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

Letter

Special Allowance Payments For 9.5 Percent Loans Have Increased More Than Threefold Since Fiscal Year 2001

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.

Decline in Interest Rate Paid by Borrowers Is Primary Reason for Increase in Special Allowance Payments

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.

Increasing 9.5 Percent Loan Volume Is Another Reason for the Increase in Special Allowance Payments

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.

Earnings on Tax-Exempt Bonds that Finance 9.5 percent Loans May be Used for Borrower Benefits

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.

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

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.

Conclusions

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.

Matter for Congressional Consideration

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.

Recommendation for Executive Action

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.

Agency Comments

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.

Appendix I: Briefing Slides

Lender subsidy payments for loans

Overview

• Introduction Research Objectives Scope and Methodology Summary of Findings Background Key Findings Concluding Observations

Introduction

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

students in school year 2002-03 through the Federal Family Education Loan Program (FFELP).

To encourage lenders to make FFELP loans, the federal government guarantees repayment and provides lenders a guaranteed rate of return.

Guaranteed rate of return equals the greater of the statutorily specified lender yield or the borrower interest rate.

When the borrower rate is less than the lender yield, the government makes subsidy payments, called special allowance payments (SAP), to lenders.

Introduction

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

reflect lenders’ financing costs and to limit SAP.

The Education Amendments of 1980 changed the SAP for loans financed with tax-exempt bonds to reduce profits for loans financed with tax-exempt bonds. Loans disbursed on or after 10/1/80 receive half the SAP of loans financed with taxable bonds but are guaranteed a minimum yield of 9.5 percent.

The Omnibus Reconciliation Act of 1993 eliminated the minimum 9.5 percent yield for loans financed with tax-exempt bonds issued on or after 10/1/93 and these loans are guaranteed the same rate of return as that for loans financed with taxable bonds or other sources.

Because of these changes, loans that are financed with tax-exempt bonds issued prior to 10/1/93 are guaranteed a minimum 9.5 percent yield, hereafter called 9.5 percent loans.

Introduction

Bonds are used to finance student loans.

Research Objectives

To what extent have lenders received SAP for 9.5 percent

loans?

What factors influence SAP? What would be the effects of making statutory and regulatory changes to the guaranteed minimum 9.5 percent yield?

Scope and Methodology

Analyzed student loan data submitted by lenders to the Department

of Education (Education). These data include information on 9.5 percent loan volume and SAP paid to lenders. On the basis of our analysis, we have determined that data from 1986 onward are sufficiently reliable for purposes of our review. Interviewed 12 lenders that reported holding 9.5 percent loans in fiscal year 2003. – Gathered data from top 10 lenders that held 9.5 percent loans in FY 2003. These lenders held 70 percent of reported 9.5 percent loan volume in FY 2003.

Interviewed officials at Education about laws, regulations and policies related to the minimum 9.5 percent yield and Internal Revenue Service (IRS) about legal aspects of tax-exempt bonds.

Scope and Methodology

Interviewed a major ratings agency that examines and rates the quality of bonds and a law firm that provides legal advice to lenders that issue tax-exempt bonds for student loans.

To estimate what the SAP for 9.5 percent loans would have been from FY 1995 to 2003 had these loans not been guaranteed a minimum 9.5 percent yield, we used Education’s data on SAP made by fiscal year, loan type, and special allowance code (which contains information on when the loan was issued), along with several assumptions.

Had the loans not been guaranteed a minimum 9.5 percent yield, we assumed that they would have received the yield for the same loan type financed with taxable bonds with the same disbursement date and repayment status.

Summary of Findings

In FY 2003, 37 lenders received SAP for 9.5 percent loans and these payments have increased by $347 million, from $209 million in FY 2001 to $556 million in FY 2003. SAP have exceeded $600 million through the third quarter of FY 2004.

A decline in the interest rates paid by borrowers and a rise in the dollar amount of 9.5 percent loans have influenced the increased SAP.

Changing the yield for 9.5 percent loans made or purchased in the future should decrease SAP and is unlikely to cause outstanding bonds to default, but lenders may not be able to offer the same borrower benefits, such as loan cancellation and interest rate reductions, in the future because earnings from their tax-exempt bonds may decrease.

Two factors have influenced increase in SAP for 9.5 percent loans

Major factor that has influenced increase in SAP is the

significant drop in borrower rate relative to 9.5 percent yield.

The volume of 9.5 percent loans has not decreased as expected, which has also influenced the SAP increase.

Difference between borrower rate and minimum 9.5 percent yield has widened significantly since FY 2001

Interest rate (in percent)

Example of how low borrower rates affect SAP

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.

The volume of 9.5 percent loans has not decreased as expected, which has also contributed to the SAP increase

9.5 percent loan volume (nominal dollars in millions)

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

FY 1995 and FY 2003 decreased.

Some of these lenders, however, have increased the amount of 9.5 percent loans they held in the first three quarters of 2004.

For the remaining 16 lenders, the amount of 9.5 percent loans held between FY 1995 and FY 2003 has increased.

Recycling allows lenders to maintain or slightly increase 9.5 percent loan volume After lenders pay costs (such as interest payments and servicing fees)

associated with a tax-exempt bond, they may use any remaining money earned from loans to reinvest in FFELP loans, called recycling. These loans are guaranteed the minimum 9.5 percent yield.

All 12 lenders interviewed utilize recycling to reinvest in 9.5 percent loans. Length of time that a lender can recycle depends on the terms of the bond—some lenders have recycling periods of 1 to 3 years while others have recycling periods that last until the bond matures – Lenders may ask ratings agency to extend their recycling period up to the bond’s maturity date. – For a bond with a maturity date in 2025 and a recycling period that lasts until maturity, the lender can likely recycle and slow the decrease in, maintain, or slightly increase its 9.5 percent loan volume until that time.

Transferring loans from pre-10/1/93 tax-exempt bonds to taxable bonds increases lenders’ 9.5 percent loan volume

Almost all lenders interviewed have transferred loans to taxable bonds, which has increased their 9.5 percent loan volume Among top 10 lenders the proportion of 9.5 percent loans that have been

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

Proportion of Top 10 Lenders' 9.5% Loans Financed by Taxable Bonds FY 2004 (as of 3/3/1/04)

half of FY 2004 varied among the 10 lenders, from 0 to 90 percent. – Some lenders interviewed have been transferring for several years

while another just started in 2004. – Some lenders have also transferred to tax-exempt bonds issued after 10/1/93.

Policy that allows lender to transfer loans and increase 9.5 percent loan volume was intended to limit SAP

In 1992, Education issued regulations intending to limit SAP by changing how SAP is calculated for a loan that is transferred from a tax-exempt bond to a taxable bond. – Under the 1992 regulation and clarified in a 1996 guidance letter, a loan transferred from a pre-10/1/93 tax-exempt bond to a taxable bond remains subject to the SAP provisions applicable to loans financed with the tax-exempt bonds so long as the lender retains a legal interest in the original tax-exempt bond and the original bond has not been retired or defeased.

At that time, Education anticipated that interest rates would rise, resulting in a higher lender yield for loans financed with taxable bonds compared with loans financed with tax-exempt bonds.

Education believed that if the regulation was not issued lenders would have an incentive to transfer loans from tax-exempt bonds to taxable bonds, which would mean that the federal government would have paid greater SAP for those loans.

Refunding a pre-10/1/93 tax-exempt bond extends the life of a bond, and loans continue to be guaranteed the minimum 9.5 percent yield Lenders may refund a pre-10/1/93 tax-exempt bond, and the

refunding bond may have a later maturity date than the original bond.

Based on interpretation of the Higher Education Act, loans now financed with the refunding bond continue to be guaranteed the minimum 9.5 percent yield.

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

Lenders have refunded tax-exempt bonds using the IRS’s 17-year rule or with new volume cap allocation Most lenders interviewed refunded using the 17-year rule.

– Using the 17-year rule, a lender does not need to receive authority to issue a refunding bond from the state. However, the maturity date must not be later than the longer of 17 years from the original bond issue date or the average maturity of the original bond.

Some lenders interviewed have used a new volume cap allocation from the state to refund a bond, and the loans continue to be guaranteed the minimum 9.5 percent yield. – When a lender uses new volume cap allocation from the state to refund a bond, the maturity date for the new bond is not restricted as it is under the 17-year rule.

Changing the yield for 9.5 percent loans to a yield that

eliminates the minimum could lower SAP for loans made or purchased in the future.

Changing the yield for 9.5 percent loans made or purchased in the future is unlikely to cause outstanding bonds to default, but lenders may not be able to offer the same borrower benefits, such as loan cancellation and interest rate reductions, in the future.

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

to market interest rates, those financed with pre-10/1/93 tax-exempt bonds have a guaranteed minimum rate of return. In an environment where interest rates are low, current law and policies provide an opportunity for lenders to increase the amount of loans guaranteed a minimum 9.5 percent rate.

Even if interest rates rise somewhat in the future, the difference between the borrower rate and the minimum 9.5 percent yield will still be large. This will require the government to continue to pay larger SAP than it would otherwise have if the loans did not have a guaranteed minimum of 9.5 percent.

Appendix II: Comments from the Department of Education

Appendix III: GAO Contacts and Staff Acknowledgments

GAO Contacts

Staff Acknowledgments

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.