Federal Family Education Loan Program: Statutory and Regulatory Changes Could Avert Billions in Unnecessary Federal Subsidy Payments
Published: 2004-09-20T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: To encourage lenders to make student loans under the Federal Family Education Loan Program (FFELP), the federal government guarantees lenders a statutorily specified rate of return--called lender yield. Some lenders may issue tax-exempt bonds to raise capital to make or purchase loans; loans financed with such bonds issued prior to 10/1/93 are guaranteed a minimum lender yield of 9.5% (hereafter called 9.5% loans). When the interest rate paid by borrowers is less than the lender yield, the government pays lenders the difference--a subsidy called special allowance payments. In light of the upcoming reauthorization of the Higher Education Act of 1965, we examined special allowance payments for 9.5% loans.
section_title: What GAO Found
paragraphs: Special allowance payments for 9.5% loans have risen dramatically in recent years, increasing from $209 million in FY 2001 to well over $600 million as of June 30, 2004. A primary reason for the increase is the sharp decline in the variable interest rates paid by borrowers relative to the minimum 9.5% lender yield. Another reason for the increase in special allowance payments is the rising dollar volume of 9.5% loans, which increased from about $11 to over $17 billion from FY 1995 to June 30, 2004. Given that current market interest rates are at or near historic lows, lenders have a financial incentive to maintain or increase their 9.5% loan volume and can do so in three ways. After paying costs, including payments to bond investors, associated with a pre 10/1/93 tax-exempt bond, lenders can use any remaining money to reinvest in more FFELP loans that, by law, are also guaranteed a minimum 9.5% yield. Lenders can issue a new bond, called a refunding bond, to repay an outstanding pre 10/1/93 tax-exempt bond that financed 9.5% loans. Consequently, the refunding bond finances the 9.5% loans and may have a later maturity date than the original bond, allowing lenders to maintain their 9.5% loan volume for a longer time. By issuing a taxable bond and using the funds obtained to purchase 9.5% loans financed by a pre-10/1/93 tax-exempt bond, lenders can significantly increase their loan volume. Lenders can use the proceeds from the sale of loans previously financed by the pre-10/1/93 tax-exempt bond to make or buy additional loans, which are also guaranteed a 9.5% yield. Under Education's regulations, loans previously financed by a pre 10/1/93 tax-exempt bond and subsequently financed by (i.e., transferred to) a taxable bond continue to be guaranteed a 9.5% yield. Some Members of Congress and the Administration have proposed making statutory changes with respect to 9.5% loans, which could save billions of dollars in future special allowance payments. An official representing a leading credit rating agency and some major lenders told us that making changes to the minimum 9.5% yield for loans made or purchased in the future should not affect lenders' ability to make required payments on outstanding tax-exempt bonds.

section_title: Letter
paragraphs: Under the Federal Family Education Loan Program (FFELP), lenders— including banks, state agencies and other nonprofit and for-profit  organizations—annually make, or originate, billions of dollars in loans to  help students and families finance postsecondary education costs. To  encourage lenders to make loans, the federal government guarantees  lenders repayment and a statutorily specified rate of return—called lender  yield—on the loans they hold. Lender yields as well as the interest rates  paid by borrowers are typically tied to, and vary with, money market  financial instruments, such as the 91-day Treasury bill. When the interest  rate paid by borrowers is less than the guaranteed lender yield, the  government pays lenders the difference—a subsidy called special  allowance payments. In exercising its oversight of the FFELP, Congress  has periodically changed the formula for lender yields to better reflect  market interest rates, federal budget constraints, or the costs incurred by  lenders to finance loans. To finance loans, some lenders, specifically state  agencies and state-designated authorities, may issue tax-exempt bonds to  raise capital to make or purchase loans, thereby providing other lenders  with more funds to make more loans. Investors who buy these bonds  receive interest income that is exempt from federal taxation. Because  these investors do not pay taxes on their interest earnings, they are willing  to accept a lower pretax rate of return on their investment, which lowers  the financing costs for agencies and authorities issuing the bonds. As  student loan borrowers repay their loans, loan holders use the money to  repay, in turn, bond investors.
Concerned that the lender yield for loans financed with tax-exempt bonds  did not adequately reflect the lower costs associated with tax-exempt  financing, Congress reduced the yield in passing the Education  Amendments of 1980. To do so, Congress reduced the special allowance  payments to be paid on loans financed with tax-exempt bonds to one-half  of that otherwise payable. At the same time, however, Congress  guaranteed that the lender yield for loans financed with tax-exempt bonds  would be no less than 9.5 percent. Several years later, in passing the  Omnibus Budget Reconciliation Act of 1993, Congress eliminated the one- half special allowance payment and minimum 9.5 percent yield provision  for loans financed with tax-exempt bonds issued on or after October 1,  1993. In so doing, Congress provided that lenders would receive the same  yield on loans, regardless of whether tax-exempt bonds or other sources  of funds had been used to finance the loans. Due to these changes, loans  that are financed with the proceeds of tax-exempt bonds issued prior to  October 1, 1993 are guaranteed a minimum 9.5 percent yield. (These loans  are hereafter called 9.5 percent loans).
Believing that changes to the law should have resulted in a decline in  special allowance payments made for 9.5 percent loans since 1993, various  news media, policy makers, and others have recently raised questions  about the extent to which the government continues to make such  payments. In light of the upcoming reauthorization of the Higher  Education Act of 1965, which authorizes the FFELP, you asked us to  examine special allowance payments for 9.5 percent loans. To conduct our  examination, we analyzed the Department of Education’s (Education) data  on 9.5 percent loan volume and special allowance payments paid to  lenders from fiscal year 1986 through the third quarter of fiscal year   2004, the most current data available at the time of our review. On the  basis of our review of the documentation for these data and our  discussions with Education officials about the steps they take to ensure  the reliability and validity of these data, we determined that the data were  sufficiently reliable for the purpose of our examination. In addition, we  interviewed officials with Education; the Internal Revenue Service; a  major credit rating agency that examines and rates the quality of student  loan bonds, including those issued by several holders of 9.5 percent loans;  a leading bond counsel law firm that provides legal advice to lenders that  issue tax-exempt student loan bonds; and 12 lenders that reported holding  9.5 percent loans in fiscal year 2003. We gathered additional data on the  amount of 9.5 percent loans in taxable bonds from the top 10 holders of  9.5 percent loans in fiscal year 2003. These 10 lenders held 70 percent of  reported 9.5 percent loan volume in fiscal year 2003.
On August 19, 2004, we briefed your staff on the results of our work. This  report summarizes the information we shared with your staff and  transmits the slides we used to brief your staff that day. In this report, we  are also making a recommendation to the Secretary of Education and  suggesting a matter for Congress’s consideration. We conducted our work  between December 2003 and August 2004 in accordance with generally  accepted government auditing standards.
subsections: section_title: Special Allowance Payments For 9.5 Percent Loans Have Increased More Than Threefold Since Fiscal Year 2001
paragraphs: Special allowance payments for 9.5 percent loans have risen dramatically  in recent years, increasing from $209 million in fiscal year 2001, to   $556 million in fiscal year 2003 and reached about $634 million at the end  of the third quarter of fiscal year 2004. Two reasons account for this  increase: (1) a decline in the interest rate paid by borrowers and (2) a rise  in the dollar volume of 9.5 percent loans. In some cases, restrictions exist  on how the nonprofit, for-profit, and state agency lenders that hold 9.5  percent loans may use their earnings, including their special allowance  payments, from 9.5 percent loans.
subsections: section_title: Decline in Interest Rate Paid by Borrowers Is Primary Reason for Increase in Special Allowance Payments
paragraphs: The primary factor influencing the increase in special allowance payments  has been the sharp decline in interest rates paid by borrowers relative to  the minimum 9.5 percent government guaranteed yield for lenders. As  borrower rates have declined, the amount the government has been  required to pay to make good on its promise to lenders has increased. To  illustrate, in 2001, the borrower interest rate was 8.2 percent. Because this  borrower rate is tied to the 91-day Treasury-bill rate and the Treasury-bill  rate subsequently declined, the borrower interest rate on the same loan in  2003 was 5.4 percent. While the borrower rate declined, the yield for a  lender who used the proceeds, or funds obtained, of a pre-October 1, 1993,  tax-exempt bond to originate or purchase the loan remained at 9.5 percent.  Over this period, the difference, or spread, between the borrower rate and  the 9.5 percent lender yield increased from 1.3 percent to 4.1 percent. As a  result, the special allowance payment required to ensure a lender yield of  9.5 percent increased for each dollar of loan volume in this example.
section_title: Increasing 9.5 Percent Loan Volume Is Another Reason for the Increase in Special Allowance Payments
paragraphs: Another factor influencing the increase in special allowance payments has  been the rising dollar volume of 9.5 percent loans. Although the overall  volume of 9.5 percent loans has increased since fiscal year 1995, volume  among lenders has varied. Most lenders experienced a decrease in their   9.5 percent loan volume between fiscal years 1995 and 2003, but by the end  of the third quarter of fiscal year 2004, some of these lenders had sharply  increased their 9.5 percent loan volume. For example, one lenders’   9.5 percent loan volume had decreased by 46 percent between fiscal years  1995 and 2003 but then increased by 136 percent between 2003 and the end  of the third quarter of fiscal year 2004, making its 9.5 percent loan volume  greater than it was in 1995.
There are primarily three ways—referred to as recycling, refunding, and  transferring—that a lender can slow the decrease in, maintain, or increase  its 9.5 percent loan volume.
First, after paying costs associated with a pre-October 1, 1993 tax- exempt bond (such as payments of interest and principal to bond  investors), lenders can reinvest, or recycle, any remaining money  earned from 9.5 percent loans to make or purchase additional loans  that, under the law, are also guaranteed a minimum 9.5 percent lender  yield.   Using this method, lenders are able to slow the decrease in,  maintain, or slightly increase their 9.5 percent loan volume.
Second, lenders can issue a new bond, called a refunding bond, to  repay the principal, interest, and other costs of an outstanding pre- October 1, 1993 tax-exempt bond. Based on how the HEA has been  interpreted, 9.5 percent loans originally financed with a pre-October 1,  1993 tax-exempt bond, but subsequently financed by a refunding bond,  continue to carry the government guaranteed minimum yield for  lenders of 9.5 percent. Moreover, the refunding bond may have a later  maturity, or payoff, date than the original bond. Using this method,  lenders can maintain their 9.5 percent loan volume.
Third, under Education regulations, a lender can significantly increase  its 9.5 percent loan volume by issuing a taxable bond and using the  proceeds to purchase 9.5 percent loans financed by a pre-October 1,  1993 tax-exempt bond. The lender then uses the cash available from the  pre-October 1, 1993 tax-exempt bond to make or buy additional loans,  which are guaranteed the minimum 9.5 percent yield. Under  regulations issued in 1992, the loans transferred to the taxable bond  continue to be guaranteed the minimum 9.5 percent lender yield, so  long as the original bond is not retired or defeased. (At the time the  regulation was promulgated, Education anticipated that interest rates  would rise, resulting in a higher lender yield for loans financed with  taxable bonds than for loans financed with tax-exempt bonds.  Education believed that if the 1992 regulation was not promulgated,  lenders would have had an incentive to transfer loans from tax-exempt  bonds to taxable bonds in order to obtain a higher yield, thus resulting  in higher special allowance payments for the government.) Among the  top 10 lenders holding 9.5 percent loans, more than half of the dollar  volume of their 9.5 percent loans had been transferred to taxable bonds  as of March 31, 2004. The extent to which lenders have transferred   9.5 percent loans to taxable bonds varies considerably. For example,  one lender had none of its 9.5 percent loans in a taxable bond, while  another held 90 percent of its 9.5 percent loans in a taxable bond as of  March 31, 2004. Some lenders interviewed have been transferring   9.5 percent loans for several years, while another lender just started to  transfer 9.5 percent loans in 2004. Additionally, some lenders have also  transferred 9.5 percent loans to tax-exempt bonds issued after October  1, 1993, thereby continuing the 9.5 percent minimum guaranteed yield.
As a result of recycling, refunding, and transferring, the overall dollar  volume of 9.5 percent loans has increased from about $11 billion in fiscal  year 1995 to over $17 billion at the end of the third quarter of fiscal year  2004. While the dollar volume of 9.5 percent loans presently accounts for  only about 8 percent of all outstanding FFELP loan volume, these loans  account for 78 percent of all special allowance payments made to FFELP  lenders thus far in fiscal year 2004.
section_title: Earnings on Tax-Exempt Bonds that Finance 9.5 percent Loans May be Used for Borrower Benefits
paragraphs: Under the Internal Revenue Code (IRC), earnings on loans financed by  tax-exempt bonds are limited.  Lenders can reduce their earnings on loans  financed with tax-exempt bonds, and avoid exceeding IRC limitations, by  providing benefits to borrowers.  Some lenders reported that they have  used, or plan to use, earnings in excess of IRC limits to provide interest  rate reductions or loan cancellation for borrowers. In contrast to tax- exempt bonds, earnings on taxable bonds are not limited. As a result,  lenders have discretion in how they use their earnings from taxable bonds  that have financed 9.5 percent loans.
section_title: Changes to the Minimum 9.5 Percent Yield For Loans Made or Purchased in the Future Could Save Billions and Is Unlikely to Cause Lenders to Default on Outstanding Tax- Exempt Bonds
paragraphs: Changing law and regulations with respect to 9.5 percent loans made or  purchased in the future could reduce the amount of special allowance  payments required to be paid by the government without compromising  lenders’ ability to meet their obligations under their outstanding tax- exempt bonds. The Administration and some members of Congress have,  in fact, already put forth proposals to make such changes. The  Administration has proposed limiting the extent to which lenders can  receive the substantially higher special allowance payments on 9.5 percent  loans in the future and estimates savings of $4.9 billion over fiscal years  2005 through 2014 by doing so. Proposed legislation introduced in the  108th Congress also seeks to revise the law pertaining to 9.5 percent loans  in order to reduce special allowance payments and change lender yields to  reflect current market interest rates.
Changing current regulations that allow lenders to transfer 9.5 percent  loans to taxable bonds and retain the minimum 9.5 percent yield could  also significantly reduce potential special allowance payments in the  future. While Education officials told us that they had considered revising  the department’s regulations, they believed that Congress could effect  such a change by law more quickly and easily. Education officials told us  that promulgating new FFELP regulations would likely be difficult and  time-consuming, in light of the HEA’s requirement that the department  engage in negotiated rule making in promulgating FFELP regulations.  Negotiated rule making requires the department to convene a committee  that would include FFELP industry representatives, such as lenders, and  attempt to reach consensus among committee members on proposed  regulations. Given the interest of lenders who hold 9.5 percent loans,  reaching consensus on new regulations would likely prove to be very  difficult, according to Education officials. However, the inability to reach  consensus does not invalidate the negotiation of rules.  Moreover,  regulations are not subject to the negotiated rulemaking requirement if the  Secretary determines that applying this requirement would be  'impracticable, unnecessary, or contrary to the public interest.'   Representatives from a major credit rating agency as well as some lenders  who hold 9.5 percent loans told us that eliminating the minimum   9.5 percent yield for loans made or purchased in the future should not  affect lenders’ ability to meet their obligations under, and make required  payments on, their outstanding tax-exempt bonds, nor should it have long- term negative effects in the student loan bond market.
section_title: Conclusions
paragraphs: Unlike other loans for which the lender yield varies with current market  interest rates, the lender yield for loans financed with pre-October 1, 1993  tax-exempt bonds are guaranteed a minimum yield of 9.5 percent. Given  that current market interest rates are at or near historic lows, lenders have  a significant financial incentive to slow the decrease in, maintain, or  increase the volume of loans that yield such a relatively high rate of return  unavailable on other FFELP loans. This incentive will remain even if  market interest rates gradually rise in the future. Ironically, moreover, an  Education regulation over 10 years old and originally intended to limit the  government’s exposure to increased special allowance payments has today  presented lenders with an extraordinary opportunity to generate  additional loans that earn a 9.5 percent yield. As we have shown, lenders  are taking advantage of these opportunities. Industry experts acknowledge  that the government could take action to eliminate the 9.5 percent yield for  loans made or purchased in the future without compromising the ability of  lenders to meet their obligations with respect to their pre-October 1, 1993  tax-exempt bonds. Without government action, the taxpayers remained  exposed to additional special allowance payments that can easily and  rapidly escalate into the billions of dollars.
section_title: Matter for Congressional Consideration
paragraphs: In light of the rapid increase in special allowance payments for loans  guaranteed a minimum 9.5 percent yield and the continuing financial  incentive for lenders to originate or purchase additional loans that qualify  for a guaranteed yield of 9.5 percent, Congress should consider amending  the HEA to address the issues identified by this report, but particularly to  change the yield for loans made or purchased in the future with the  proceeds of pre-October 1, 1993 tax-exempt bonds, and any associated  refunding bonds, to more closely reflect these loans’ financing costs and  current market interest rates.
section_title: Recommendation for Executive Action
paragraphs: Given that lenders are increasing the volume of 9.5 percent loans based on  Education regulations that allow lenders to transfer 9.5 percent loans to  taxable bonds and tax-exempt bonds issued after October 1, 1993 while  retaining the special allowance payment provisions applicable to loans  financed with pre-October 1, 1993 tax-exempt bonds, and the resulting  increased costs for taxpayers, we recommend that the Secretary of  Education promulgate regulations to discontinue the payment of the  special allowance applicable to loans financed with pre-October 1, 1993  tax-exempt bonds that are subsequently transferred to taxable bonds or  tax-exempt bonds issued on or after October 1, 1993.
section_title: Agency Comments
paragraphs: We provided a draft of this report to Education for review and comment.  In commenting on our report, Education agreed that special allowance  payments for 9.5 percent loans should be scaled back considerably and  that, as noted in our report, such a proposal was included in the  President’s fiscal year 2005 budget. Education also stated that it had  considered changing its regulation or its interpretation of the regulation  last year, but believed at that time that the HEA would be reauthorized and  amended to address the issues discussed in our report before any  proposed regulation or regulatory interpretation it might undertake could  become effective. Education stated this was the case because of certain  requirements contained in the HEA and other laws, including a  requirement that it engage in negotiated rule making.
Education also commented on the statutory exception to the general  requirement that it engage in negotiated rule making, which we highlighted  in our report. As mentioned in our report, the Secretary need not subject a  rule making to the negotiated rule making process if the Secretary  determines that the process would be “impracticable, unnecessary, or  contrary to the public interest.” In its comments, Education stated that the  courts have construed this exception only to cover routine determinations  that are insignificant in nature and impact, inconsequential to industry and  to the public, or which raise issues of public safety. While we believe that  it is Education’s responsibility to interpret the law as it relates to its own  programs, on the basis of our review of the case law, we disagree with  Education’s characterization of the case law concerning the scope of the  exception in the Administrative Procedure Act. Specifically, it does not  fully address the courts’ treatment of the “public interest” prong of the  three-pronged exception noted above.
The federal courts have interpreted the three-pronged exception in many  cases involving a wide variety of factual situations. Education’s  characterization of the case law describes the courts’ discussion of the  first two prongs, “impracticable” or “unnecessary,” but does not fully  address the potential applicability of the third prong, which, if met, would  independently justify use of the exception. In fact, in the case cited by  Education in its comments, Utility Solid Waste Activities Group v.  E.P.A., 236 F.3d 749 (D.C. Cir. 2001), the court briefly explains the “public  interest exception” by pointing to a situation where announcement of the  rule in advance would “enable the sort of financial manipulation the rule  sought to prevent.”  Id. at 755; see also, Attorney General’s Manual on the  Administrative Procedure Act, pp. 30-31.  Thus, it is clear that the  applicability of the “public interest” exception turns neither on the  insignificance of the rule nor on whether it raises issues of public safety.   See also Nader v. Sawhill, 514 F.2d 1064 (D.C. Cir. 1975).  Moreover, in  reviewing challenges to an agency’s use of an exception, the Court of  Appeals for the District of Columbia has stated that it will review the  “totality of the circumstances,” including the complexity of the statute and  congressionally imposed time frames.  See Methodist Hosp. of  Sacramento v. Shalala, 38 F.3d 1225 (D.C. Cir. 1994); Petry v. Block, 737  F.2d 1193 (D.C. Cir. 1984).
Determining whether the unique circumstances present here support the  agency’s use of an exception is beyond the scope of our report and is a  matter, in the first instance, for Education.  Nevertheless, we continue to  believe that Education should consider all of its options in effecting the  desired policy change as we recommend in the report.  This could include,  for example, determining whether Education could use less formal  guidance, as it has in the past, to clarify or alter its position; whether a full  consideration of all the facts and circumstances as well as all the  applicable case law would support use of an exception to the negotiated  rule making requirement; whether an interim final rule could be issued to  take effect immediately; or whether negotiated rule making could be  accomplished on an expedited basis.  Given Education’s position that it is  essentially unable to implement regulations until July 1, 2006, more than  21 months away, we think it is important that Education fully explore all  of its options, consistent with applicable law.  Education’s written  comments appear in appendix II.
We are sending copies of this report to the Secretary of Education,  appropriate congressional committees, and other interested parties. In  addition, the report will be available at no charge on GAO’s Web site at  http://www.gao.gov.
If you or your staff have any questions about this report, please contact me  at (202) 512-8403 or Jeff Appel, Assistant Director, at (202) 512-9915. You  may also reach us by e-mail at ashbyc@gao.gov or appelc@gao.gov. Other  contacts and staff acknowledgments are listed in appendix III.
section_title: Appendix I: Briefing Slides
subsections: section_title: Lender subsidy payments for loans
section_title: Overview
subsections: section_title: • Introduction Research Objectives Scope and Methodology Summary of Findings Background Key Findings Concluding Observations
section_title: Introduction
subsections: section_title: Private and public lenders made about $42 billion in new loans to
paragraphs: students in school year 2002-03 through the Federal Family  Education Loan Program (FFELP).
To encourage lenders to make FFELP loans, the federal  government guarantees repayment and provides lenders a  guaranteed rate of return.
Guaranteed rate of return equals the greater of the statutorily  specified lender yield or the borrower interest rate.
When the borrower rate is less than the lender yield, the  government makes subsidy payments, called special allowance  payments (SAP), to lenders.
section_title: Introduction
subsections: section_title: Through the years Congress has made changes to the lender yield to
paragraphs: reflect lenders’ financing costs and to limit SAP.
The Education Amendments of 1980 changed the SAP for loans  financed with tax-exempt bonds to reduce profits for loans financed  with tax-exempt bonds.  Loans disbursed on or after 10/1/80 receive  half the SAP of loans financed with taxable bonds but are guaranteed  a minimum yield of 9.5 percent.
The Omnibus Reconciliation Act of 1993 eliminated the minimum  9.5 percent yield for loans financed with tax-exempt bonds issued on  or after 10/1/93 and these loans are guaranteed the same rate of return as that for loans financed with taxable bonds or other sources.
Because of these changes, loans that are financed with tax-exempt  bonds issued prior to 10/1/93 are guaranteed a minimum 9.5 percent  yield, hereafter called 9.5 percent loans.
section_title: Introduction
subsections: section_title: Bonds are used to finance student loans.
section_title: Research Objectives
subsections: section_title: To what extent have lenders received SAP for 9.5 percent
paragraphs: loans?
What factors influence SAP?  What would be the effects of making statutory and regulatory  changes to the guaranteed minimum 9.5 percent yield?
section_title: Scope and Methodology
subsections: section_title: Analyzed student loan data submitted by lenders to the Department
paragraphs: of Education (Education).  These data include information on 9.5  percent loan volume and SAP paid to lenders.  On the basis of our  analysis, we have determined that data from 1986 onward are  sufficiently reliable for purposes of our review. Interviewed 12 lenders that reported holding 9.5 percent loans in  fiscal year 2003. – Gathered data from top 10 lenders that held 9.5 percent loans  in FY 2003. These lenders held 70 percent of reported 9.5  percent loan volume in FY 2003.
Interviewed officials at Education about laws, regulations and  policies related to the minimum 9.5 percent yield and Internal  Revenue Service (IRS) about legal aspects of tax-exempt bonds.
section_title: Scope and Methodology
paragraphs: Interviewed a major ratings agency that examines and rates the  quality of bonds and a law firm that provides legal advice to lenders  that issue tax-exempt bonds for student loans.
To estimate what the SAP for 9.5 percent loans would have been  from FY 1995 to 2003 had these loans not been guaranteed a  minimum 9.5 percent yield, we used Education’s data on SAP  made by fiscal year, loan type, and special allowance code (which  contains information on when the loan was issued), along with  several assumptions.
Had the loans not been guaranteed a minimum 9.5 percent  yield, we assumed that they would have received the yield for  the same loan type financed with taxable bonds with the same  disbursement date and repayment status.
section_title: Summary of Findings
paragraphs: In FY 2003, 37 lenders received SAP for 9.5 percent loans and these  payments have increased by $347 million, from $209 million in FY 2001 to  $556 million in FY 2003.  SAP have exceeded $600 million through the  third quarter of FY 2004.
A decline in the interest rates paid by borrowers and a rise in the dollar  amount of 9.5 percent loans have influenced the increased SAP.
Changing the yield for 9.5 percent loans made or purchased in the future  should decrease SAP and is unlikely to cause outstanding bonds to default,  but lenders may not be able to offer the same borrower benefits, such as  loan cancellation and interest rate reductions, in the future because  earnings from their tax-exempt bonds may decrease.
subsections: section_title: Two factors have influenced increase in SAP for 9.5 percent loans
subsections: section_title: Major factor that has influenced increase in SAP is the
paragraphs: significant drop in borrower rate relative to 9.5 percent yield.
The volume of 9.5 percent loans has not decreased as  expected, which has also influenced the SAP increase.
subsections: section_title: Difference between borrower rate and minimum 9.5 percent yield has widened significantly since FY 2001
subsections: section_title: Interest rate (in percent)
section_title: Example of how low borrower rates affect SAP
paragraphs: SAP = (9.5% - borrower rate)
These borrower rates are for Stafford loans from October to June of that fiscal year disbursed after July 1, 1998, that were in repayment.
section_title: The volume of 9.5 percent loans has not decreased as expected, which has also contributed to the SAP increase
paragraphs: 9.5 percent loan volume (nominal dollars in millions)
section_title: For 21 lenders, the amount of 9.5 percent loans they held between
paragraphs: FY 1995 and FY 2003 decreased.
Some of these lenders, however, have increased the amount of  9.5 percent loans they held in the first three quarters of 2004.
For the remaining 16 lenders, the amount of 9.5 percent loans held  between FY 1995 and FY 2003 has increased.
section_title: Recycling allows lenders to maintain or slightly increase 9.5 percent loan volume After lenders pay costs (such as interest payments and servicing fees)
paragraphs: associated with a tax-exempt bond, they may use any remaining money  earned from loans to reinvest in FFELP loans, called recycling.  These  loans are guaranteed the minimum 9.5 percent yield.
All 12 lenders interviewed utilize recycling to reinvest in 9.5 percent loans.  Length of time that a lender can recycle depends on the terms of the  bond—some lenders have recycling periods of 1 to 3 years while others have recycling periods that last until the bond matures – Lenders may ask ratings agency to extend their recycling period up to  the bond’s maturity date. – For a bond with a maturity date in 2025 and a recycling period that  lasts until maturity, the lender can likely recycle and slow the decrease  in, maintain, or slightly increase its 9.5 percent loan volume until that  time.
section_title: Transferring loans from pre-10/1/93 tax-exempt bonds to taxable bonds increases lenders’ 9.5 percent loan volume
section_title: Almost all lenders interviewed have transferred loans to taxable bonds, which has increased their 9.5 percent loan volume Among top 10 lenders the proportion of 9.5 percent loans that have been
paragraphs: transferred to a taxable bond increased between FY 2003 and 2004.
Proportion of Top 10 Lenders' 9.5% Loans Financed by Taxable Bonds FY 2004 (as of 3/3/1/04)
section_title: half of FY 2004 varied among the 10 lenders, from 0 to 90 percent. – Some lenders interviewed have been transferring for several years
paragraphs: while another just started in 2004. – Some lenders have also transferred to tax-exempt bonds issued after  10/1/93.
section_title: Policy that allows lender to transfer loans and increase 9.5 percent loan volume was intended to limit SAP
paragraphs: In 1992, Education issued regulations intending to limit SAP by changing  how SAP is calculated for a loan that is transferred from a tax-exempt bond  to a taxable bond.   – Under the 1992 regulation and clarified in a 1996 guidance letter, a  loan transferred from a pre-10/1/93 tax-exempt bond to a taxable bond  remains subject to the SAP provisions applicable to loans financed  with the tax-exempt bonds so long as the lender retains a legal interest  in the original tax-exempt bond and the original bond has not been  retired or defeased.
At that time, Education anticipated that interest rates would rise, resulting in  a higher lender yield for loans financed with taxable bonds compared with   loans financed with tax-exempt bonds.
Education believed that if the regulation was not issued lenders would have  an incentive to transfer loans from tax-exempt bonds to taxable bonds,  which would mean that the federal government would have paid greater  SAP for those loans.
section_title: Refunding a pre-10/1/93 tax-exempt bond extends the life of a bond, and loans continue to be guaranteed the minimum 9.5 percent yield Lenders may refund a pre-10/1/93 tax-exempt bond, and the
paragraphs: refunding bond may have a later maturity date than the original  bond.
Based on interpretation of the Higher Education Act, loans now  financed with the refunding bond continue to be guaranteed the  minimum 9.5 percent yield.
Almost all nonprofit lenders interviewed refunded a pre-10/1/93 tax- exempt bond. – A lender that did not refund made this choice because its bonds  had maturity dates 20 to 30 years from their issue date. – For-profit lenders are not permitted to refund tax-exempt bonds. – Some reported reasons to refund included: to obtain a lower  interest rate than paid on the original bond or to extend period of time loans are guaranteed the minimum 9.5 percent yield.
section_title: Lenders have refunded tax-exempt bonds using the IRS’s 17-year rule or with new volume cap allocation Most lenders interviewed refunded using the 17-year rule.
paragraphs: – Using the 17-year rule, a lender does not need to receive  authority to issue a refunding bond from the state.  However,  the maturity date must not be later than the longer of 17 years  from the original bond issue date or the average maturity of the original bond.
Some lenders interviewed have used a new volume cap allocation  from the state to refund a bond, and the loans continue to be  guaranteed the minimum 9.5 percent yield. – When a lender uses new volume cap allocation from the state  to refund a bond, the maturity date for the new bond is not  restricted as it is under the 17-year rule.
section_title: Changing the yield for 9.5 percent loans to a yield that
paragraphs: eliminates the minimum could lower SAP for loans  made or purchased in the future.
Changing the yield for 9.5 percent loans made or  purchased in the future is unlikely to cause outstanding  bonds to default, but lenders may not be able to offer  the same borrower benefits, such as loan cancellation  and interest rate reductions, in the future.
subsections: section_title: Unlike other loans whose rates of return vary because they are tied
paragraphs: to market interest rates, those financed with pre-10/1/93 tax-exempt  bonds have a guaranteed minimum rate of return. In an environment where interest rates are low, current law and  policies provide an opportunity for lenders to increase the amount  of loans guaranteed a minimum 9.5 percent rate.
Even if interest rates rise somewhat in the future, the difference  between the borrower rate and the minimum 9.5 percent yield will still be large.  This will require the government to continue to pay  larger SAP than it would otherwise have if the loans did not have a  guaranteed minimum of 9.5 percent.
section_title: Appendix II: Comments from the Department of Education
section_title: Appendix III: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contacts
section_title: Staff Acknowledgments
paragraphs: In addition to those named above, the following people made significant  contributions to this report: Cynthia Decker, Margaret Armen, Richard  Burkard, Jason Kelly, Rebecca Christie, and Jeff Weinstein.