Federal Student Loans: Challenges in Estimating Federal Subsidy Costs
Published: 2005-09-29T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In fiscal year 2004, the federal government made or guaranteed about $84 billion in loans for postsecondary education through two loan programs--the Federal Family Education Loan Progam (FFELP) and the Federal Direct Loan Program (FDLP). Under FFELP, private lenders fund the loans and the government guarantees them a minimum yield and repayment if borrowers default. When the interest rate paid by borrowers is lower than the guaranteed minimum yield, the government pays lenders special allowance payments (SAP). Under FDLP, the U.S. Treasury funds the loans that are originated through participating schools. Under the Federal Credit Reform Act (FCRA) of 1990 the government calculates, for purposes of the budget, the net cost of extending or guaranteeing credit over the life of a loan, called a subsidy cost. Agencies generally update, or reestimate, subsidy costs annually to include actual program results and adjust future program estimates. GAO examined (1) whether reestimated subsidy costs have differed from original estimates for FFELP and FDLP loans disbursed in fiscal years 1994 through 2004, (2) what factors explain changes between reestimated and original subsidy rates--that is subsidy cost estimates per $100 disbursed; and (3) which federal costs and revenues associated with the student loan programs are not included in subsidy cost estimates.
section_title: What GAO Found
paragraphs: Both FFELP and FDLP subsidy cost reestimates have differed from original estimates for loans made in fiscal years 1994 through 2004, reflecting the challenges inherent in estimating the actual costs of loans made under each of these federal loan programs. Reestimated subsidy costs for FFELP loans were close to or lower than original estimates for loans made in fiscal years 1994 to 2002, but higher than originally estimated for loans made in fiscal years 2003 and 2004. FDLP reestimated subsidy costs were generally similar to or higher than originally estimated for loans made in fiscal years 1994 through 2004. Differences between original and reestimated subsidy cost estimates per $100 disbursed were, in part, due to market interest rates that were lower than originally forecasted, greater than anticipated loan consolidation, and the availability of additional data on student loans. Each of these factors has affected reestimated subsidy costs for each loan program in a different way. For example, interest rates fell to lower than expected levels in 2001 and the condition persisted through 2004. For FFELP, lower than expected interest rates have made the difference between the borrower interest rate and lender yield smaller than expected resulting in lower SAP paid to lenders, which in turn resulted in lower reestimated subsidy cost estimates. For FDLP, lower than expected interest rates contributed to higher reestimated subsidy costs because the government received smaller interest payments from borrowers than originally anticipated and, in some cases, the rate paid by student borrowers fell below the government's fixed borrowing rate. Certain federal costs and revenues associated with the student loan programs, such as federal administrative expenses, some costs of risk associated with lending money over time, and federal tax revenues generated by both student loan programs, are not included in subsidy cost estimates. For example, under current law, federal administrative expenses are excluded from subsidy cost estimates. Moreover, both loan programs generate federal tax revenues from private sector companies and investors that are encompassed in the revenue portion of the budget but are not included in subsidy cost calculations. Estimating the amount of federal tax revenues generated by the loan programs would be difficult and was beyond the scope of our review. Education reviewed a draft copy of this report and did not have any comments.

section_title: Letter
paragraphs: In fiscal year 2004, the federal government made or guaranteed about   $84 billion in loans to assist students in paying for their postsecondary  education under title IV of the Higher Education Act (HEA), as amended.  Federal student loans are primarily administered through two programs:  the Federal Family Education Loan Program (FFELP) and the William D.  Ford Direct Loan Program (FDLP). The federal government’s role in  financing and administering loans for these two programs differs  significantly. Under FFELP, private lenders, such as banks, fund the loans,  and the federal government guarantees FFELP lenders a minimum yield  on the loans they make and repayment if borrowers default. When the  interest rate paid by borrowers is lower than the minimum yield  guaranteed to lenders, the government pays lenders the difference—a  subsidy called special allowance payments (SAP). Additionally, state- designated guaranty agencies receive federal funding to perform a variety  of administrative functions in FFELP and also work with lenders and  borrowers to prevent loan defaults and collect on the loans after default.  Under FDLP, the U.S. Treasury funds the loans, which are originated  through participating schools. The Department of Education contracts  with private-sector firms to provide administrative functions for its  student loan programs.
In general, which program a student uses to obtain a loan depends upon  which program the student’s school has chosen to use. Both FFELP and  FDLP offer students and their parents the same types of loans to pay for  postsecondary education—Stafford subsidized, Stafford unsubsidized,  Parent Loans for Undergraduate Students (PLUS), and consolidation  loans. The interest rate borrowers pay on Stafford and PLUS loans is a  variable rate based on a statutory formula. Subsidized loans are awarded  based on a student’s financial need and the federal government pays the  interest on behalf of students while they are attending school and during a  brief grace period when the student first leaves school. Unsubsidized and  PLUS loans are available to borrowers regardless of financial need, and  borrowers are responsible for interest payments during the life of the loan.  Consolidation loans allow borrowers to combine multiple federal student  loans into a single loan with a fixed interest rate based on the weighted  average of the interest rates in effect on the loans being consolidated.
In recent years, competition between FFELP and FDLP has been credited  with improving services provided for both schools and borrowers and  enhancing borrower benefits, but there has been ongoing debate about  whether the costs and benefits of one program outweigh those of the  other. Assessing and comparing the total costs and benefits of the two  loan programs would require consideration of, among other things, costs  incurred by schools in operating the loan programs, quality of services  provided to schools and borrowers, benefits to society and individuals  from postsecondary education, as well as federal costs and revenues  generated by each loan program—federal budgetary costs. With respect to  the latter, the technical nature of how the government accounts for the  federal budgetary costs of the two loan programs, and disagreement about  whether estimates of subsidy costs fully represent federal costs have made  debate about comparing costs of the loan programs challenging.
The Federal Credit Reform Act of 1990 (FCRA) significantly changed the  way that the federal government accounted for the budgetary costs of  credit programs, including FFELP and FDLP. Prior to FCRA, the  government calculated costs on a cash basis—whereby costs and revenues  were recorded when money was paid or received. On a cash basis, direct  loans initially appeared to be as expensive as grants because the budget  did not recognize the expected repayment of direct loans. Loan  guarantees, on the other hand, initially appeared to be cost free (or could  even appear to make money because of upfront fees paid by borrowers  and lenders to the government) because the budget did not recognize  expected federal payments to lenders as a consequence of loan defaults.  Under FCRA, the government calculates, for purposes of the budget, the  net cost to the government of extending or guaranteeing credit over the  life of a loan—called the subsidy cost. FCRA was enacted to require  agencies to measure the lifetime costs of a loan in a way that would permit  better cost comparisons between guaranteed and direct loans, and  between credit and non-credit programs (e.g., grants). Agencies are  required to estimate the subsidy cost to the government of a direct loan or  a loan guarantee based on the net present value of all estimated cash  flows, excluding administrative costs, when preparing their annual  budget. Agencies generally update or revise these estimates, called  reestimates, annually to take into account changes in interest rates and  other conditions. To provide Congress with information about federal  costs for the student loan programs to use as it considers reauthorization  of the HEA, we examined:  1.  whether reestimated subsidy costs have differed from original  estimates for FFELP and FDLP loans disbursed in fiscal years 1994  through 2004;  2.  what factors explain changes between reestimated and original  subsidy rates—that is, subsidy cost estimates per $100 disbursed; and  3.  which federal costs and revenues associated with the student loan  programs are not included in subsidy cost estimates.
To determine whether subsidy cost estimates have changed over time, we  compared original subsidy cost estimates to the most recent estimates by  analyzing subsidy cost estimates and reestimates for loans made and  guaranteed in each fiscal year, called a loan cohort, from 1994—the first  fiscal year loans were disbursed through FDLP—to 2004. We collected  and analyzed this information for loan cohorts by loan type in both FFELP  and FDLP as presented in the Budget of the United States Government. On  the basis of our review of the documentation for these data, we  determined that the data were sufficiently reliable for the purpose of our  examination. To determine the factors that explain changes in subsidy  cost estimates, we reviewed documentation prepared by the Department  of Education (Education) for its financial statement audits and  interviewed Education officials. To determine which federal costs and  revenues are not included in the subsidy cost estimates, we reviewed the  HEA and related regulations, FCRA, Office of Management and Budget  (OMB) guidance, Education’s financial statements and auditor reports,  and the federal budget. We also interviewed officials with Education,  OMB, the Congressional Budget Office, and an FFELP lender and  reviewed studies about estimating the costs of the student loan programs.  Moreover, we gathered data from Education on federal administrative  costs in each loan program and reviewed literature about discounting cash  flows and incorporating risk into cost estimates. We conducted our work  in accordance with generally accepted government auditing standards  from January 2005 to August 2005.
subsections: section_title: Background
paragraphs: The federal government makes loans to students through private- and  public-sector lenders in the FFELP or directly to students through FDLP.  These two programs are among the largest of the federal government’s  credit programs. At the end of 2004, there were about $245 billion in  outstanding FFELP loans, about 20 percent of total federal guaranteed  loans outstanding, and $107 billion in outstanding FDLP loans, about   43 percent of total federal direct loans outstanding.
subsections: section_title: Types of Federal Loans and Terms for Borrowers
paragraphs: Students and parents are able to borrow the same types of loans through  FFELP and FDLP, which include:    Subsidized and Unsubsidized Stafford Loans—variable rate loans available  to students. The federal government pays the interest on behalf of  subsidized loan borrowers while the student is in school and during a brief  grace period when the student first leaves school.
PLUS Loans—variable rate loans made to parents, on behalf of students.
The borrower pays all interest costs.
Consolidation Loans—borrowers may combine multiple federal student  loans into a single loan. The interest rate is fixed based on the weighted  average of the interest rates in effect on the loans being consolidated.
Under either loan program borrowers are able to repay loans earlier than  required, with no penalty. The programs have several repayment options  available to borrowers. For Stafford and PLUS loans, the standard  repayment in both loan programs is a fixed amount per month for up to  10 years. Borrowers have other repayment options that allow them to  extend repayment for up to 30 years, gradually increase the monthly  payment, or base monthly payments on their adjusted gross income. The  criteria for some of the alternative repayment options are different in  FFELP and FDLP. For consolidation loans, the repayment terms depend  on the loan amount. Moreover, borrowers that graduate, leave school, or  become a less than half-time student are given a 6-month grace period  before they must begin to repay their Stafford or consolidation loans. All  borrowers may postpone repayment through deferment or forbearance if  they meet certain criteria and the loan is not in default. Deferment is  allowed for borrowers who remain in a postsecondary school at least half- time, a graduate program, or have experienced economic hardship. For  borrowers who are temporarily unable to meet repayment obligations but  are not eligible for deferment, lenders may grant a temporary and limited  time period in which these borrowers do not need to repay their student  loans, called forbearance.
section_title: Developing Subsidy Cost Estimates
paragraphs: The FCRA guidance issued by OMB and accounting standards provide the  framework for the process Education uses to calculate subsidy costs for  student loans. Subsidy costs are calculated by estimating the federal  government’s future cash flows for loans made or guaranteed in a  particular fiscal year, called a loan cohort. In estimating cash flows for a  loan cohort, Education must make assumptions about loan characteristics  and future borrower behavior, such as:  type and dollar amount of loans obligated or guaranteed, and   how many borrowers will pay early, pay late, or default on their loans and  at what point in time.
Moreover, the model used to estimate future cash flows includes  assumptions about future interest rates. OMB provides Education with  interest rate assumptions that are used for the discount rate, borrower  interest rate, and lender yields. Education aggregates cash flows by loan  cohort, loan type, and risk category, which reflects the differences in the  likelihood of default. Education has five risk categories, which include, in  order of higher to lower risk of default: (1) students at proprietary schools,  (2) students at 2-year colleges, (3) freshman and sophomores at 4-year  colleges, (4) juniors and seniors at 4-year colleges, and (5) students at  graduate schools.
section_title: Federal Government’s Role in Each Loan Program and Difference in Cash Flows
paragraphs: Although the method for calculating the subsidy cost is the same for both  FFELP and FDLP, the federal government’s role in each loan program  differs significantly, which, in turn, affects the type and timing of cash  flows in each program. In FFELP, private lenders, such as banks, fund the  loans, and the federal government guarantees lenders a statutorily  specified minimum yield that is tied to, and varies with, market financial  instruments. When the interest rate paid by borrowers is below that yield,  the federal government gives lenders subsidy payments, called SAP.  Moreover, the federal government, through state-designated guaranty  agencies, guarantees repayment of loans if borrowers default. Guaranty  agencies provide insurance to lenders for 98 percent of the unpaid  principal of defaulted loans. The federal government, in turn, pays  guaranty agencies 95 percent of their default claims. Guaranty agencies  also perform various administrative functions in the FFELP. As shown in  figure 1, under FFELP cash inflows to the federal government include fees  and other payments from lenders and outflows from the federal  government include SAP and default payments. FFELP cash flows are  spread out over the life of the loan. fees)
Under FDLP, the U.S. Treasury funds the loans, which are originated  through participating schools and contractors. Education’s Office of  Federal Student Aid is responsible for delivering funds to schools  participating in FDLP, monitoring its contracts, and providing technical  assistance to schools. Education contracts with private-sector companies  to perform various administrative activities in FDLP, such as originating  and servicing loans, and collecting defaulted loans. As shown in figure 2,  FDLP cash inflows to the federal government are repayments of principal  and interest payments and outflows include loan disbursements to  borrowers. Because the federal government funds the loans, cash outflows  occur in the early years as loan disbursements are made. Cash inflows, in  the form of principal repayment and interest payments, occur in later  years as borrowers enter repayment.
Principal repayments may be less than disbursements, reflecting defaults, loan discharges, and loan  forgiveness.
Annually, agencies are generally required to update or “reestimate” loan  costs for differences in estimated loan performance, such as differences  between assumed and actual default rates, the actual program costs  recorded in the accounting records, and new forecasts of future economic  conditions, such as interest rates. Reestimates include all aspects of the  original cost estimate, including prepayments, defaults, delinquencies,  recoveries, and interest. Reestimates of the credit subsidy allow agency  management to compare the original budget estimates with actual  program results to identify variances from the original estimate, assess the  quality of the original estimate, and adjust future program estimates as  appropriate.
section_title: Reestimated Subsidy Costs Differed from Original Estimates for Both Loan Programs
paragraphs: Both FFELP and FDLP reestimated subsidy costs have differed from  original estimates for loans made in fiscal years 1994 through 2004,  highlighting the challenges in estimating the costs of federal student loans.  FFELP reestimated subsidy costs were similar to or lower than original  estimates for loans made in fiscal years 1994 to 2002, but higher than  originally estimated for loans made in fiscal years 2003 and 2004. In  comparison, FDLP reestimated subsidy costs were generally similar to or  higher than original estimates for loans made in fiscal years 1994 through  2004. Across all types of loans, FDLP subsidy costs per $100 of loans  disbursed were, for almost all loan cohorts, lower than those of FFELP.
subsections: section_title: FFELP Reestimated Subsidy Costs Were Generally Similar to or Lower Than Original Estimates, with the Exception of Loans Disbursed in Fiscal Years 2003 and 2004
paragraphs: Reestimated subsidy costs for FFELP loans disbursed between fiscal years  1994 and 2002 were, in general, close to or lower than original estimates,  while reestimated subsidy costs for loans disbursed in 2003 and 2004 were  higher than originally expected, as shown in figure 3.
From fiscal years 1994 to 1999, reestimated subsidy costs for FFELP were  typically close to original estimates, while loans disbursed from fiscal year  2000 to fiscal year 2002 had reestimated subsidy costs that were lower  than original estimates, ranging from $1.5 to $2.2 billion lower.  Reestimated subsidy costs for loans disbursed in fiscal years 2003 and  2004 were $2.7 and $3.6 billion higher than original estimates. Differences  between reestimated and original subsidy costs estimates for the 2003 and  2004 loan cohorts were in part due to significant differences between  expected and actual loan volume. For example, Education originally  estimated about $40 billion in FFELP loans would be disbursed in 2003  when actually $69 billion was disbursed that year. The large difference  was primarily due to a significantly higher volume of FFELP consolidation  loans than originally estimated and the relatively high subsidy costs per  $100 of these loans compared to consolidation loans made in previous  years.
After controlling for loan volume, FFELP reestimated subsidy costs per  $100 disbursed were generally close to or lower than original subsidy cost  estimates across loan types. As shown in table 1, for FFELP Stafford  unsubsidized and PLUS loans, reestimated subsidy costs per   $100 disbursed were lower for all loan cohorts than what was originally  estimated—except fiscal year 1999. For subsidized Stafford loans, about  two-thirds of the loan cohorts had lower reestimated subsidy costs per  $100 disbursed. Slightly over half of all consolidation loan cohorts had  lower reestimated subsidy costs per $100 disbursed than originally  estimated.
section_title: FDLP Reestimated Subsidy Costs Were Generally Similar to or Higher Than Original Estimates
paragraphs: Reestimated subsidy costs for FDLP loans were in general similar to or  higher than original estimates for loans disbursed between fiscal years  1994 and 2004. For FDLP loans disbursed between fiscal years 1994 and  1999, total reestimated subsidy costs were in general close to original  estimates, but there was one loan cohort that had higher reestimated  subsidy costs and another with much lower reestimated subsidy costs than  originally expected, as shown in figure 4.
In comparison, reestimated subsidy costs for FDLP loans disbursed  between fiscal years 2000 and 2004 were higher than original estimates. In  some cases original estimates projected a net gain for the government, but  subsequent reestimates project a smaller gain or even a net cost for the  government. For example, original subsidy cost estimates of the fiscal year  2000 loan cohort projected a net gain of $930 million for the government  and reestimated subsidy costs project a net cost of $1.1 billion. Such  swings in estimated subsidy costs illustrate that originally anticipated  federal revenues may not, in fact, ultimately materialize. Differences  between total reestimated and original subsidy cost estimates were not  driven by differences between original and actual loan volume, but rather  by changes in the subsidy rates—that is, subsidy costs per $100 disbursed.
FDLP reestimated subsidy costs per $100 disbursed were usually close to  or higher than original subsidy cost estimates across loan types. For  example, as shown in table 2, reestimated subsidy costs per   $100 disbursed for FDLP Stafford unsubsidized, and PLUS loans were, for  almost all loan cohorts, higher than original estimates. For Stafford  subsidized and consolidation loans, slightly over half of the loan cohorts  had reestimated subsidy costs that were higher than originally estimated.
For most Stafford unsubsidized and PLUS loan cohorts, and slightly over  half of consolidation loan cohorts, reestimated subsidy costs per   $100 disbursed were higher than the original estimate, but still project a  net gain for the federal government. For example, Stafford unsubsidized  loans disbursed in fiscal year 1998 were originally estimated to have a net  gain of $6.93 for every $100 in loans disbursed. Reestimated subsidy costs  show that the projected net gain for these same loans is estimated to be  $5.13 per $100 disbursed. Some loan cohorts that originally projected a net  gain for the federal government have reestimated subsidy costs with a net  cost to the government. For example, PLUS loans disbursed in fiscal year  2000 that were originally projected to have a net gain of $13.41 per   $100 disbursed were subsequently reestimated to have a net cost of   $2.21 per $100 disbursed.
section_title: FDLP Reestimated Subsidy Costs Were Lower Than FFELP Reestimated Subsidy Costs
paragraphs: For all loans disbursed between fiscal years 1994 and 2004, FDLP  reestimated subsidy costs were lower than FFELP reestimated subsidy  costs in aggregate and after controlling for loan volume. Reestimated total  subsidy costs for FDLP loans were $2.5 billion compared to $36.6 billion  for FFELP loans, as shown in table 3 below.
After controlling for loan volume and comparing reestimated subsidy costs  across the four types of loans—Stafford subsidized and unsubsidized,  PLUS, and consolidation—FDLP reestimated subsidy costs per $100  disbursed were in general lower than FFELP reestimated subsidy costs per   $100 disbursed. (See app. I for comparisons of reestimated subsidy costs  of FDLP and FFELP loans, by loan type.) The difference between the  reestimated subsidy cost for FDLP and FFELP varied significantly and  depended on the type of loan and the year that the loan was disbursed. For  example, reestimated subsidy costs per $100 disbursed for FDLP  subsidized Stafford loans disbursed in fiscal year 2003 were $11.66 lower  than for FFELP subsidized Stafford loans, while the difference for the  same loans disbursed in 2000 was $1.35 per $100 disbursed.
The primary reason for the difference in subsidy cost estimates between  FFELP and FDLP were differences in the structure of the programs rather  than the characteristics of the borrowers. According to Education  officials, estimates of long-term costs associated with subsidizing  borrowers’ interest; canceling repayment of loans due to death, disability,  and bankruptcy; and defaulted loans are roughly equivalent in both  programs. However, under FFELP there are larger cash outflows in the  form of SAP to lenders than cash inflows of lender fees, while in FDLP  there are large cash inflow projections, net of interest payments to  Treasury, in the form of borrower interest payments and no SAP or  guaranty fees.
section_title: Recent Low Interest Rates, Increased Loan Consolidation, and Additional Data Contributed to Differences between Reestimated and Original Subsidy Cost Estimates
paragraphs: Differences between original and reestimated subsidy cost estimates per  $100 disbursed can be explained, in part, by lower than expected market  interest rates, greater than anticipated loan consolidation, and more data  on student loans incorporated into cash flow model. Differences between  actual and expected interest rates and rates of consolidations affected  reestimated subsidy costs for each loan program in a different way. For  example, lower than expected interest rates over the last several years  have resulted in lower reestimated subsidy cost estimates for FFELP and  higher reestimated subsidy costs for FDLP. Larger than expected volumes  of consolidation loans, which stemmed in part from low interest rates,  contributed to lower FFELP reestimated subsidy costs for the underlying  loan cohorts and higher FDLP reestimated subsidy cost estimates of the  underlying loan cohorts. Furthermore, the availability of additional data  for both FFELP and FDLP loans have enabled Education to refine its cash  flow model, which has also contributed to differences between  reestimated and original subsidy costs.
subsections: section_title: Interest Rates Lower Than Previously Forecasted Contributed to Differences between Reestimated and Original Subsidy Cost Estimates
paragraphs: Interest rates fell to lower than expected levels in 2001 and persisted at  those levels through 2004, which affected subsidy cost estimates in both  FFELP and FDLP because estimates, especially for the FDLP, are highly  sensitive to changes between projected and actual interest rates. Cost  estimates for the loan programs are sensitive to such changes because  borrower interest rates in both FFELP and FDLP and the lender yield in  the FFELP, are variable rates. As a result, differences between projected  and actual interest rates can have a significant impact on estimates of cash  flows in both loan programs. OMB’s interest rate projections made prior to  2001, as well as those by other government agencies and the private  sector, were considerably higher than actual interest rates for 2001 and  beyond. For example, as shown in table 4, actual interest rates from 2001  to 2003 were substantially lower than OMB’s forecasts of interest rates  used in the budget for fiscal year 1999 and fluctuated slightly from year to  year. To the degree that such fluctuations were unanticipated, they  contributed to volatility in subsidy cost reestimates from year to year.
For FFELP, lower than expected interest rates have resulted in lower than  expected SAP to lenders, which, in turn, resulted in lower reestimated  subsidy cost estimates. As interest rates decreased, the difference, or  spread, between the 3-month commercial paper (CP) and the 91-day  Treasury bill narrowed. For example, as can be seen in figure 5, the  average rates on the 91-day T-bill and the 3-month CP were 5.82 and 6.33,  respectively, in 2000, a difference of 0.51. However, in 2004 the difference  between the two rates was 0.15. The spread between commercial paper  and Treasury bill rates serves as the primary basis for SAP payments to the  lenders, and, as the spread narrowed, Education paid lower SAP, thus  lowering reestimated subsidy costs.
The climate of declining interest rates not only narrowed the spread  between the T-bill rate and the CP rate and reduced SAP payments, it also  eliminated SAP payments for some loans because interest rates paid by  borrowers were higher than the guaranteed lender yield. Whether SAP is  paid on a loan can change during a year because borrower interest rates  are adjusted annually based on the final auction of T-bills before June 1 of  each year while lender yields are adjusted each quarter. Thus in a climate  of declining interest rates, SAP on certain loans was eliminated because  the 3-month CP rate—on which the lender yield is based—fell, for a  particular quarter, below the annually adjusted borrower rate. SAP was  zero in 50 percent of the quarters for Stafford loans issued after         January 1, 2000 through July 1, 2005. This is illustrated in figure 6, where  one can also see that the more recent climate of rising interest rates could  lead to increased SAP.
In contrast, lower than expected interest rates contributed to higher  reestimated FDLP subsidy costs. Under FDLP, the government had  originally anticipated larger interest payments from borrowers as they  repaid their loans because original subsidy cost estimates were based on  forecasts that did not anticipate the significant decline in interest rates.  Lower than expected interest rates thus resulted in lower than expected  cash inflows to the government and higher FDLP subsidy cost reestimates.  For example, using the numbers in table 4, one can see that original  subsidy cost estimates made for the 1999 loan cohort assumed that  interest rates on the 91-day Treasury bill would be 4 times higher than they  actually were when some students would be entering repayment on loans  they obtained in 1999. Moreover, original estimates were based on the  assumption that the interest rate paid by borrowers on those loans would  be higher than the interest rate Education pays to Treasury for borrowing  the funds to make the loans. As can be seen in figure 7, the borrower  interest rate fell below the discount rate (rate paid to Treasury) in 2001.
Again, such a climate of lower than anticipated interest rates led to higher  reestimates of subsidy costs. As interest rates rise, the interest paid by  borrowers will increase–possibly to rates higher than the discount rate.
Lower than expected interest rates also affected the actual rate used to  discount cash flows for FFELP and FDLP subsidy cost estimates. When  subsidy cost estimates are first prepared for the budget, agencies use an  estimated discount rate. Education sets the actual discount rate when a  loan cohort is fully disbursed. Because subsidy cost estimates are  prepared prior to when a loan is disbursed, it is expected that differences  between the estimated and actual discount rate will contribute to  differences between reestimated and original subsidy cost estimates. For  example, the actual discount rate for loans disbursed in fiscal year 2002  was lower than originally estimated, which lowered reestimated subsidy  costs slightly in both FFELP and FDLP.
section_title: Higher Than Expected Consolidation Volume Was Another Factor Contributing to Differences between Reestimated and Original Subsidy Cost Estimates
paragraphs: Higher than expected consolidation volume, which stemmed in part from  low interest rates, also affected reestimated subsidy costs. As we have  previously reported, the number of borrowers consolidating their loans  has increased substantially over the last several years. Consolidation  activity has been higher than expected in both loan programs since fiscal  year 1999. When borrowers consolidated their student loans and locked in  recent low interest rates, they effectively paid off the underlying loans— Stafford subsidized and unsubsidized and PLUS—ahead of schedule and  started a new consolidation loan. With the new consolidation loans,  borrowers began new repayment periods that could be up to 30 years from  when the consolidation loans were made. Because Education calculates  subsidy costs for consolidation loans separately, it must adjust original  estimates of the underlying loans to reflect unanticipated prepayments.  Education considers the consolidation a new loan in the year that the loan  was disbursed. Figures 8 and 9 provide a simplified example of  consolidation from both the borrower’s and Education’s perspective.
Consolidation activity has been particularly high for FFELP loans,  increasing from about $7 billion in fiscal year 2000 to $37 billion in fiscal  year 2004. Education had not anticipated such an increase in consolidation  loans, which contributed to lower reestimated subsidy costs for the  underlying loan cohorts. Under FFELP, consolidation loans shortened the  length of time Education anticipated paying SAP to lenders and eliminated  default risk on the underlying loans, thus lowering reestimated subsidy  costs. Estimated subsidy costs for recent consolidation cohorts, which  reflect costs associated with default risk and SAP to lenders, are quite  large in comparison to previous consolidation loan cohorts. For example,  reestimated subsidy costs per $100 disbursed for consolidation loans made  in 2003 were $11.21 and in 2004 were $15.98 compared to $3.11 for  consolidation loans made in 2002. The increase is due in part because  borrowers locked in lower fixed interest rates on their consolidation loans  and the minimum yield guaranteed to lenders is projected to be much  higher than the fixed interest rate paid by borrowers, thus requiring the  government to pay higher SAP than they would have on the 2002 loans.
Consolidation activity in FDLP also increased—from $5 billion in fiscal  year 2000 to $8 billion in fiscal year 2004. As borrowers consolidated their  loans, they repaid the underlying loans that shortened the length of time  Education had expected to receive interest payments on these loans.  According to Education, it had calculated that the interest payments from  borrowers would contribute positively to Education’s cash flows because  expected interest rates that borrowers paid to Education were higher than  the rate Education paid to borrow the funds. However, greater than  expected prepayment due to consolidation decreased the anticipated  interest payments on the underlying loans, which in turn contributed to  higher reestimated subsidy cost estimates of the underlying loan cohorts.  Moreover, as we reported in August 2004, large amounts of FDLP loans— about $7.5 billion between 1998 and 2002—were consolidated into FFELP.  As a result, Education will not receive any of the future projected interest  payments on those loans that are now FFELP loans, which also  contributed to higher reestimated FDLP subsidy costs. Additionally, for  the FDLP loans consolidated into FFELP, the government may need to pay  SAP that it otherwise would not have had to pay.
section_title: Availability of Additional Data for Both FFELP and FDLP Loans Have Enabled Education to Refine Its Cash Flow Model
paragraphs: More data for both FFELP and FDLP loans has allowed Education to make  refinements to its cash flow model, a result of changes made by Education  to address recommendations in our prior reports and by Education’s  auditors. The addition of data about borrower behavior to the cash flow  model has also contributed to the differences between reestimated and  original subsidy costs. For example, Education officials reported that in  recent years, data on FFELP and FDLP borrowers’ use of deferment  options, which allow them to delay making payments on a loan when they  return to school or are experiencing economic hardship, has become  available. With this data Education is able to explicitly include in its model  the number of students using deferment options and project the effect on  cash flows in both FFELP and FDLP, rather than implicitly including  deferments in its model through adjustments in the length of time a loan  was expected to be in repayment. According to Education officials, more  FFELP borrowers than they had predicted have used deferment options  and, when this data was incorporated into FFELP’s cash flow model, it  contributed to an increase in reestimated FFELP subsidy costs of   $5 billion in fiscal year 2003. Education reported that deferment data will  be added to the FDLP cash flow model and will be reflected in reestimated  subsidy costs in the fiscal year 2007 Budget of the United States  Government.
Education also noted that more data has become available in FDLP  because the program has been in existence for 10 years and in FFELP  because of improvements made by guaranty agencies. Previously,  Education had based its FDLP cash flow assumptions on FFELP data, but  Education now has data on when borrowers default or enter repayment  based on FDLP borrowers. According to Education, actual defaults in  FDLP have not been much different from the assumptions made using  FFELP data because defaults are best predicted by the borrower and the  type of school attended rather than from which loan program the student  borrowed. According to Education officials, guaranty agencies—that are  responsible for reporting on the status of a loan, i.e., in repayment,  deferred, defaulted, or in-school—have made changes in their data  systems and the quality checks on the data. As a result, Education has  been better able to estimate default rates, subsequent collections, and  their effect on cash flows in FFELP. In particular, Education noted that  there have been improvements in the data Education uses in estimating of  collections of defaulted loans in both FFELP and FDLP, which showed  higher than originally estimated collections and contributed to lower  reestimated subsidy costs.
section_title: Certain Federal Costs and Revenues Associated with the Student Loan Programs Are Not Included in Subsidy Cost Estimates
paragraphs: Additional federal costs and revenues associated with the student loan  programs, such as federal administrative expenses, some costs of risk  associated with lending money over time, and federal tax revenues  generated by both student loan programs are not included in subsidy cost  estimates. These are important factors to consider when determining costs  of the student loan programs; however, they are difficult to measure.  Under current law, federal administrative expenses are excluded from  subsidy cost estimates. In addition, subsidy cost estimates do not  explicitly include all risk that the government incurs by lending money  over time. Moreover, both loan programs generate federal tax revenues  that are not included in subsidy cost calculations.
subsections: section_title: Federal Administrative Expenses, by Law, Are Not Included in Subsidy Cost Estimates
paragraphs: Under FCRA, federal administrative expenses are excluded from subsidy  cost estimates. Federal administrative expenses for the student loan  programs have been accounted for in Education’s budget on a cash  basis—showing how much money is allocated for administering all federal  student aid programs in one fiscal year. The federal government is  primarily responsible for administering the FDLP and, for the most part,  Education has contracted with private-sector companies to perform  administrative tasks, such as originating and servicing loans. In the  FFELP, lenders and guaranty agencies perform administrative functions.  In addition to the SAP paid to lenders to guarantee a minimum yield,  which includes coverage of the administrative expenses incurred,  Education pays guaranty agencies account maintenance fees for their  administrative costs. In fiscal year 2006, Education requested $939 million  for administrative expenses for all federal student loan and grant aid  programs. Of this amount, $238 million was for FFELP administrative  expenses and $388 million was for FDLP administrative expenses.
When FCRA was first passed there were concerns about whether agencies  could change existing accounting systems to estimate long term  administrative expenses for a loan program. Over the last few years,  Education’s Office of Federal Student Aid has been developing a system  that allocates its administrative expenses to each student aid program in a  particular fiscal year so that management would have information that  could be used for decision making purposes. While developing the system,  Education officials reported that some administrative expenses are clearly  linked to either FFELP or FDLP—such as payments to originate or service  FDLP loans, and servicing defaulted FFELP loans. However, other  administrative expenses are incurred by both loan programs, such as  information systems used to process financial aid applications, thus  requiring Education to develop a systematic way to allocate such expenses  to FFELP or FDLP.
In the fiscal year 2006 budget, Education included, as supplementary  information, modified cost estimates that included estimated  administrative expenses. As shown in table 5, if administrative expenses  are included, subsidy cost estimates for loans disbursed in fiscal year 2006  would increase by $1.45 per $100 disbursed in FDLP and by $0.69 per   $100 disbursed in FFELP.
To produce cost estimates that included administrative expenses,  Education not only needed to know how much of an expense was  allocated to FDLP or FFELP, but also had to project how such costs might  change in the future and whether an expense was paid now or later. For  example, servicing costs for an FDLP loan while the borrower is in-school  are paid in the first years that a loan is disbursed and are lower than the  same costs when a borrower is in repayment that are typically paid several  years later. According to Education, determining the timing of the expense  was important because expenses in later years were discounted and,  therefore, cost less in present value terms than those made in the first  year. Moreover, Education officials acknowledged that there are  limitations with these estimates because they assumed that administration  of student aid programs would remain the same in the future. They  reported that there is the possibility that administration processes and  functions will change based on legislative or technological changes, but it  was not possible to develop assumptions that could be used in estimating  the effects of any such changes.
section_title: Current Subsidy Estimates Do Not Incorporate All Risk Associated with Lending Money Over Time
paragraphs: While current subsidy cost estimates account for some risks— uncertainties regarding future cash flows—they do not include all risks  incurred when lending money over time. Among the risks borne by any  lender are credit risk—the possibility that the loan will not be fully  repaid—and interest rate risk—unanticipated fluctuations in the interest  rate due to changes in the economy that cause changes in the present  value of the loans’ cash flows. Some studies have commented that by not  incorporating all risks in subsidy cost estimates, the government does not  present an accurate picture of the costs of its credit programs, including  both FFELP and FDLP. Risk can be reflected in subsidy cost estimates in  different ways.  For example, one way is to incorporate it in estimates of  cash flows, and another way is to adjust the discount rate to reflect the  risk.
Currently, Education incorporates some risks into its FFELP and FDLP  subsidy cost estimate model by explicitly adjusting cash flow estimates.  For example, credit risk is explicitly incorporated into Education’s subsidy  cost model. Cash flow estimates are adjusted to reflect the likelihood that  borrowers will default on their loans based primarily on the type of school  a borrower attends (e.g., 2-year college, graduate school, etc.). Interest  rate risk, however, is not explicitly incorporated into Education’s model.  Interest rate fluctuations can affect estimates of SAP and borrower  interest payments as well as borrower behavior with respect to loan  prepayment and consolidation. Although Education uses estimated  prepayment rates in adjusting estimated FFELP and FDLP cash flows,  these estimates are based on historical averages rather than an  econometric forecast of how interest rates might fluctuate in the future  and, thereby, influence borrowers’ decisions to prepay or consolidate their  loans.  Relying on historical averages—especially if such averages do not  reflect a variety of interest rate environments and stable loan terms and  borrower characteristics—may not reflect the tendency for prepayments  to increase or decrease at times when it is advantageous for borrowers.
CBO and others have suggested that, rather than adjusting cash flows, the  discount rate could be changed to incorporate certain types of risk, such  as interest rate risk, in estimating subsidy costs of federal credit programs.  Currently, subsidy cost estimates calculate the net present value of the  loans using the “risk-free” discount rate determined by OMB in accordance  with FCRA, which reflects the government’s cost of borrowing funds. The  rate is known as risk-free because an investor buying a U.S. Treasury  instrument knows with certainty what cash flows will be received and  when they will be received and there is assumed to be no probability of  default on the investment. This risk-free discount rate tends to be  relatively low compared to interest rates used to discount cash flows in  private industry, where interest rates reflect the market’s valuation of  transactions and incorporate considerations of various types of risk. In a  2004 report, CBO proposed, among other methods, using a risk-adjusted  discount rate, rather than the risk-free rate, to estimate subsidy costs of  federal credit programs. In the case of federal student loans, one way to  calculate a risk-adjusted discount rate would be to evaluate the secondary  market for student loans, where student loans are often sold to banks or  other investors. However, there are limitations to this approach given  numerous differences in private-sector versus public sector assessments  of risk.  Notwithstanding this, the market price of the student loans would  reflect the market’s valuation of the loans, because the expected cash  flows would have been discounted using a higher discount rate that  incorporates risks—such as interest rate risk—that are not included in  Education’s subsidy cost model. The present value (price) of loans being  sold on the secondary market would tend to be lower than the  government’s valuation of similar loans, i.e., loans with similar default risk,  loan amount, time to repayment, and other factors. This difference in loan  valuation could be helpful in determining a risk-adjusted discount rate to  use in calculating the cost to the government, although determining an  appropriate rate would be challenging.
Incorporating interest rate risk would affect subsidy cost estimates for  both credit programs, FFELP and FDLP. Modeling interest rate risk more  systematically through the cash flow estimates would affect prepayment  and interest payment projections under FDLP, as well as SAP projections  and prepayment activities under FFELP. The extent to which subsidy cost  estimates would change for FFELP and FDLP would depend on the  interest rate scenarios forecasted and the subsequent effect on cash flows  in each program. However, using a risk-adjusted discount rate would have  a greater impact on the subsidy cost estimates of FDLP relative to  FFELP. This difference would result, in part, because of differences in  the amount and timing of cash flows: FDLP has large cash outlays early in  a loan’s life and large cash inflows later, when loans are in repayment.  Thus these late cash inflows would be discounted at a higher rate and  would have a smaller present value than under the current discounting  methodology. FFELP, on the other hand, generates some cash inflows to  the government early while cash outflows occur later as loans default or  when SAP payments, if any, are made.
section_title: Private-Sector Activity in Both Student Loan Programs Generates Tax Revenues for the Federal Government That Are Not Included in Subsidy Cost Estimates
paragraphs: Both FFELP and FDLP generate federal tax revenues that are reflected in  the revenue portion of the budget but are not included in subsidy cost  calculations. Federal tax revenues are generated by a variety of sources,  including private-sector lenders that account for a majority of the lenders  that make or hold FFELP loans. Many of these lenders participate actively  in the multi-billion dollar financial services industry of taxable and tax- exempt bonds, asset-backed securities, and other debt instruments and  pay federal taxes on the income earned from these sources as well as from  their student loan business. In addition, other private-sector companies  that work with FFELP lenders and investors buying student loan bonds  and securities also generate federal tax revenues from the income earned  from their participation in FFELP. Moreover, to service and collect  defaulted FFELP loans, Education contracts with private-sector  companies that are another source of federal tax revenue.
Although FDLP is financed and primarily administered by the federal  government, Education contracts with private-sector companies for many  key administrative tasks, such as servicing loans while borrowers are in  school, repayment, or default. In fiscal year 2004 Education reported that  it paid $321 million to private-sector contractors to service student loans  and perform other administrative tasks in the FDLP. These private-sector  contractors earn income from their participation in FDLP on which they  may pay federal taxes. Another source of tax revenue is income tax paid  by U.S. investors that hold Treasury securities used to finance FDLP loans.
Estimating the dollar amount of federal tax revenues generated by private  sector entities and investors in FFELP and FDLP would be challenging.  For example, many lenders are large publicly traded financial services  companies with student loans being one portion of their business, making  it difficult to identify the tax revenue generated from their student loan  business. Moreover, to make an estimate of tax revenues would require  knowledge of each lender’s profits from its student loan business and  applicable tax rates.
section_title: Concluding Observations
paragraphs: Significant reestimates of subsidy costs over the past 10 years illustrate  the challenges of estimating the lifetime costs of loans. As we have shown,  subsidy cost estimates and reestimates are sensitive to the assumptions  used in estimating these costs. The historically low interest rates that  persisted over the last several years were below levels previously  forecasted. Because cost estimates for FFELP and especially for FDLP  loans are sensitive to changes between projected and actual interest rates,  subsidy cost reestimates varied from original estimates. To the extent that  current assumptions correctly predict future loan performance and  interest rates, subsidy costs per $100 of FFELP loans made from fiscal  years 1994 to 2004 will be, in many cases, less costly than originally  anticipated. On the other hand, over the same time period, subsidy costs  per $100 of FDLP loans will in many cases be higher than originally  anticipated.
FDLP subsidy costs per $100 of loans disbursed have, in general, remained  lower than those of FFELP. Nonetheless, if current assumptions correctly  predict future loan performance and economic conditions, the originally  estimated gain to the government from FDLP loans made in fiscal years  1994 to 2004 will not materialize, and instead these loans will result in a  net cost to the government. In reality, however, subsidy cost estimates of  FFELP and FDLP loans made in fiscal years 1994 to 2004 will continue to  change as future reestimates incorporate actual experience and new  interest rate forecasts. Similarly, initial subsidy cost estimates for loans  made in the future will also change over the life of these loans and at times  be lower or higher than initially estimated, depending on the extent to  which loan performance and interest rates differ from assumptions used to  develop initial estimates. Actual subsidy costs for a cohort of student loans  will remain unknown until all payments that will be made on such loans  have been collected.
Despite the fact that subsidy cost estimates will change from year to year,  estimates developed in accordance with FCRA more fully and accurately  present the expected long-term costs of federal student loans than did the  prior method of calculating costs based on single-year cash flows to and  from the government. As a result of FCRA, the budget is a more useful tool  for allocating resources among the myriad of competing demands for  federal dollars than it once was. Subsidy cost estimates, for example,  provide policymakers the means to more accurately evaluate the long-term  budgetary implications of potential legislative, regulatory, and  administrative reforms. At the same time, it is important for policymakers  to understand how credit reform subsidy cost estimates are developed and  to recognize that such estimates will change in the future. Decisions made  in the short-term on the basis of these estimates can have long-term  repercussions for the fiscal condition of the nation.
While subsidy cost estimates include many of the federal costs associated  with FFELP and FDLP loans, they do not capture all federal costs and  revenues associated with the loan programs. Consideration of all federal  costs and revenues of the loan programs would be an important  component of a broader assessment of the costs and benefits of the two  programs. Because federal administrative expenses—in accordance with  FCRA—are excluded from subsidy cost estimates, for example, these  estimates can underestimate the total lifetime costs of FFELP and FDLP  loans. Other costs and revenues are also not considered in subsidy costs  estimates, including interest rate risk inherent to lending programs, and  federal tax revenues generated by private-sector activity in both FFELP  and FDLP. Calculations of total federal costs would be enhanced were  these additional costs and revenues considered, though doing so may  require complex methodologies and/or data that are not currently readily  available.
section_title: Agency Comments
paragraphs: We provided Education with a copy of our draft report for review and  comment. Education reviewed the report and had no comments.  Education noted that because the report did not include recommendations  for the Department, it was not providing a formal response to be included  in the report.
As agreed with your offices, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 30 days from its  date.  At that time we will send copies of this report to the Secretary of  Education, appropriate congressional committees, and other interested  parties. We will also make copies available to others upon request. In  addition, the report will be available at no charge on GAO’s Web site at  http://www.gao.gov.
If you or your staff have any questions about this report, please contact me  at (202) 512-7215 or ashbyc@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. Key contributors to the report are listed in appendix II.
section_title: Appendix I: Comparison of Fiscal Year 2006 FDLP and FFELP Reestimated Subsidy Costs per $100 Disbursed, by Loan Type and Cohort
paragraphs: Appendix I: Comparison of Fiscal Year 2006  FDLP and FFELP Reestimated Subsidy Costs  per $100 Disbursed, by Loan Type and Cohort Subsidy cost per $100 disbursed (nominal dollars)
section_title: Appendix II: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: The following individuals made important contributions to the report:   Jeff Appel, Assistant Director; Andrea Sykes, Analyst-in-Charge,   Nagla’a El-Hodiri, Jeffrey W. Weinstein, Christine Bonham, Marcia Carlsen,  Austin Kelly, Mitch Rachlis and Lauren Kennedy.