260

student loan bonds costs the federal government $30 million

annually in foregone tax revenue.12

In addition to the above-mentioned costs, the federal government pays principal and accrued interest on defaulted student

loans and 7 percent interest on loans while students are in

school. The special allowance, in-school interest subsidy, and

payment on defaulted loans would be incurred whether loans were

made by commercial lenders or tax-exempt bond authorities. To the

extent that bond programs increase the total number of student

loans, however, they increase federal costs for these subsidies.

The largest extra cost associated with student loan bonds results

from the tax-exemption of interest on the bonds.

12. The exact amount of federal revenue loss stemming from the

tax-exemption of interest on state and local bonds is a

controversial issue. See Congressional Budget Office,

Tax-Exempt Bonds for Single-Family Housing (April 1979), pp.

47-51; and Roger Kormendi and Thomas Nagle, "The Interest

Rate and Tax Revenue Effects of Mortgage Revenue Bonds"

(unpublished manuscript, University of Chicago Graduate

School of Business, July 26, 1979), pp. 11-21.

19
TABLE 5. CURRENT LAW PROJECTIONS OF FEDERAL COSTS OF STUDENT LOAN

BONDSa (By fiscal year, in millions of dollars)

1981 1982 1983 1984 1985

If annual bond issues remain

20 percent of annual loan

originations

Revenue loss from tax

exemption of interest

on bonds 80 102 123 141 159

Cost of special allowance13

 81 101 105 111 116

Total 161 203 228 252 275

If annual bond issues as

percent of annual loan

originations increase 5

percentage points each

year

Revenue loss from tax

exemption of interest

on bonds

Cost of special allowance'3

Total

98'

98

196

140

138

278

187

160

347

237

189

426

290

218

508

a. In addition to the costs listed here—special allowance payments and revenue foregone because interest on the bonds is

exempt from federal income taxation—the federal government

pays principal and accrued interest on defaulted loans and

7 percent interest on the loans while loan recipients are in

school.

b. These projections are based on CBOfs projections of interest

rates on 91-day Treasury bills: 8.9 percent for 1981; 8.7

percent for 1982; 8.0 percent for 1983; 7.7 percent for 1984;

and 7.5 percent for 1985. If actual interest rates exceed

these projections, the special allowance costs will be correspondingly greater than those projected in this table.

20
CHAPTER III. LEGISLATION AFFECTING STUDENT LOAN BONDS

The profits that issuers of student loan bonds may now earn

are the combined result of 1976 tax legislation and subsequent,

significant expansion of the guaranteed student loan program in

higher education legislation. Drafters of the tax legislation had

no reason to anticipate this expansion, and drafters of the

student loan legislation probably did not foresee the effect their

actions would have on what were, at that time, small-scale student

loan bond programs.^

TAX TREATMENT OF STUDENT LOAN BONDS FOR ARBITRAGE PURPOSES

Section 1305 of the Tax Reform Act of 1976 granted certain

private nonprofit corporations authority to issue tax-exempt

student loan bonds and excluded the special allowance from arbitrage yield restrictions on all student loan bonds. Section 1305

was not included in the House version of the bill but was added as

an amendment in the Senate Finance Committee and subsequently

agreed to in conference. The Senate Finance Committee Report on

the Tax Reform Act of 1976 suggests that the section was intended

primarily to allow nonprofit corporations in Texas to issue

student loan bonds and that the arbitrage provision was included

to ensure that these nonprofit corporations would be able to cover

the costs of their programs.^

1. The difficulties that may arise from separate consideration of

tax and direct outlay programs prompted the Congress to give

the House and Senate Committees on the Budget the duty to

"devise methods of coordinating tax expenditures, policies,

and programs with direct budget outlays." Congressional

Budget Act of 1974, P.L. 93-344 (July 12, 1974), sees. 101 and

102.

2. There may have been concern that the administrative costs of

student loan programs would exceed the 1.5 percentage point

spread generally allowed by the arbitrage regulations.

21

58-650 0-80- 5
The forerunner of Section 1305 was S.3272, introduced by

Senator Lloyd Bentsen (D-Texas) in April, 1976. In a floor

statement on the bill, the Senator said only that he wanted

nonprofit corporations in Texas to be able to issue tax-exempt

bonds for student loans.^

The Senate Finance Committee's report on the Tax Reform Act

of 1976 briefly describes what was by then called the "Bentsen

Amendment." As the following quotation from the committee report

suggests, the committee realized that what it was doing would

apply to bonds issued outside Texas as well:

The interest to be paid by students, together with the

incentive payments received by the institution making the

loan from the Commissioner of Education, will constitute

a yield that could be higher than the maximum yield the

corporations believe they will be able to pay on their

bonds . . . only one State, Texas, has been called to the

committee's attention in which this situation exists.

However, similar problems, which may exist in other

States, could benefit from the committee amendment.

The committee apparently did not envision that large volumes

of student loan bonds would be issued in Texas or elsewhere. Only

7 states had issued student loan bonds prior to 1976. Moreover,

based on previous levels of special allowance payments, the

committee would not have had any reason to expect that it was

opening the door for substantial profits. Until 1976, special

allowance payments had been low by today's standards and had a

statutory ceiling of 3 percent. The special allowance rate

averaged 1.7 percent between 1969 and June 1976, compared to an

average of 5.2 percent in 1978 and 1979.

EDUCATION LEGISLATION AFFECTING STUDENT LOAN BOND PROFITS

Education legislation enacted since 1976 has affected student

loan bond programs in two ways. First, all adjustments to the

3. Congressional Record, April 8, 1976, p. 10029.

4. Report on H.R. 10612, the Tax Reform Act of 1976, Senate

Committee on Finance, 94:2 (1976), p. 406.

22
return on student loans have been added to the special allowance.

This is the portion of the return that was excluded from arbitrage

yield calculations by the Tax Reform Act of 1976, and thus allows

bond issuers to accumulate profits* Education legislation has

held the student's interest share fixed at 7 percent since 1968,

while it has repeatedly increased the special allowance to account

for higher interest rates caused by inflation.5 Had the education

legislation held the special allowance fixed and incorporated

yield increases in the student's interest share, arbitrage regulations would probably have caused bond issuers to reduce the

interest rate charged to students or to rebate part or all of the

special allowance to the federal government. In that case, bond

issuers would have been able to accumulate only small surpluses,

if any.

Second, the Middle Income Student Assistance Act (P.L. 9556),

enacted in the fall of 1978, greatly expanded the guaranteed

student loan program. This legislation was a reaction to forces

far removed from student loan bonds. Partly an attempt to head

off pressure for a tuition tax credit, for which all parents would

be eligible, the act extended the in-school interest subsidy on

guaranteed student loans to all students, regardless of family

income. This subsidy extension, coupled with the increasing

attractiveness of 7 percent loans, has greatly increased student

demand for loans. Annual guaranteed student loan originations,

for example, have increased from $1.5 billion in fiscal year 1977

to about $3.0 billion in fiscal year 1979. This surge in the

demand for loans has correspondingly increased the popularity of

student loan bonds, so that current projections of student loan

bond volumes for 1981 and future years are much greater than

projections that would have been made in 1976.

5. Education legislation has made 2 major adjustments to the

special allowance: (1) in late 1976, by establishing a formula

that tied the special allowance to the Treasury bill interest

rate, which rises and falls with anticipated inflation rates,

and (2) by setting higher and higher ceilings and eventually

removing the ceiling on the special allowance.

23
PENDING PROPOSALS TO RESTRUCTURE STUDENT LOAN PROGRAMS

All higher education programs, including student loan programs, must be reauthorized before October 1, 1980." Partly

because of the rapid increase in the demand for student loans, the

student loan program in general and student loan bonds in particular have become far more costly to the federal government than

anticipated. Even in fiscal year 1980, interest subsidies,

special allowances, and payments on defaulted loans will probably

cost the federal government about $500 million more than estimated

in the budget in January 1979. In grappling with this rapid

increase in cost, the Congress may decide to restructure the

student loan program or change the way it treats student loan

bonds.

In November 1979, the House passed a bill (H.R. 5192) that

would make some changes in the student loan program but would

basically maintain its existing structure. The bill authorizes a

commission to study many aspects of the student loan program,

including "the cost to the Federal government of the arbitrage

derived from revenue bonds . . . and the appropriate role of such

bonds as a mechanism for raising student loan capital."

H.R. 5192 initially contained another section dealing with

tax-exempt student loan bonds, but this was deleted by the full

Committee. This section would have denied special allowance payments to authorities that: are not the sole student loan authority

in the state, make loans to students who are not either state

residents or attending in-state schools, contract loan servicing

with anyone who has financial ties to an employee or office holder

of the authority, do not issue bonds through a competitive bidding

process, use revenues from the student loans for anything other

than administrative costs or to make more student loans, or do not

remit remaining assets at the end of the program to the federal

government for the student loan insurance fund.

6. For a more complete discussion of pending reauthorization

proposals, see CBO, Fiscal Year 1981 Options for Federal Postsecondary Student Assistance Programs (forthcoming).

7. For a comparison of estimates made in 1979 and 1980, see The

Budget of the U.S. Government, Fiscal Year 1980, p. 423 and

The Budget of the U.S. Government, Fiscal Year 1981, p. 432.

24
The Senate Subcommittee on Education, Arts, and Humanities is

likely to draft its reauthorization legislation in March. Three

reauthorization bills have been introduced in the Senate. S.1870

is similar to the House-passed bill, in that it would modify and

expand the guaranteed student loan program without changing its

basic structure. S.1840 and S.1600 would both revamp the federal

student loan program in ways that would significantly affect

student loan bonds.

Both S. 1840 and S. 1600 would divide student loans into two

categories: direct/basic loans and guaranteed/supplemental loans.

In both bills, direct/basic loans would be federally financed from

the repayment of outstanding student loans and borrowing from the

Treasury. These loans would be made to students on the basis of

need. Independent students and parents of dependent students

would be eligible under both bills for guaranteed/supplemental

loans. These loans would be originated and owned by commercial

lending institutions, schools, state authorities, and nonprofit

state and local corporations.

If the final legislation ^ uses the approach of S.1600 or

S.1840, state authorities would be able to issue bonds only for

guaranteed/supplemental loans. CBO projects that the volume of

these loans would be much lower than the volume of guaranteed student loans that would be made if there were no change in the law.

For fiscal year 1981, for instance, CBO estimates that, under current law, about $4 billion in guaranteed student loans would be

originated. Under S.1840, about $3 billion in guaranteed/supplemental loans would be originated, and under S.1600, about $2

billion in guaranteed/supplemental loans would be originated.

Moreover, depending on how the special allowances were calculated

in the final legislation, issuers of tax-exempt bonds might not

receive as large surpluses as are now permitted.

25

CHAPTER IV. OPTIONS

The Congress could take a variety of approaches with respect

to the profits accruing from student loan bonds. It could take no

action or could simply restrict the permissible uses of surplus

funds. Alternatively, it could reduce or remove one of the

federal subsidies now received by states that issue these bonds,

and thus reduce the profits.

The Congressional options discussed in this chapter are:

o Take no action.

o Reduce the direct interest subsidy received in the form of

the special allowance on student loans held by tax-exempt

bond authorities.

o Impose usual arbitrage rules on student loan bonds.

o Tax interest on student loan bonds and thus remove the

indirect subsidy received through the low interest rates

on tax-exempt bonds.

o Withdraw federal insurance from loans financed with taxexempt bonds and thus remove the subsidy inherent in the

insurance.

o Require that surpluses be used to make additional student

loans.

The options in this chapter are evaluated by a comparison of

costs and benefits. Because most of the options would reduce one

of the federal subsidies now provided to student loan bond

issuers, they would reduce federal costs at the possible expense

of losing some of the benefits provided by student loan bonds.

Student loan bonds produce benefits to the extent that they increase the availability of student loans. If a reduction in a

subsidy resulted in a cutback in the volume of bonds issued, then

that subsidy reduction would indirectly be responsible for a

decline in the total volume of lending to students.

27
Calculating the precise amount by which student loan bonds

have increased loan availability would entail subtracting from the

actual level of lending the level that would have been attained

had states not issued student loan bonds. Unfortunately, there is

no way of knowing the volume of student loans that would have been

made by commercial lenders without the state bond programs. To

some extent, lending supported by student loan bonds has probably

simply displaced private lending. Isolating the effect of student

loan bonds on loan availability is now infeasible, both because

concentrated state issuance of student loan bonds is such a recent

phenomenon and because there are too many other important factors

influencing the demand and supply of student loans.

In at least one state, Utah, such a surge in loan originations followed the issuance of student loan bonds that it would be

hard not to credit the bond program with greatly increasing loan

availability. Utah issued its first student loan bonds in January

1979, and the dollar volume of loans insured by Utah's guarantee

agency in the following three quarters was triple the volume for

the preceding three quarters.^

Although it may be impossible to estimate numerically the

effect of each option on loan availability, the options can be

ranked relative to one another. An analysis of relative impact on

loan availability is included in the following discussion of each

option. The options are also evaluated on the basis of administrative ease and federal cost reduction.

TAKE NO ACTION

Several arguments can be made for taking no action on student

loan bonds. The prospect of earning surpluses may give states

added incentive to issue student loan bonds, thereby increasing

the availability of student loans. These surpluses would then

1. From January through September 1979, $19.7 million of loans

were guaranteed, compared to $6.5 million from March through

December 1978. The $47 million bond issue provided $22

million for the purchase of existing student loans and $17

million for new student loans. (Figures were supplied by the

Utah Higher Education Assistance Authority.)

28
represent the cost to the federal government of increasing the

availability of student loans in this way.

This justification of student loan bond surpluses raises

several questions. Does the Congress in fact wish to extend the

availability of student loans beyond what private lending institutions and Sallie Mae would provide? If so, by how much do anticipated surpluses actually increase the total volume of bonds issued

and loans made? Are there less costly ways of accomplishing the

same objective?^

Another argument for taking no action now centers around the

uncertainty of future levels of surplus. The special allowance is

now at the highest level in its eleven-year history; consequently,

the return on student loans is also at an all-time high. Interest

rates and, correspondingly, the return on student loans may drop

in the future. If so, states may then have to draw on surpluses

that they accumulated during earlier periods to meet their

expenses.

According to CBO's projections, however, the yield on student

loans will average 12 percent over the next six years—considerably below the current 16 percent yield, but high enough to cover

the projected costs of student loan bonds now outstanding and

those that will be issued over the next six years. Therefore,

states probably have little need to accumulate surpluses now in

anticipation of insolvency in the near future.

More importantly, states should not need to accumulate surpluses, because they can take other steps to protect themselves

against insolvency. States would have occasion to draw on accumulated surpluses only if the yield on their student loans dropped

below the level necessary to cover costs. Because, under current

law, the yield on student loans cannot drop below the 7 percent

student share, the threat of insolvency is not serious as long as

interest rates on tax-exempt bonds are below 7 percent.^ Only

2. A discussion of the costs of student loan program proposals is

contained in CBO, Fiscal Year 1981 Options for Federal Postsecondary Student Assistance Programs (forthcoming).

3. Although all lenders are allowed by law to charge students

less than 7 percent interest, only the state of Texas has done

29
recently, when interest rates on these bonds rose above 7 percent

did issuers of student loan bonds begin to worry about insolvency,

but most have adapted and taken measures to protect themselves.

Some states, for example, are borrowing from banks to meet

their current need for loanable funds, with the intention of paying back the banks with the proceeds of bonds they will issue when

interest rates drop. Others are issuing short-term, fixed

interest rate bonds at interest rates below 7 percent, with plans

to sell their portfolios to Sallie Mae in 3 years and use the proceeds to retire their bonds. Others are experimenting with a new

type of tax-exempt bond: long-term bonds with floating interest

rates. In contrast to fixed interest rate tax-exempt bonds, these

bonds bear interest at a different rate each quarter or each six

months. The interest rate is recalculated periodically by a

formula that pegs it to the 91-day Treasury bill rate, so that it

"floats" up and down. By issuing floating interest rate bonds,

student loan authorities can tie their borrowing costs to the

fluctucting yield on their investments, thus insuring a positive

spread to cover administrative expenses. Floating interest rate

bonds may encounter investor resistence initially, but once the

technique is refined, investors may find them appealing since they

offer better protection against unanticipated inflation than do

fixed interest rate bonds whose prices drop when the inflation

rate proves to be higher than anticipated.

By issuing floating rate bonds in the future, states can

practically guarantee that their programs will remain solvent,

thus obviating the need for the protection offered by accumulated

surpluses. And since interest rates on nearly all outstanding

student loan bonds are below 7 percent, there should be no need to

accumulate surpluses to cover this past debt.

LOWER SPECIAL ALLOWANCE FOR STUDENT LOANS FINANCED BY TAX-EXEMPT

BONDS

The Congress could reduce the profits now generated by

student loan bonds but still maintain their viability if it

so. All lenders are guaranteed to receive interest they have

charged students, so in fact all but the state of Texas are

guaranteed at least a 7 percent yield on their loans.

30
lowered the yield on student loans held by tax-exempt bond

authorities.^ This approach would involve setting up _a two-tier

yield structure, so that the yield on loans held by private

lenders would exceed the yield on loans held by tax-exempt bond

authorities. If the yield on student loans were set at a level

just high enough to make the loans a sound investment for bond

authorities, the yield reduction would produce almost no cutback

in loan availability. Student loan bond issuers are state agencies and nonprofit corporations, whose motivation should not be to

make a profit, but rather to provide a service, in this case

making loans available to students. As long as they can cover

their costs in providing this service, the prospect of earning no

profits should not affect their decisions about bond issuance.

Naturally, some states would be better able than others to

adjust to a yield cutback, but the differential impact of such a

change would not be as great as might be expected. The claim made

is that large states or states with long-established student loan

authorities might be better able to adjust than other states.

Although large states may have lower administrative costs because

of the efficiency of servicing a large loan portfolio, nearly all

states can (and most do) take advantage of the economies of scale

by contracting out their loan servicing to large national servicing organizations. The per-loan administrative expenses of

running a student loan program, therefore, do not vary much with

the size of the program. Moreover, it should not be necessary to

give all bond issuers yields large enough to cover the initial

costs of establishing new agencies. For other programs supported

by tax-exempt bonds, states customarily help offset start-up costs

either with direct state appropriations or interest-free loans.

The Congress could decrease the yield on student loans by

cutting either the student's share (now a flat 7 percent) or the

federal government's share (now a fluctuating special allowance).

Cutting the interest rate charged students would create some

problems, however. Most people would judge that students are

already getting a bargain at a 7 percent interest rate. Because

4. In this chapter, as in Chapter II, the term yield represents

the total return on student loans—the sum of the special

allowance and interest paid by students or the federal

government. Because it does not take costs into account, it

is not the same thing as rate of return.

31
the inflation rate is well above 7 percent, students are now

paying no interest (negative interest, in fact) on their loans in

real terms. Moreover, if students paid less than 7 percent

interest on loans held by bond authorities, Sallie Mae would

probably be unwilling to buy loans from the authorities, since it

could buy higher-yield loans from commercial lenders. In addition, if bond authorities lent at interest rates below 7 percent,

students would prefer their loans, and there would probably be a

large shift from commercial lending to lending financed by taxexempt bonds.

Cutting the federal government's share of the yield could be

accomplished by giving bond authorities a lower special allowance

than that given to private lenders. When the Congress initially

authorized the special allowance in 1969, it felt that one special

allowance might not be appropriate for all lenders. Section

2(a)(2) of the Emergency Insured Student Loan Act of 1969 (P.L.

91-95) states: "The Secretary of Health, Education, and Welfare

. . . [may] set differing allowance rates for different regions or

other areas or classifications of lenders, within the limit of the

maximum." The Secretary never exercised the option to set differing special allowances, however, and in 1976 a single special

allowance was established by law.

The federal cost savings resulting from a lower special

allowance on loans financed through tax-exempt borrowing would

offset much of the federal revenue loss from the tax exemption of

the bonds. Depending on the specifications of the proposal for a

separate special allowance, this option would save a cumulative

total of between $200 million and $400 million over the next five

years.

The special allowance on loans held by bond authorities could

be a percentage of the commercial special allowance or it could be

calculated by a separate formula. ~> The Congress could establish a

formula analagous to the current formula for the special allowance, with some index of interest rates for long-term, tax-exempt

bonds substituted in place of the 91-day Treasury bill rate in the

current formula. It could then apply the special allowance de5. Throughout this discussion, the assumption is made that the

special allowance will continue to be calculated in the

present manner for all loans held by commercial lending

institutions and Sallie Mae.

32
rived from that formula quarterly to all outstanding loans held by

bond authorities, or it could apply the special allowance permanently to all loans financed from bonds issued in each quarter.

Under the first approach, the yield on a student loan would fluctuate quarterly and the special allowance would be recalculated

each quarter for all loans. Under the second approach, the yield

on a student loan would be constant during the life of the loan

with the special allowance calculated at the time of bond issuance

and fixed at that rate for all loans financed with that bond

issue.

If calculated at today's interest rates, the special allowance produced by a formula tied to tax-exempt interest rates would

be just half the special allowance produced by the present formula. In fact, this 1:2 ratio holds under most projections of

tax-exempt and taxable interest rates. Only if there were a major

tax code change or a huge rise or fall in the 91-day Treasury bill

rate would the 1:2 ratio be significantly out of line. Thus, if

the Congress wanted to achieve basically the same result as

establishing a separate special allowance formula for bondfinanced loans, it could set the special allowance on these loans

at half the special allowance given to commercial lenders."

Because this approach is nearly equivalent to the separate

formula option, an independent analysis would be redundant; therefore, only the separate formula approach is discussed below. (See

Table 6 on page 38 for a comparison of the federal cost savings

from the two approaches.)

Fixing the Special Allowance at Bond Issuance

If states continue to issue long-term, fixed interest rate

bonds, the Congress can both guarantee the solvency of student

loan bond programs and remove the possibility of their making

profits by assigning one lifetime special allowance to bondfinanced student loans. This would set and hold the yield on

This is the approach endorsed by the National Council of

Higher Education Loan Programs, which represents state

guarantee agencies and student loan bond agencies. The

National Council also favors a floor of 2.5 percent on the

tax-exempt special allowance. (Letter from National Council

of Higher Education Loan Programs to Senate Subcommittee on

Education, Arts and Humanities, February 1, 1980.)

33
student loans above the interest rate on student loan bonds—high

enough above to cover administrative costs and yet not high enough

to create surpluses.

Under this option, the yield on student loans could be

permanently set at the time of bond issuance at a rate 3.5

percentage points above the average interest rate of comparable

tax-exempt bonds issued during the previous quarter. The total

yield on bond-financed student loans would be the sum of the

student's 7 percent interest payment and the federal government's

tax-exempt special allowance payment. The tax-exempt special

allowance formula would work in much the same way as the present

formula. The special allowance rate would be set 3.5 percentage

points below the value of the chosen index of tax-exempt interest

rates.^ The special allowance would be set each quarter for all

loans financed from bonds issued in that quarter, so the yield on

any given loan would not change as long as it was held by the bond

authority.

For example, if a state issued student loan bonds at an

interest rate of 8 percent at a time when the chosen tax-exempt

bond interest rate index was 8 percent, the state's borrowing

costs would be 8 percent annually, and it would receive a yield of

11.5 percent annually on its student loans." Thus, it would

always have precisely 3.5 percent to cover administrative

expenses. If the state could borrow at a rate below the interest

7. When the student's 7 percent payment is added to this special

allowance, it results in a total yield 3.5 percentage points

above the tax-exempt rate [7 percent + (TER -3.5 percent) =

TER + 3.5 percent]. TER stands for the value of the chosen

index of tax-exempt interest rates.

8. The yield on the loans (11.5 percent) would be the sum of the

student's 7 percent interest rate and the special allowance

rate, which would be 4.5 percent. The special allowance (4.5

percent) is the value of the chosen index of tax-exempt bond

interest rates (8 percent) minus 3.5 percent (8 percent - 3.5

percent =4.5 percent).

9. The state would have the difference between the yield on the

loans (11.5 percent) and the interest rate on its bonds (8

percent) to cover administrative expenses. In this case,

this difference works out to be 3.5 percent (3.5 percent =

11.5 percent - 8 percent).

34
rate index, it would have slightly more than 3.5 percent to cover

administrative expenses; if it had to borrow at a rate above the

interest rate index, it would have slightly less than 3.5 percent

to cover administrative expenses. This option thus preserves the

incentive for states to get the best interest rate possible on

their bonds.10

Because loans financed from bonds issued at different times

would carry different special allowances, this option would require the federal government to keep track of the loans from each

bond issue in order to determine the appropriate special allowance. This would be a burdensome administrative task under certain circumstances. It would be difficult, for instance, to trace

the proceeds of any one bond issue if a state issued several bond

series and established a revolving fund into which it deposited

payments on outstanding student loans and from which it made new

student loans.

As mentioned above, the approach of fixing the special allowance at the time of bond issuance is geared to a bond market like

the present one, in which states issue long-term, fixed interest

rate bonds. There is no assurance that the bond market will continue to operate in this way, and establishing a fixed special

allowance would discourage movement toward possibly more efficient

floating rate tax-exempt bonds.

Recalculating Special Allowance for All Loans Each Quarter

If the tax-exempt special allowance were recalculated every

quarter for all student loans held by tax-exempt bond authorities,

the federal administrative burden would be kept relatively

light.11 Under this approach, the yield on bond-financed loans

10. By contrast, it does not preserve the incentive states now

have to refrain from issuing bonds during periods of generally high interest rates. Since a federal policy goal may be

to facilitate a stable source of funds for student loans,

however, it may be desirable for states to be somewhat

insulated from the rising and falling costs of borrowing to

finance student loans.

11. The special allowance is now recalculated every quarter for

all outstanding student loans and it will probably continue

to be recalculated every quarter for all outstanding

privately financed loans.

35
would fluctuate from quarter to quarter at 3.5 percentage points

above the prevailing average interest rate on tax-exempt bonds.

The total yield on bond-financed loans would again be the sum of

the student's 7 percent and the federal government's tax-exempt

special allowance. Under this option, however, the tax-exempt

formula would reset the special allowance rate every quarter for

all outstanding loans held by bond authorities; the rate would be

3.5 percentage points below the prevailing value of the chosen

index of tax-exempt interest rates.

If states continue to borrow for long terms at fixed interest

rates, a fluctuating special allowance would give them good years

and bad years, although the good years would not be as good as if

the special allowance continued to be calculated using the present

formula. The majority of a bond program's costs would be fixed at

the interest rate prevailing when the bonds were issued, but

revenues would fluctuate with market interest rates, sometimes

rising above and sometimes falling below their initial level. If

interest rates consistently rose, the authorities could reap

unexpected profits, while if interest rates consistently fell, the

authorities could suffer losses. As discussed earlier, the threat

of insolvency is serious only when states have to borrow at rates

exceeding 7 percent, the minimum guaranteed yield on their student

loans. When interest rates on long-term, tax-exempt bonds were

above 7 percent, states would have to find ways of reducing the

threat of insolvency, just as they are now doing.

By issuing student loan bonds with floating interest rates,

states could cope quite well with a special allowance that was

recalculated quarterly. They could offer bondholders interest

rates that would be recalculated each quarter at the value of the

index of tax-exempt interest rates used in the special allowance

formula. In this way, states could make their interest costs move

in tandem with the special allowance (and hence with the yield on

their loans), and they could guarantee themselves about 3.5 percent to cover administrative expenses. -^

12. The yield on the loans in time period i would be TERj^ +3.5

percent. Under this floating rate technique, if states could

make their interest costs in time period i equal to TER-^, the

difference between the yield on the loans and the interest

rate on the bonds would be a constant 3.5 percentage points.

36
Even if states continued to issue fixed interest rate bonds,

they could protect themselves somewhat against insolvency under a

fluctuating tax-exempt special allowance. They could structure

their bonds with call options, which would allow states to pay off

their bonds before maturity and then to refinance at the

prevailing lower interest

Floor on Special Allowance. Even though states could

probably protect themselves against losses under a fluctuating

special allowance system, they could still run some risk. For

instance, investors might consider floating interest rates to be

less desirable than fixed rates and demand relatively high

interest rates on floating rate bonds. If investors demanded

interest rates in excess of the difference between the yield on

student loans and the associated administrative expenses, states

could not issue floating rate student loan bonds.

A floor on the special allowance would provide additional

protection. If the floor were set at 2.5 percent, for instance,

states and bond purchasers would be assured that the total return

on student loans would never fall below 9.5 percent.^ Since the

net interest cost of student loan bonds has not yet exceeded 9.5

percent, a special allowance floor of 2.5 percent would currently

offer excellent protection against losses.

Federal Cost Reduction

The federal government would save between $20 and $30 million

in fiscal year 1981 and between $40 and $120 million in fiscal

year 1985 if it cut the special allowance on student loans held by

tax-exempt bond authorities.^ Table 6 shows the savings that

13. This procedure is not costless. In addition to the costs of

transacting the operation, a state that called its bonds

would have to pay a premium to the bondholders for doing so.

14. States would then be guaranteed a 2.5 percent special

allowance in addition to the guaranteed 7 percent student's

interest payment, bringing the guaranteed minimum yield up to

9.5 percent.

15. All estimates in this section are based on the assumption

that loans made from the proceeds of bonds issued before 1980

would continue to receive the present-law special allowance.

37
TABLE 6. FEDERAL SAVINGS FROM PROPOSALS TO CUT SPECIAL ALLOWANCEa

(By fiscal year, in millions of dollars)

Cumulative

Five-Year

1981 1982 1983 1984 1985 Totalb

If annual bond issues

remain 20 percent of

annual loan originations

Establish a separate,

fixed special allowance based on an

index of tax-exempt

bond rates 19 32 35 40 45 171

Establish a separate,

fluctuating special

allowance based on an

index of tax-exempt

bond rates 23 38 47 54 60 223

Give states a

special allowance

equal to half the

special allowance of

commercial lenders,

with no floor 23 38 44 49 53 208

Give states a special allowance equal

to half the special

allowance of commercial lenders, with a

2.5 percent floor 23 38 39 40 40 180

These estimates are based on CBO's projections of interest

rates on 91-day Treasury bills: -8.9 percent for 1981; 8.7

percent for 1982; 8.0 percent for 1983; 7.7 percent for 1984;

and 7.5 percent for 1985. If the actual interest rates exceed

these projections, federal cost savings from these proposals

will be greater than estimates in this table. The estimates

38
TABLE 6. (Continued)

Cumulative

Five-Year

1981 1982 1983 1984 1985 Totalb

If annual bond issues

as a percent of annual

loan originations increase 5 percentage

points each year

Establish a separate

fixed special allowance based on an

index of tax-exempt

bond rates 27 49 59 75 94 303

Establish a separate

fluctuating special

allowance based on an

index of tax-exempt

bond rates 32 56 77 97 118 379

Give states a

special allowance

equal to half the

special allowance of

commercial lenders,

with no floor 32 56 72 88 104 352

Give states a speccial allowance equal

to half the special

allowance of commercial lenders, with a

2.5 percent floor 32 56 64 71 78 302

are based on the assumption that student loans made from the

proceeds of bonds issued before 1980 would continue to receive

the commercial special allowance.

b. Details may not add to totals because of rounding.

39
would be achieved by four alternative changes in the special

allowance. Because the magnitude of the budgetary impact depends

in each case on the volume of student loan bonds that will be

issued, the budgetary effects are shown for each option under both

the lower- and upper-path bond volume projections made in Chapter

II.

The difference in savings between a fixed and fluctuating

special allowance for bond-financed loans is shown in Table 6.

With a fixed allowance, the cumulative five-year savings would

range between $171 million and $303 million while the fluctuating

allowance savings would range between $223 million and $379

million. A fixed special allowance would save less than a

fluctuating special allowance mainly because CBO projects that

interest rates will consistently drop over the next five years.

For comparative purposes Table 6 also shows the similarity

between the federal cost savings produced by a separate formula

for the fluctuating tax-exempt special allowance and by a special

allowance for tax-exempt bond authorities equal to half that for

commercial lenders, with no floor. The similarity of the cost

savings shows that the two proposals are nearly equivalent under

CBO's interest rate projections. In addition Table 6 gives the

cost of a 2.5 percent floor on the tax-exempt special allowance.

By 1985 the 2.5 percent floor would erode about a quarter of the

cost saving from a tax-exempt special allowance equal to half that

for commercial lenders. *•"

IMPOSE USUAL ARBITRAGE RESTRICTIONS ON STUDENT LOAN BONDS

Instead of cutting the special allowance directly, as discussed in the previous section, the Congress could cut it indirectly

by imposing on student loan bonds the same arbitrage restrictions

that apply on other tax-exempt bonds. This would nearly eliminate

the profitability of student loan bonds but would probably not

cause a cutback in bond issuance.

16. These estimates are again highly dependent on CBOfs interest

rate projections. If interest rates are higher than

projected, the cost of the 2.5 percent floor would be lower.

40
The usual arbitrage rules limit the difference between the

yield on tax-exempt bonds and the yield on investments made with

bond proceeds. These rules could be adjusted to accomodate a

fluctuating student loan yield. The Internal Revenue Code could

be amended, for example, to include in student loan yield

calculations the gross yield on the loans less any portion of the

special allowance that was rebated to the federal government.

Under this approach, if the arbitrage restrictions prohibited a

yield on student loans above a certain level, the bond issuer

would be required each quarter to rebate as much of the special

allowance as necessary to bring the yield on the loans down to

that level. Suppose, for example, the arbitrage rules prohibited

investments from a given bond issue from yielding more than 10

percent. As long as the special allowance remained below 3

percent, the total yield on student loans would be below 10

percent, and there would be no problem in complying with the

arbitrage rules. If the special allowance were 5 percent in one

quarter, however, the bond issuer would be able to keep 3 percent

but would have to rebate 2 percent to the federal government.

The ordinary arbitrage rules would permit a difference between the yield on student loans and the yield on student loan

bonds of 1.5 percentage points, or a higher amount if the bond

issuer demonstrated that a higher amount was necessary. In order

to get a higher amount, a state would have to get a private letter

ruling from the Internal Revenue Service (IRS) in advance of bond

issuance. If student loan bonds were subject to the ordinary

arbitrage rules, all states wanting to issue them would probably

have to apply for private letter rulings, because the costs of

servicing student loans drives the costs of these programs above

the 1.5 percent limit.

This approach would thus impose an administrative burden both

on the IRS and on issuers of student loan bonds. If the Congress

thought this case-by-case approach was too burdensome, it could

change the arbitrage rules to allow these bonds a spread of more

than 1.5 percentage points.

Under this option, states would rebate to the federal

government part of the special allowance they received on their

loans. The amount rebated would reduce federal expenditures by

between $20 and $25 million in fiscal year 1981 and between $45

and $95 million in fiscal year 1985, as shown in Table 7.

41
TABLE 7. FEDERAL SAVINGS FROM PROPOSALS TO LIMIT PROFITS ON

STUDENT LOAN BONDS* (By fiscal year, in millions of

dollars)

Cumulative

Five-Year

1981 1982 1983 1984 1985 Totalb

If annual bond issues

remain 20 percent of

annual loan originations

Give states a special

allowance equal to

half the special

allowance of commercial lenders, with

no floor 23 38 44 49 53 208

Impose usual arbitrage rules on student loan bonds 19 32 35 40 45 171

Tax interest on student loan bonds 49 74 99 119 138 479

Withdraw federal

insurance from loans

financed with taxexempt bonds . 8 17 23 29 35 112

The estimates are based on CBO's projections of interest rates

and are made on the assumption that no changes would affect

bonds issued before 1980 or loans made from the proceeds of

those bonds. The estimates are based also on the assumption

that none of the options would cause a reduction in bond

42
TABLE 7. (Continued)

Cumulative

Five-Year

1981 1982 1983 1984 1985 Totalb

If annual bond issues

as a percent of annual

loan originations increase 5 percentage

points each year

Give states a special

allowance equal to

half the special

allowance of commercial lenders, with

no floor

Impose usual arbitrage rules on

student loan bonds

Tax interest on

student loan bonds

Withdraw federal

insurance from loans

financed with taxexempt bonds

32 56 72 88 104

27 49 59 75 94

67 112 163 214 269

352

303

826

10 24 36 49 64 182

issuance. To the extent that reductions do occur, federal

costs would be further reduced.

b. Details may not add to totals because of rounding.

43
TAX INTEREST ON STUDENT LOAN BONDS

As explained above, student loan bond issuers accumulate

profits because they receive the same yield on student loans as

commercial lenders do, even though their costs are lower since

they can raise funds by issuing tax-exempt bonds at low interest

rates. The previous sections outlined proposals that would remove

the profits by cutting the yield on the loans. This section and

the next present proposals that would remove the profits by

increasing the cost of the bond programs to the states. The

option discussed in this section would take away the subsidy

states receive through the tax exemption of interest on their

bonds.

If states were required to issue taxable, instead of taxexempt, student loan bonds, they would face a potentially difficult transition period during which they would have to find a new

market for their bonds and possibly restructure them as well.

Even after the transition period, states would probably find it

difficult to issue long-term, fixed interest rate, taxable bonds

for student loans, for the same reasons that they now find it

difficult to issue fixed interest rate, tax-exempt bonds for

student loans. The interest rate investors would demand on fixed

interest rate, taxable student loan bonds would be determined by

the interest rate they could get on other taxable bonds. Currently that interest rate is about 14 percent. Because of the

fluctuating and uncertain yield on student loans, bond authorities

could not issue long-term bonds at 14 percent and have any assurance that they would be able to cover their costs over the fifteen

years or so of their programs. Consequently, the fluctuating

yield on the student loans would probably induce states to borrow

short term or to issue floating rate taxable bonds, just as under

the fluctuating special allowance option it would induce them to

issue floating rate tax-exempt bonds.

In order for the floating rate taxable bond approach to work,

states would have to be able to market bonds with interest rates

that would be set close to the rate on 91-day Treasury bills,

which serves as the basis for the special allowance payments.

Because rates on long-term bonds have historically been above

rates on short-term bonds and because student loan bonds are not

as safe an investment as securities of the federal government,

investors would probably demand that long-term taxable student

loan bonds with floating interest rates offer rates higher than

the rate on 91-day Treasury bills. Investors might accept a yield

44
on their bonds only a percentage point above the yield on 91-day

Treasury bills, in which case states would probably be able to

issue floating rate bonds for student loans and still cover their

expenses. By putting a floor on the special allowance or by fixing the special allowance at the time of bond issuance, the

federal government could offer bondholders and states added protection against losses. *•'

Depending on the difficulty states would have in issuing taxable student loan bonds, this option could cause some cutback in

student loan availability. The severity of that cutback would

depend on the degree to which student loan bond issues were curtailed and on the degree to which bonds increase loan availability.

As shown in Table 7, the federal government could save

between $50 and $70 million in fiscal year 1981 and between $140

and $270 million in fiscal year 1985 by taxing interest on student

loan bonds issued in 1980 and thereafter. These estimates are

made on the assumption that there would be no cutback in the

volume of bonds issued. Any cutback would, of course, reduce

federal costs further.

If the Congress wanted to reduce profits of student loan

bonds by removing one of their federal subsidies, cutting back the

special allowance or imposing the usual arbitrage rules on the

bonds would be more consistent with past Congressional actions

than would taxing interest on the bonds. The Congress has generally sought to preserve tax exemption on bonds that serve public

or at least partly public purposes. It would be a departure from

this practice to deny tax exemption on student loan bonds. In

general, though, the Congress has restricted the yield on assets

purchased with the proceeds of tax-exempt bonds through the arbitrage rules, even for bonds that serve a wholly public purpose, so

it would not be a departure for it to reduce the yield on student

loans financed by tax-exempt bonds.

17. These proposals were discussed in the section on lowering the

special allowance. Their pros and cons are explained there

for tax-exempt student loan bonds; the same arguments apply

for taxable student loan bonds.

45
The argument for eliminating tax exemption rather than

reducing the special allowance is essentially a budget process

argument: subsidies for special purposes should come out of the

budget of the agency that has special expertise in the area and

that handles other comparable programs, in this case the

Department of Education. The costs and benefits of alternative

ways of subsidizing higher education can be better evaluated, it

is argued, if the necessary trade-offs can take place within one

agency.

WITHDRAW FEDERAL INSURANCE FROM LOANS FINANCED WITH TAX-EXEMPT

BONDS

Withdrawing the federal insurance from student loans held by

tax-exempt bond authorities is yet another way of reducing the

federal subsidy those authorities now receive. This option would

reduce the surpluses authorities may now accumulate by raising the

cost of the programs to the states.

Over the past decade, the Congress has repeatedly rejected

the concept of coupling tax-exempt bonds with federal guarantees

of the assets backing the bonds.*° Some people object to this

combination on the grounds that it is "double-dipping."

In the absence of federal insurance on the loans backing

student loan bonds, investors would demand much higher interest

rates than they now receive on student loan bonds. At present

these bonds are a relatively safe investment in that there is

little risk that bondholders will not receive scheduled debt

payments. If the federal insurance on the loans were removed,

however, investors, knowing of the high default rate on student

loans, would require much higher interest rates on the bonds to

18. Since 1970, the Congress has passed nineteen bills which

preclude federal guarantees of tax-exempt obligations

(Department of Treasury, "Statutes Which Preclude Federal

Guarantees of Tax-Exempt Obligations," 1979). One of the

more recent examples of this was legislation providing New

York City with loan guarantees for taxable bonds (P.L.

95-339, August 8, 1978, 31 U.S.C. 1522).

46
compensate for the increased chance of bond default.^ This

option would push up both the direct expenses of running a student

loan bond program (because loan defaults would then be unreimbursed expenses) and the interest rates bond authorities would

have to pay.

States would be better able to market bonds for uninsured

student loans if the bonds were backed not only by the student

loans but also by the states1

 full faith and credit. In other

words, states would have to stand ready to make up any shortfall

if payments on the student loans were insufficient to meet debt

payments on the bonds. The state of Texas is the only state to

have issued student loan bonds backed by the state's full faith

and credit, but it would certainly be possible for other states to

back their student loan bonds in this way.

From 1966 to 1971, Texas used the proceeds of tax-exempt

bonds to make student loans that were not federally insured

against default. It is difficult, however, to use the Texas

experience to predict how easily other states could adapt to

issuing bonds for uninsured student loans. Not only were Texas1

student loans uninsured, but—because they were made outside of

the federal guaranteed student loan program—they did not qualify

for special allowance payments. The yield on the loans made by

Texas between 1966 and 1971, therefore, has been only 6 or 7

percent—much lower than the yield on guaranteed student loans.

Texas has had to rely on surpluses generated from student loan

bonds issued since 1971 to cover the expenses of bonds it issued

for uninsured student loans prior to 1971. If the Texas loans had

qualified for the special allowance, however, the bonds for uninsured student loans might have been self-supporting.

If the Congress decided to withdraw the federal insurance

from student loans held by tax-exempt bond authorities, it would

have to decide whether the insurance should be reinstated when

loans are sold to Sallie Mae. If the insurance were reinstated

upon sale to Sallie Mae, most bond authorities would probably sell

their loans to Sallie Mae just before the loan recipients entered

the risky repayment period. The lack of federal insurance would

19. According to the Office of Education, the default rate on

guaranteed student loans was about 10 percent in 1979.

47
not make student loans a bad risk prior to the repayment period,

because the federal government is contractually obligated to pay

all interest on the loans until students enter repayment. Since

students cannot default on their loans until they are in

repayment, bond authorities "would in effect be insured against

default if they could sell in-repayment loans to Sallie Mae. If

federal insurance were reinstated upon sale to Sallie Mae, therefore, the Congress would not be eliminating the profitability of

student loan bonds by withdrawing the insurance on loans held by

bond authorities. 0 If the insurance were not reinstated upon

sale to Sallie Mae, authorities would probably not be able to earn

large profits from student loan bonds. Because Sallie Mae would

almost certainly be reluctant to purchase uninsured loans from

bond authorities, the difficulties states would have in marketing

bonds for uninsured student loans would be compounded.

The states that would have the most difficulty marketing

bonds for uninsured student loans would be those that currently do

the best job lending to high-risk students who are unable to get

loans from commercial banks. This is because states that lent to

high-risk student would have higher default rates on their loans

and correspondingly higher expenses than other states. Withdrawing federal insurance from student loans held by bond authorities

could, therefore, encourage states to lend to low-risk students in

an effort to keep program expenses to a minimum.

Table 7 shows that the reduction in federal costs from the

withdrawal of federal insurance would be small—less than $10

million in fiscal year 1981 and between $35 million and $65

million in fiscal year 1985—compared to that of other options.

One reason for the small savings in this period is that there

would be few defaults on newly made loans financed with bonds

issued after 1980, because the majority of those loans would not

enter repayment until after 1985. Even ten or fifteen years after

the federal insurance was withdrawn, however, this option would

still save the federal government much less than the other options

listed in Table 7.

20. If bond authorities had no option but to hold student loans

until they were paid off, the authorities would be able to

accumulate some surpluses during the time the federal government was paying the entire yield on the loans, but they would

have to draw on some of the accumulated surpluses to cover

defaults on loans during the risky repayment periods.

48
SPECIFY PERMISSIBLE USES OF SURPLUS FUNDS

Coupled with or instead of reducing the federal subsidies for

student loan bonds, the Congress could specify the purposes for

which states could use surplus funds. Advocates of this approach

most often suggest that Congress require surplus funds to be

invested in more student loans.

Section 103(e) of the Internal Revenue Code states that

residual income earned by private nonprofit student loan

corporations must either be used to purchase additional student

loans or be paid to the state or one of its political

subdivisions.^ The Code imposes no restrictions on state use of

surplus funds. This is the same rule that applies to the profits

of other tax-exempt bond authorities, but the yield restrictions

that apply to other tax-exempt bonds do not in general allow

issuers to amass large surpluses.^2

When asked informally by CBO about use of surplus funds, many

directors of student loan authorities replied that they did not

expect any residual after their operating costs had been paid. In

some cases, the directors indicated that surplus funds would be

used to make additional student loans. Surplus funds accruing

from the programs of local authorities in Texas, however, revert

to the sponsoring localities, and in Wisconsin surplus funds help

pay administrative costs of the state's entire higher education

grant and loan department.

By requiring surplus funds to be invested in additional

student loans, the Congress could address itself to the charge

that the surpluses student loan bond programs now generate are

equivalent to no-strings-attached federal grants to the states.

This requirement alone would not necessarily prohibit states from

earning general revenue from student loan bonds, however. States

could sell the newly made loans to Sallie Mae, and then use the

proceeds for general purposes. Even if states were required to

21. There are no restrictions on use of surpluses earned by other

student loan bond issuers.

22. The Mortgage Subsidy Bond Tax Act of 1979 (H.R. 5741) does,

however, require investment gains from tax-exempt, singlefamily housing bonds to be rebated to home purchasers.

49
hold the student loans until they were paid off, in the interim

they would receive a stream of revenue from the interest and

special allowance on the loans, and ultimately, when the principal

had been paid back, the states would have the proceeds for general

state purposes. In order to be sure that surplus funds were not

used for general state purposes, very comprehensive limits on the

use of these funds would have to be established.

CONCLUSION

Except for the option of taking no action, each option

discussed in this paper would restrict either the profitability of

student loan bonds or the uses to which states could put profits.

The profits could be reduced by cutting the yield on the student

loans or by raising the costs of the programs. The yield on the

student loans could be cut by reducing the special allowance on

these loans (either directly or by imposing the usual arbitrage

rules on the bonds), and the costs of the programs could be

increased by taxing interest on the bonds or by withdrawing

federal insurance from the student loans. Because each option

would reduce one of the federal subsidies of student loan bonds,

each would cut federal costs. Table 8 ranks the options in order

of federal cost reduction. The other main consideration in

weighing the options is the degree to which each would decrease

student loan availability. The options also are ranked in Table 8

by this standard.

50
TABLE 8. RANKING OF OPTIONS BY THEIR EFFECTS ON FEDERAL COSTS AND

AVAILABILITY OF STUDENT LOANS

Reduction in

Federal Costsa

(Big reduction to

small reduction)

Reduction in

Student Loan

Availability

(Small reduction

to big reduction)

Taxing interest on student

loan bonds

Cutting special allowance*5

Taking no action

Requiring profits be used for

additional student loans

Imposing usual arbitrage rules

on student loan bonds

Removing federal insurance on

student loans

Removing federal insurance

on student loans

Requiring profits be used

for additional student loans

Taking no action

Imposing usual arbitrage rules

on student loan bonds

Cutting special allowance*5

Taxing interest on student loan

bonds

These cost reductions are based on the assumption that the

proposals would cause no reduction in bond issuance. To the

extent the options reduce bond volume, they would further cut

federal cost. Considering these second-order effects would

probably change the rankings in this column.

This special allowance option would make the special allowance

on tax-exempt bond-financed loans half the special allowance

of commercial lenders.

51

APPENDIX

APPENDIX. CASH FLOW ANALYSIS OF EXPECTED PROFITS FROM TWO

STUDENT LOAN BOND ISSUES

Tables A-l and A-2 are consolidated versions of the cash flow

tables in the official statements of the most recent student loan

revenue bond issues of North Dakota and Wisconsin.-'- Reading

across any row shows the expected revenues from the program in a

given year, less the expected uses of the revenues for that year.

The excess funds flow first into a program assets fund (one of

several reserve accounts) and then into a surplus fund.

The total profit that each state expects to receive from its

bond issue is the sum of all of the entries in the program assets

and surplus fund columns. Since the promise of a dollar to be

received in the future is less valuable than a dollar received

today, a discount factor should be applied to future profits to

indicate their present value. In this case, the appropriate

discount rate is seven percent, since in the prospectuses the

assumption is made that the states can invest surplus funds in

accounts yielding 7 percent annually.2

1. These issues were chosen for analysis because the cash flow

tables in their official statements are especially lucid and

complete.

2. Expected future profits should be discounted back from the

time they are expected to be realized. In both North Dakota

and Wisconsin, amounts on deposit in the program assets fund

must be left on deposit until all bonds are retired, so those

profits will be realized in the last year of each program and

should be discounted back from then. (In the event of

unanticipated cash flow problems, the authorities may have to

withdraw funds from the program assets funds in order to make

scheduled debt service payments.)

In both North Dakota and Wisconsin, money in the surplus

funds, by contrast, may be withdrawn before the end of the

programs, but may be used only for purposes specified in the

bond resolutions. In North Dakota, although surplus funds may

55
Because these cash flow tables extend into future years, the

future values of some of the entries in the tables are not known

for certain today. The uncertain components include future administrative expenses, the timing of student loan debt repayment, and

the level of future special allowances. CBO has accepted the bond

issuers1 assumptions about all uncertain entries except those for

future special allowances.

There are two columns under the heading "Special Allowance"

in Tables A-l and A-2. The first column shows the level of revenues from special allowance payments as calculated under the

assumptions made in the prospectuses; the second column shows the

level of revenues from special allowance payments of 5 percent

annually. Other things being equal, larger special allowance payments create larger surpluses, so there are two columns under the

heading "Excess Funds," one column for each assumption about the

level of future special allowance payments.

The present value of the surplus North Dakota expects to

receive from its $79 million bond issue is about $5 million.

be withdrawn prior to 1996, interest from the surplus fund is

included in the cash flow table under sources of revenue each

year, and from the prospectus it does not appear that the

state intends to use those funds before the end of the program. Therefore, profits in the North Dakota surplus fund are

discounted from the last year of the program, 1996. Permissible uses of the surplus fund in North Dakota include financing the creation and operation of a state guarantee agency,

making additional student loans, and calling bonds.

Wisconsin, on the other hand, intends to make annual withdrawals from its surplus account, which it calls the "Additional Purpose General Account." This money may be used for

the expenses of any other higher education aid program run by

the state, including a state student grant program, a loan

servicing program for commercial lenders, and a program of

grants to Wisconsin's dental schools. The Wisconsin prospectus also does not include interest from this account in

sources of funds for the program, providing evidence that

Wisconsin expects to make these annual withdrawals. Payments

to the Additional Purpose General Account should, therefore,

be discounted from the date they are made.

56
Using the CBO assumptions about future special allowances, North

Dakota would get about $8 million in present-value terms. The

present value of Wisconsin's expected surplus from its $40 million

bond issue is about $4 million; CBO's special allowance assumptions project a surplus of $8 million in present-value terms.

57
TABLE A-l. NORTH DAKOTA CASH FLOW PROJECTIONS, 1979 SERIES A STUDENT LOAN REVENUE BONDS ($78 MILLION BOND ISSUE), 1980-1996 (In thousands

of dollars)

Revenue Sources (LESS)

Special Total Sources

Program Investment Allowance of Funds

Year Income3

1980 5,176

1981 7,114

1982 8,755

1983 9,458

1984 9,917

1985 7,938

1986 7,458

1987 6,815

1988 5,950

1989 5,898

1990 4,437

1991 3,959

1992 3,481

1993 3,004

1994 2,048

1995 1,091

1996 410

TOTAL 92,909

SOURCE: Compiled

Income b

5,085

1,895

1,175

1,288

1,371

1,342

1,388

1,425

1,451

1,518

1,487

1,502

1,520

1,533

1,527

5,417

5,104

36,028

(Dc

1,084

1,275

1,546

1,394

1,215

1,045

898

757

627

501

388

294

208

130

66

25

5

(2)a , (l)c

1,936 11,345

2,277 10,284

2,761 11,476

2,490 12,140

2,170 12,503

1,866 10,325

1,604 9,744

1,352 8,997

1,120 8,028

895 7,917

693 6,312

525 5,755

371 5,209

232 4,667

118 3,641

45 6,533

9 5,519

11,458 20,464 140,395

by Congressional

(2)a

12,197

11,286

12,691

13,236

13,458

11,146

10,450

9,592

8,521

8,311

6,617

5,986

5,372

4,769

3,693

6,553

5,523

149,401

Budget Office from

Debt

Service

Payments

10,043

8,748

9,618

10,369

10,841

8,771

8,271

7,595

6,693

6,640

5,109

4,605

4,111

3,604

2,606

5,499

4,457

117,580

Preliminary

Uses

Program

(EQUALS) Excess Funds

Total

Excess Funds Deposited to

Program

Operating Uses of

Expenses

644

785

908

822

720

622

537

457

382

312

246

193

143

98

62

39

28

6,998

Official

Funds

10,687

9,533

10,526

11,191

11,561

9,393

8,808

8,052

7,075

6,952

5,355

4,798

4,254

3,702

2,668

5,538

4,485

124,578

Statement

(Dc

658

751

950

949

942

932

936

945

953

965

957

957

955

965

973

995

1,034

15,817

dated .June

(2)d

1,510

1,753

2,165

2,045

,897

,753

,642

,540

,446

,359

,262

,188

1,118

1,067

1,025

1,015

1,038

24,823

14, 1979

Assets Surplus Fund*

Fund6

218

234

248

264

286

303

325

352

373

401

0

0

0

0

0

0

0

3,004

(State

(Dc

440

517

702

685

656

629

611

593

580

564

957

957

955

965

973

995

1,034

12,813

of North

(2)a

1,292

1,519

1,917

1,781

1,611

1,450

1,317

1,188

1,073

958

1,262

1,188

1,118

1,067

1,025

1,015

1,038

21,819

Dakota -

b.

f.

$78,530,000 1979 Series A Student Loan Revenue Bonds).

Principal and interest (7 percent annually) payments made by students, plus claims payments made on defaulted loans.

Interest earned on balances in reserve accounts, including the earnings on balances in the Surplus Fund, and including retirement of the

reserve accounts in the last two years.

Assumed federal special allowance payment rate of 2.8 percent annually (as reported in prospectus).

Assumed federal special allowance payment rate of 5 percent annually (not reported in prospectus).

The Program Assets Fund is to be used first to make up any deficiencies in the Bond Funds. Once the Program Assets Fund is fully

funded, excess funds flow into the Surplus Fund.

The Surplus Fund is used first to make up deficiencies in reserve funds and then for new student loans, market purchase, call of bonds,

or to fund a guarantee agency's guarantee program. The additional excess funds created by the larger special allowance assumption are

assumed to go directly into the Surplus Fund. As a simplification, the interest that would be earned on this addition to the Surplus

Fund is not included in Investment Income.
TABLE A-2. WISCONSIN CASH FLOW PROJECTIONS, 1979 SERIES A STUDENT LOAN REVENUE BONDS ($40 MILLION BOND ISSUE), 1980-1997 (In thousands of

dollars)

Excess Funds Deposited to

Revenue Sources

Special Total

Program Investment Allowance of

Year Incomea Income b (l)c

1980 0 3

1981 910 1

1982 2,126

1983 2,599

1984 3,229

1985 3,835

1986 4,148

1987 4,298

1988 4,378

1989 4,412

1990 4,477

1991 4,481

1992 4,396

1993 4,004

1994 3,118

1995 2,144

1996 1,013 2

1997 132 2

TOTAL 53,700 19

SOURCE: Compiled

,425 260

,804 455

652 900

489 912

541 894

587 856

618 803

639 740

661 668

681 589

704 504

724 411

743 312

742 213

715 125

684 59

,640 17

,432 2

,481 8,720

(2)a (l)c

325 3,685

650 3,169

1,500 3,678

1,629 4,000

1,597 4,664

1,529 5,278

1,434 5,569

1,322 5,677

1,193 5,707

1,052 5,682

900 5,685

734 5,616

557 5,451

380 4,959

223 3,958

105 2,887

30 3,670

4 2,566

15,164 81,901

Sources

Funds

(2)d

3,750

3,364

4,278

4,717

5,367

5,951

6,200

6,259

6,232

6,145

6,081

5,939

5,696

5,126

4,056

2,933

3,683

2,568

88,345

by Congressional Budget Office from

(LESS)

Debt

Service

Payments

3,300

2,578

2,620

2,914

3,581

4,218

4,553

4,710

4,799

4,837

4,910

4,919

4,833

4,423

3,491

2,468

3,277

2,180

68,611

Uses (EQUALS) Excess Funds Assets and

Program Total

Operating Uses of

Expenses Funds

252

245

366

389

326

357

383

303

322

333

252

246

154

157

181

155

167

170

4,758

3,552

2,823

2,986

3,303

3,907

4,575

4,936

5,013

5,121

5,170

5,162

5,165

4,987

4,580

3,672

2,623

3,444

2,350

73,369

Preliminary Official Statement dated

(Dc

133

346

692

697

757

703

633

664

586

512

523

451

464

379

286

264

226

216

8,532

Augus t 7 ,

Operating

Reserve

(2)d Funds6

198

541

1,292

1,414

1,460

1,376

1,264

1,246

1,111

975

919

774

709

546

384

310

239

218

14,976 4,

1979 (State

133

346

267

157

160

175

184

199

207

223

236

252

266

284

286

264

226

216

081

Additional Purpose

General Account

(Dc

0

0

425

540

597

528

449

465

379

289

287

199

198

95

0

0

0

0

4,451

of Wisconsin -

(2)a

65

195

1,025

1,257

1,300

1,201

1,080

1,047

904

752

683

522

443

262

98

46

13

2

10,895

$40,000,000

1979 Series A Student Loan Revenue Obligation Bonds).

a. Principal and interest (7% annually) payments made by students, plus payments by the state education corporation on defaulted loans.

b. Interest earned on balances in reserve accounts, including the capitalized interest on the Student Loan Trust Fund due in 1980.

c. Assumed federal special allowance payment rate of 4 percent for 1980, 3.5 percent for 1981, 3 percent for 1982, and 2.8 percent each year

thereafter (as reported in prospectus).

d. Assumed federal special allowance payment rate of 5 percent each year (not reported in prospectus).

e. The Program Assets Fund is to be used first to make up any deficiencies in certain Bond Funds. Once the Program Assets Fund is fully

funded, excess funds will flow to the Additional Purpose General Account, which operates like a Surplus Fund, i.e., funds are to be used

first to make up deficiencies in certain Bond Funds. Then excess funds can be used to purchase bonds, finance new loans, or finance any

higher education program allowed by law. The Operating Reserve Fund is the depository for special allowance payments in excess of administration expenses; withdrawals from the fund may be made whenever special allowance payments are not sufficient to cover administration

expenses.

f. The Additional Purpose General Account is set up with excess funds to redeem or purchase bonds, to finance additional loans, or to fund

any other higher education program which is authorized and appropriated by state law. The additional excess funds that are generated by

the larger special allowance assumption are assumed to be deposited in the Additional Purpose General Account.