Federal Student Loans: Flexible Agreements with Guaranty Agencies Warrant Careful Evaluation
Released: 2002-01-31T00:00:00

Letter

Background

The federal government supports two major loan programs for postsecondary students under Title IV of HEA: the Federal Family Education Loan Program (FFELP) and the William D. Ford Direct Loan Program (FDLP). In 2000, FFELP and FDLP provided approximately $23 billion and $10 billion, respectively, in loans and loan guarantees to postsecondary students and their parents. Both programs provide subsidized and unsubsidized Stafford loans, Parent Loans for Undergraduate Students and Consolidation loans. Under the FFELP, private lenders, such as banks, provide loan capital. The federal government guarantees the loans but uses 36 guaranty agencies to administer many aspects of the program. With federal funding, these guaranty agencies generally provide insurance to the lenders for 98 percent of the unpaid amount of defaulted loans. The guaranty agencies also work with lenders and borrowers to prevent loan defaults and collect on the loans after default. In contrast, under the FDLP the federal government provides the loan capital to borrowers.

For over a decade, GAO has included student aid programs on a list of “high-risk” federal programs. These programs are designated high-risk primarily because of deficiencies in Education’s maintenance of the financial and management information required to administer the student aid programs and the internal controls needed to maintain the integrity of the programs. Over the years Education has addressed many of the high- risk issues identified by GAO; however, these long-standing conditions continue to plague the student aid programs.

To achieve FFEL program and cost efficiencies, and to improve the availability and delivery of loans, the VFA legislation of 1998 authorized VFAs between Education and the state-designated guaranty agencies. The VFA legislation restricted Education to six VFAs through fiscal year 2001, and as of January 2002, Education had entered into agreements with four guaranty agencies. Five other guaranty agencies applied for VFAs but either were not selected or failed to reach agreement with Education (see table 1). Since the beginning of fiscal year 2002, Education has had the authority to enter into VFAs with all of the guaranty agencies.

In May 1999, Education officials discussed VFAs with guaranty agency representatives who were attending a conference hosted by the National Council of Higher Education Loan Programs, Inc. Two months later, notice of invitation for any of the 36 guaranty agencies to apply for a VFA appeared in the Federal Register. The Register Notice included five “criteria” Education planned to use in its evaluation of the proposals for the VFAs, including (1) how the agency’s proposed VFA could be extrapolated and easily used by other FFEL participants; (2) how the proposal would improve the “system” for delivering and servicing of loans for borrowers and schools; (3) if and how the proposal uses new technology; (4) the impact the proposal would have on overall operating costs for the agency and its partners, including Education; and (5) a description of any proposed waiver of the prohibited inducement restrictions (prohibited inducements are efforts by guaranty agencies to encourage schools, borrowers, or lenders to submit applications for loan guarantees through direct or indirect premiums, payments, or, for example, uncompensated services such as loan processing services normally performed by lenders).

VFA Development Process Did Not Fully Meet Participants’ Needs

The VFA development process did not fully meet the needs of guaranty agencies and other program participants. Most of the guaranty agency officials we talked to indicated frustration in one or more steps of the process, which began when Education invited all guaranty agencies to submit VFA proposals. Guaranty agency officials were particularly dissatisfied with Education’s lack of communication about the VFA development process and its inability to meet its own timetable. Program participants other than guaranty agencies, such as representatives of lender and loan servicing groups, said that the opportunities for examining the proposed agreements were insufficient. Also, these program participants criticized Education for not using a more formal process for determining VFA selection criteria and inviting VFA proposals. In response to these criticisms, Education explained that some of the delay in the VFA development process was the result of broader changes at Education and turnover of key staff assigned to the VFA project. Additionally, Education noted that it had taken extra actions—such as posting the draft agreements to an Internet site—to facilitate public comment on the VFA draft agreements. In commenting on a draft of the report it also noted that some guaranty agencies and other program participants that we consulted had been opposed to the VFA legislation from its inception.

Guaranty Agencies Criticize Education’s Efforts during VFA Development Process

According to the guaranty agency officials we talked to, after the invitation process, Education did not communicate adequately with guaranty agencies after failing to stay on schedule. Most of these guaranty agency officials, including those that were generally supportive of Education, expressed a variety of concerns about Education’s communication efforts during the VFA development process. For instance, several guaranty agencies indicated a need for more information on Education’s methodology for analyzing the projected federal program costs of the VFAs, or on Education’s five criteria for selecting the VFAs.

Furthermore, the established timetable was not met. Education indicated it would select the six initial guaranty agencies within two weeks after the application deadline of August 27, 1999, but the notice of selections did not occur until February 2000. Education set December 1, 1999, as the target date for signing the VFAs; however, the first VFA was not signed until November of 2000 and the other three were not signed until March 2001. Guaranty agency officials told us that criticisms of Education’s failure to meet its own timetable would have been somewhat mitigated if Education had done a better job in communicating the status of the VFAs to the guaranty agencies. In response to these criticisms, Education officials explained that the process was hampered by organizational changes and staff turnover that occurred during the VFA development process. For instance, officials told us that delays were partially the result of Education’s decision to place a higher priority on developing regulations for implementing other 1998 HEA amendments and on reorganizing the Office of Student Financial Assistance as a performance- based organization. Education officials also indicated that turnover of key personnel assigned to the VFA project as well as disagreements within Education concerning, for example, evaluations of the costs of VFAs contributed to the delays in the VFA development process.

Other Program Participants Also Had Concerns about the Development Process

Although Education provided opportunity for public comment, program participants other than guaranty agencies—for instance, representatives of lender groups such as the Consumer Bankers Association—said these opportunities were insufficient. Education posted each draft agreement for about a 2-week period on the Internet in order to allow interested third parties the opportunity to comment on the agreements. However, some third parties told us that information available on the Web site was insufficient to evaluate the draft agreements and that Education did not provide responses to those who commented on the draft agreements. In response to this, Education officials told us that the Internet posting was not required by the VFA legislation, but that they did so to increase opportunities for public comment. Additionally, Education staff have recently begun meeting with a variety of student loan industry participants to discuss ongoing VFA concerns.

Program participants other than guaranty agencies also criticized Education for not using a more formal process in determining VFA selection criteria and inviting VFA proposals. A couple of third party participants we talked to said the selection criteria should have been developed through a rulemaking process similar to that used to develop federal regulations. Another participant said that VFA proposals should have been solicited through a more formal process, such as those used in federal contracting procedures. According to Education, however, because the agreements were specifically authorized by statute and involved state-designated, not competitively selected, entities, Education was not subject to legal requirements applicable to the rulemaking process and that it was not required to use the more formal contracting process.

In commenting on a draft of this report, Education noted that some guaranty agencies and third party program participants had been opposed to the VFA legislation from its inception, and not surprisingly continued to be dissatisfied with the implementation of the VFAs.

Most VFA Provisions Complied with Legislative Requirements; However, Compliance with the Projected Federal Cost Requirement Is Questionable

VFA provisions complied with most of the legislative requirements. For instance, we found that as required by the VFA legislation, the agreements made no changes to the statutory terms and conditions of the loans. However, we were not convinced that the agreements conform to the requirement that the projected program cost to the government not increase due to the VFAs. For one VFA, Education projected federal program costs would increase each year of the 3-year analysis period. Furthermore, the agreements appear to have violated the cost requirement if Education’s cost determination had been based on a different time period, or if the analyses had been based on changes in assumptions about certain factors, such as default rates.

The authorizing statute specifies, “in no case may the cost to the Secretary of the agreement, as reasonably projected by the Secretary, exceed the cost to the Secretary, as similarly projected, in the absence of the agreement.” Education’s budget service analyzed each of the four VFAs in the course of Education’s negotiations with the guaranty agencies and concluded that each agreement met the requirement. However, Education’s analysis of the Texas VFA projected that federal costs will increase an average of about $1 million a year. Budget service staff indicated that they regarded this amount as insignificant compared with total federal cash flows being estimated. Education’s estimates for the Texas agency show that the projected amount of collections on defaulted loans less federal program costs is an average of $161 million per year over fiscal years 2001 to 2003. An alternative basis of comparison could be to use the projected net amount of the agency’s receipts from federal sources and its retentions of collections (an average of $71 million per year over the same time period). In either case, the projected increase is not consistent with the VFA legislative requirement that the projected federal program costs not increase due to the VFA.

Our review of Education’s analyses raised two additional questions about Education’s conclusion that the VFAs would not increase projected federal costs.

Costs considered for first 3 years only. First, Education based its conclusion on projected costs for only the first 3 years, while Education’s projections show that costs for three VFAs would increase substantially in years 4 and 5. As table 2 shows, during the first 3 years, only the Texas agreement (discussed above) was projected to cause an increase in federal costs. By including projections for the fourth year or for both the fourth and fifth year, however, costs for three of the four VFAs would rise, with costs for the Texas and Great Lakes guaranty agencies rising substantially. These increases would occur as the size of these guaranty agencies’ loan volumes and the cumulative size of their portfolios increase.

Education officials and Office of Management and Budget officials said they took this approach because they viewed the VFAs as demonstration programs of limited duration to be evaluated by the Congress during the next reauthorization of HEA. This act is due for reauthorization at the end of fiscal year 2003. Although the American Student Assistance VFA specifies a termination date at the end of fiscal year 2003, the other three agreements have no specified termination date. They each remain in effect until either the guaranty agency or Education chooses to withdraw with advanced written notice.

Effects of changes in performance not adequately considered. Second, budget service officials reached their conclusions about the cost effects of the VFAs using a set of base year assumptions that did not adequately consider the effect of changes in guaranty agency performance—that is, they assumed that such things as default rates, collection rates, and delinquency rates would remain unchanged in future years. The VFAs were designed to improve guaranty agency performance and under the agreements, doing so would mean higher payments to the guaranty agencies for their improved performance. Thus, analyzing the proposed payment structures to estimate how such improvements would affect net federal costs—in the form of lower default rates, for example— seems warranted. However, according to budget service officials this happened in only one case and to a limited extent.

In that particular case, budget service staff analyzed the effect of a decline in loan defaults for the California VFA, and its estimates illustrate the importance of considering the effect of changes in guaranty agency performance on federal costs. A provision in the California VFA provides an incentive payment to the guaranty agency for achieving lower default payments. At the time this VFA was being developed Education staff calculated that California’s fiscal year 1998 “trigger default rate”–was 3.1 percent compared with the aggregate national rate of 2.9 percent. In an effort to encourage the California guaranty agency to reduce its trigger default rate, the VFA provides for a payment from Education to the guaranty agency equal to half of the amount of claims payments avoided by having a trigger rate below 3 percent. Budget service staff then analyzed the effects of a decline in trigger default rates below 3 percent— to see how much the payment would be in the event the agency was able to reduce it’s trigger default rate that much. Education found that the payment to California would be greater than the savings from the reduced defaults—and thus would result in increases in federal costs. However, in doing their formal analysis of the California’s VFA, budget service staff did not include the results of their default analysis and instead assumed no change in the base-year 3.1 percent trigger default rate; thus as table 2 shows, there are no projected increases or decreases to the costs for that VFA. Subsequently, California’s trigger default rate did drop below 3 percent—down to 2.6 percent for fiscal year 2001. Our analysis based on Education’s estimates shows that the California guaranty agency’s fiscal year 2001 trigger rate of 2.6 percent entitles it to a VFA incentive payment of about $17.3 million—an amount approximately $2.6 million greater than the estimated total the government saved due to the lower volume of defaulted loans. Because there were no other projected cost considerations for this VFA, the decline in loan defaults under the VFA resulted in an increase in projected net federal costs. Appendix II discusses this analysis in more detail.

Changes Offer Potential for Improved Performance

All four agreements contain provisions for incentive payments for improved guaranty agency performance, and all four grant waivers to certain statutory and regulatory requirements. For the most part these changes are designed to enhance agency performance, such as reduce delinquencies and defaults, while increasing guaranty agency efficiencies. At the same time, however, guaranty agencies without VFAs told us that they have efforts under way to improve their agencies’ performance— efforts that did not require the incentive payment structure or waivers granted for the VFA agencies.

Incentive Payments Reward Improved Performance

The VFAs establish incentive payments that reward a guaranty agency for better performance. The use of these incentive payments offers an alternative to the traditional guaranty agency payment structure—a structure some participants describe as containing a perverse payment incentive for the guaranty agencies. Under the traditional payment structure that continues to be used for the non-VFA agencies, it is financially more beneficial for a guaranty agency to allow borrowers to default on their loans and to subsequently collect on the loans than to prevent defaults in the first place. A guaranty agency currently retains 24 percent of the money that it recovers from borrowers whose loans are in default—that is, the borrowers who are more than 270 days behind in making payments. According to some guaranty agency officials, this percentage is typically higher than a guaranty agency’s actual cost of collecting on defaulted loans. As a result, a non-VFA guaranty agency has more financial incentive to “allow” borrowers to default than to prevent the default upfront.

Three of the four VFAs have incentive provisions that reduce the guaranty agencies’ share of collections on defaulted loans. To compensate for this lower collection retention rate, the VFAs have enhanced incentives for better performance. For example, the American Student Assistance VFA reduces the collection retention rate from 24 percent to 18.5 percent for regular collections on defaulted loans in exchange for potentially greater incentive payments for lower defaults. To implement such incentive provisions, VFA agencies have created programs aimed at improving their performance, particularly in the areas of reducing delinquencies and net defaults. For example:

To help borrowers with defaulted loans, American Student Assistance created Bright Beginnings. This program focuses on providing support to the borrowers and finding solutions to loan default instead of making payment demands and threatening sanctions for nonpayment, such as wage garnishment and negative reports to credit bureaus. Help may involve, for example, working with the borrowers on a strategy to get the education or training necessary to obtain employment that would provide the income needed to repay their loans. Additionally, the program points out to borrowers the advantages of making payments on their loans. For example, if borrowers make nine consecutive monthly payments they will be eligible for rehabilitation, a process by which the guaranty agency sells the defaulted loan back to a lender. Rehabilitation is important because, in addition to being current on their loan payments, the borrowers become eligible for additional Title IV student financial aid.

To avert defaults by borrowers who withdraw from school without completing their educational program, the California Student Aid Commission is planning an early-withdrawal counseling program. Individuals who withdraw from school early are at high risk of defaulting on their loans and the Commission believes that early intervention by the guaranty agency is more likely to result in the borrowers being able to avoid default. Under current regulations, a guaranty agency provides default aversion assistance to borrowers only after they become 60 or more days delinquent on their loan. Under the early-withdrawal counseling program, the Commission will contact borrowers as soon as they withdraw from school. The program plans to educate borrowers through a variety of services and provide information about their responsibilities and options for avoiding default.

To help keep delinquent borrowers from defaulting, Great Lakes Higher Education Guaranty Corporation and the Texas Guaranteed Student Loan Corporation are both requiring lenders to submit requests for default aversion assistance between the 60th and the 70th day of delinquency. Under current regulation lenders can submit requests as soon as the 60th day or as late as the 120th day to submit such a request. Great Lakes and Texas guaranty agency officials believe that by helping to contact delinquent borrowers earlier, they have a better chance to prevent defaults.

Statutory and Regulatory Waivers Are Aimed at Enhancing Guaranty Agency Performance

The statutory and regulatory waivers granted under VFAs attempt to improve guaranty agency performance in two ways—by eliminating duplicate or less effective fiscal, administrative, and enforcement requirements; and by substituting more efficient and effective alternatives. For example:

The Great Lakes VFA allows for the elimination of some duplicative collection efforts that lenders or loan servicers and the guaranty agency are both required to perform when a borrower became delinquent. Officials from Great Lakes explained that they were concerned that the duplication of effort can be confusing and unnecessarily frustrating to borrowers.

The American Student Assistance VFA grants authority to replace certain administrative requirements for collection efforts on defaulted loans with new, more targeted approaches. Current regulations specify in considerable detail what collection actions must be taken and during what time periods. For example, after 45 days of delinquency, the guaranty agencies must “diligently attempt to contact the borrower by telephone.” Between 46 and 180 days of delinquency, the agencies must “send at least three written notices to the borrower forcefully demanding immediate commencement of repayment.” Under the VFA, American Student Assistance has flexibility to develop procedures it considers to be more efficient utilizing best practices common to the financial services industry. Agency officials told us of plans to study borrower behavior to determine the characteristics of borrowers that are most apt to respond to particular default aversion or collection efforts.

Guaranty Agencies without While VFAs represent a new approach to such matters as reducing VFAs Also Taking Steps to perverse payment incentives and allowing guaranty agencies to be more Improve Performance innovative in efforts to prevent defaults, they are not the only avenue through which important attempts are being made to seek improvements and innovations in the FFEL program. Guaranty agencies without VFAs are introducing efforts to reduce delinquencies and defaults. Some of the non-VFA guaranty agency officials we contacted indicated that they were uncertain that VFAs are needed in order to improve performance. They believe their mission provides sufficient motivation to increase efforts to prevent defaults by, for example, devoting more resources to work with delinquent borrowers and improving the exchange of information between guaranty agencies, lenders, schools, and Education. They also said that any innovations in customer service could be accomplished under current regulations. For example, the largest guaranty agency, USA Funds, Inc., is working in cooperation with other guaranty agencies on electronic data exchange and electronic signature authority. The agency is also implementing a program to provide students with current and historical student financial aid information from guarantors, lenders, and secondary- markets, as well as to deliver services over the Internet.

For most of the guaranty agencies, the trend in recent years has been a decline in default rates. As figure 1 shows, trigger default rates decreased steadily through fiscal year 2000. The reasons for this reduction are likely multiple, including a low unemployment rate (giving more people jobs to pay off their student loans) resulting from generally favorable economic conditions during that period. Although many observers also credit the decline to the effect of more diligent or effective efforts by guaranty agencies, how much these efforts have contributed is unclear. We were not able to identify any study that has isolated the effects of these influences on default rates.

Education Is Not Fully Prepared to Evaluate VFAS

Education is not fully prepared to evaluate the results of the VFA agreements. The agreements went into effect without Education having developed a clear way to measure changes in guaranty agency performance. For example, Education does not have a way to uniformly measure satisfaction among the agencies’ customers. Furthermore, it cannot adequately determine what has happened as a result of the VFAs through, for instance, comparisons with the results of past efforts to cure delinquent loans and comparisons of the results of similar efforts by other guaranty agencies. For the latter, a commonly used measure is the “cure rate” (the rate at which guaranty agencies and lenders keep borrowers who are delinquent in their payments from defaulting on their loans). This measure currently varies from guaranty agency to guaranty agency. It is likely to be difficult to distinguish the results of the VFAs from the effects of other factors, such as the general condition of the economy, but without uniform measures the task becomes even more difficult.

To measure and compare the benefits that result from VFAs, Education needs uniform performance measures. The data Education routinely collects from guaranty agencies will provide several comparable measures of guaranty agencies’ performance, such as certain default rates and the delinquency status of guaranteed loans in repayment.

According to an Education official, Education is working with a consulting firm to develop additional evaluation measures. Additionally, in commenting on a draft of this report, Education noted that it is establishing common measures to evaluate the performance of each VFA. These measures should provide useful data for comparing non-VFA and VFA guaranty agencies. However, other measures of VFA guaranty agency performance might not be as easily compared across the guaranty agencies. For example, Education currently lacks a means of calculating the cost of the VFAs. Specifically, it cannot calculate the amount by which VFA provisions increase federal payments to the VFA agencies, because it does not have a way to determine the amount of default aversion fees that each agency would have received in the absence of the VFA agreements. Also, the Great Lakes guaranty agency plans to measure VFA performance, in part, by measuring customer satisfaction. However, according to guaranty agency and Education officials, no effort is under way to measure other guaranty agencies’ customer satisfaction in a similar manner, thus making comparisons difficult.

Another example is the lack of uniformity in calculating a cure rate. Although two of the VFAs specify cure rates as performance measures, these two guaranty agencies calculate cure rates differently and another guaranty agency uses a third method to calculate a cure rate. A uniformly calculated cure rate could be a useful indicator of guaranty agencies’ success in preventing defaults for loans that are prone to default (delinquent loans). The current inconsistencies in methods of calculating cure rates make systematic evaluation of VFA results difficult.

The VFA legislation required that Education report on the status of the VFAs, including a description of the standards by which each agency’s performance under the agreement was assessed and the degree to which each agency achieved the performance standards. Additionally, Education was required to include an analysis of the fees paid by the secretary, and the costs and efficiencies achieved under each agreement. The report was due no later than September 30, 2001; however, as of this time, no report has been issued.

Conclusions

The VFA development process did not fully meet the needs of the guaranty agencies or other program participants. Despite circumstances at Education that hampered VFA development, such as turnover of key staff, Education might have been able to develop the VFA with fewer frustrations had officials better communicated with participants, particularly with respect to how the cost projections were done. Additionally, a more realistic initial timetable might have lessened some of the criticism from guaranty agency officials.

Education’s evaluation of the cost effects of the current agreements raises concerns about whether the federal program costs of current VFAs will grow in the years ahead to the point that they exceed projected costs in the absence of the agreements. In particular, we question the time period Education used for making the cost estimates and the fact that Education did not generally consider potential changes in agency performance for the cost estimates. Although projected cost increases were relatively small in comparison with the total amount of program costs during the first 3 years, estimates for years 4 and 5 showed substantial growth. Also, the general lack of a more thorough analysis of VFA costs—including an analysis of how factors, such as changing default rates might change projected costs—could leave the government vulnerable to greater than projected costs for the VFAs.

VFAs are principally aimed at improving guaranty agency performance through innovative incentive payment structures and in granting waivers to statutory and regulatory procedures that might be hampering agency performance. To that end, the VFAs afforded the guaranty agencies the opportunity to try new ways of operating. Whether the incentive payments and waivers used by the VFA agencies improve guaranty agency performance more than the self-initiated efforts of the non-VFA agencies remains to be determined.

Measuring the benefits of the VFAs is central in deciding if more VFAs should be entered into and if current VFA practices should be replicated at other guaranty agencies. We found that Education is not fully prepared to evaluate the success of VFAs in part because it does not have adequate standardized performance measures, such as delinquent loan cure rates. Without adequate performance measures Education is not well positioned to judge the success or failure of the VFA provisions.

Recommendations for Executive Action

To improve the VFA development process for any future VFAs, we recommend that the secretary of Education develop a plan to more regularly communicate with guaranty agencies concerning the status of VFA development efforts, including disclosing to program participants the planned methods for projecting the federal program cost effects of VFAs; and a timetable for selection, negotiation, and completion of agreements based on experience developing the first four VFAs.

In order to ensure that all VFAs are in compliance with statutory requirements, we recommend that the secretary of Education renegotiate the Texas VFA as soon as practicable to obtain changes necessary to ensure that the VFA does not increase projected federal costs; renegotiate the California VFA as soon as practicable to obtain changes necessary to ensure that the VFA does not increase projected federal costs, with or without changing the trigger default rate; renegotiate the Great Lakes and American Student Assistance VFAs for time periods after fiscal year 2003 to ensure that the VFAs do not increase projected federal program costs; and improve projections of the cost effects of renegotiated VFAs and any future VFA proposals by (1) requiring that each VFA specify an effective time period, (2) conducting a cost analysis covering that period, and (3) conducting analyses to project the cost effects of changes in assumptions regarding guaranty agency performance, such as default rates, in making the cost projections.

To ensure that the results of the VFAs can be effectively evaluated, we recommend that the secretary of Education develop specific evaluation plans enabling Education to compare VFA guaranty agency performance with past performance and the performance of other guaranty agencies using uniformly defined performance measures, including delinquent loan cure rates.

Agency Comments

We provided a draft of this report to Education for comment. In its response, Education indicated that it had a number of concerns about the report.

Education stated that our mention of GAO’s designation of the student financial assistance programs as “high-risk” (in the Background section) was beyond the scope of our review and that it detracts from the analysis in the report. We disagree. The report contains analyses and descriptive information on many aspects of the FFEL program, which provided approximately $23 billion of loans for postsecondary students in fiscal year 2000. The mention of the student loan programs as high risk and the ensuing discussion are important to help establish the significance that any changes—including the VFAs—might have on the program.

Regarding the development of the VFAs, Education said that it appears that our conclusions were based primarily on conversations with individual guaranty agencies that did not apply for a VFA and representatives of various interest groups, many of which had consistently opposed the VFAs. In fact, as indicated in our report, our conclusions are largely based on comments from representatives of 18 guaranty agencies—including representatives from all four agencies with VFAs; representatives from those agencies that had unsuccessfully sought a VFA; representatives from agencies that did not seek a VFA, but may wish to in the future; and representatives from agencies that had opposed the VFA legislation from the beginning.

Concerning the cost effects of the VFAs, Education stated that it had, in keeping with its standard procedures for estimating costs, (1) used a closed time period (in this case, 3 years) to project costs; (2) not considered the impact of possible changes to borrower or institutional behavior in projecting costs; and (3) appropriately treated the $1 million per year projected cost increase for the Texas VFA as “insignificant.”

First, in looking at the 3-year time period, Education said that its conclusions about the cost effects of the VFAs were appropriately limited to the first 3 years because there was no reason to expect that the agreements would necessarily remain in effect beyond the time period for reauthorization of HEA, which may bring changes that could alter any cost analyses. We agree that the projected increases in federal costs in the fourth and fifth years would not be relevant if the current agreements no longer remain in effect after the end of fiscal year 2003. However, since three of the VFAs are open-ended, there is reason to believe they could extend beyond three years. Therefore, to ensure that projected federal costs do not increase due to the VFAs, Education would need to renegotiate the VFAs for the time period beyond 3 years. Education’s statement that, "GAO's interpretation of the statute as requiring strict 'cost neutrality' over a long period of time is not supported in the statute or the legislative history," is incorrect. We did not interpret the statute in this manner. Instead, our reading of the statute is that the period of time to be examined should correspond to the projected life of the agreement. As mentioned above, three of the agreements we reviewed were for an open- ended period of time. Education chose a 3-year period for their cost analysis, which is within its discretion and not inconsistent with the statute. However, the report was intended to make clear that, given the open-ended nature of the agreements, a decision by Education not to terminate the agreements after 3 years would warrant a reassessment of the cost projections and a renegotiation of the agreements, if necessary.

Second, Education stated that it does not base cost estimates on behavioral assumptions that cannot be supported by available data. We agree that this is appropriate for baseline estimates, however one of the purposes of the VFAs is to improve guaranty agency performance, and thus the cost effects of potential improvements need to be considered in Education’s cost projections. Accordingly, we recommended that Education supplement baseline estimates with sensitivity analyses in order to avoid provisions that increase federal costs when an agency’s performance improves, by reducing default rates for example.

Third, with respect to Education’s assertion that the projected increase of $1 million per year for the Texas VFA is “insignificant,” we disagree. Education based its assertion on a comparison of the $1 million to the total federal cash flows being estimated. The projected amount of collections on defaulted loans less federal program costs averaged $161 million per year for the 3-year period—an amount lower than the “hundreds of million of dollars per year” Education cited in its comments. Additionally, an alternative basis of comparison could be to use the projected net amount of the agency’s receipts from federal sources and its retentions of collections (an average of $71 million per year for the 3-year period). In either case, the projected increase is not consistent with the VFA legislative requirement that the projected federal program costs not increase due to the VFAs.

Regarding preparations to evaluate the VFAs, Education said that it is establishing common, general measures to evaluate the performance of each VFA and, whenever possible, to compare VFA guaranty agency performance with other non-VFA guaranty agencies. Education noted that it has had preliminary discussions with representatives of the 36 guaranty agencies regarding uniform performance measures. Also, it noted that the guaranty agencies are in the process of establishing an eight-member task force to assist in determining the specific formulae for measuring VFA performance. As our report indicates, Education does currently have several possible uniform measures of agency performance. We welcome its efforts to develop additional measures, but conclude that a uniform cure rate measure would assist in evaluating the performance of the VFAs, considering that two guaranty agencies with VFAs specifically identified a cure rate as a performance indicator.

We reviewed these and additional Education comments and modified the draft as appropriate. Education’s comments are included in appendix IV.

We are sending copies of this report to Honorable Roderick R. Paige, secretary of Education; appropriate congressional committees; the guaranty agencies with VFAs; and other interested parties. Please call me at (202) 512-8403 if you or your staff have any questions about this report. Key contacts and staff acknowledgements for this report are listed in appendix V.

Appendix I: Scope and Methodology

As agreed with your office, we focused our review of voluntary flexible agreements (VFA) on addressing the following questions: 1. To what extent did the VFA development process meet the needs of guaranty agencies and other program participants? 2. To what extent do VFAs comply with requirements in the VFA legislation? 3. What changes are being implemented under the VFAs? 4. How well prepared is Education to assess the effects of the VFAs?

To determine the extent to which Education’s VFA development process met the needs of guaranty agencies and other program participants, we interviewed Education officials involved in the development of the VFAs, officials at each of the nine guaranty agencies that submitted an application for a VFA, and nine guaranty agencies that did not submit applications. The nine guaranty agencies that did not submit applications included the five guaranty agencies with the largest amounts of loan guarantees and four randomly selected smaller guaranty agencies that did not submit applications. We also reviewed VFA proposals and comments Education received during the public comment period.

To determine the extent to which the VFAs complied with statutory requirements we reviewed the VFA agreements, provisions of the Higher Education Act (HEA) concerning the Federal Family Education Loan Program (FFELP), and related regulations. We also discussed the agreements with Education and guaranty agency officials, and representatives of industry associations including the National Council of Higher Education Loan Programs, Inc. and the Consumer Bankers Association. To review Education’s methods for projecting the costs of the VFA agreements, we examined computerized schedules Education used to project each VFA guaranty agency’s costs and financial data compiled by Education staff from submissions by the guaranty agencies. We also discussed these projections with Education’s budget service staff and Congressional Budget Office and Office of Management and Budget officials.

To identify changes being implemented under the VFAs we reviewed the VFAs and discussed them with the guaranty agency officials and reviewed documents they provided concerning their programs.

In addition, to determine how well prepared Education is to identify the effects of the VFAs, we discussed plans for evaluation of the VFAs with guaranty agency officials and Education officials responsible for collecting and analyzing data from guaranty agencies.

Appendix II: Comparison of Projected Federal Costs with California Trigger Default Rate at 2.6 or 3 Percent

On the basis of budget service subsidy rate estimates, we projected the level of noninterest federal costs for $263 million of loans—the amount of loans that would default if the California guaranty agency’s trigger default rate were 3 percent in fiscal year 2001. As shown in table 3 below, we estimated the net federal costs of these loans (excluding interest subsidy costs that the budget service indicated would not be affected) under four different scenarios: (1) a 3 percent trigger default rate with all $263 million of these loans defaulting without the VFA in effect, (2) a 3 percent trigger default rate with the VFA in effect, (3) a 2.6 percent trigger default rate with $228 million of the $263 million of loans defaulting without the VFA in effect, and (4) a 2.6 percent trigger default rate with the VFA in effect. As shown in table 3, federal noninterest costs for these loans would be about $107 million under either scenario 1 or scenario 2. In scenario 3, federal costs would decline by about $15 million to $92 million as trigger basis defaults decline from 3 percent to 2.6 percent.

Under scenario 4, however, Education would benefit from lower loan defaults, but it would also have to pay the California guaranty agency half of the $34.7 million reduction in the amount of claims payments to lenders (a $17.3 million VFA fee). Because the VFA fee exceeds the benefit Education would realize from the lower level of defaults, federal costs would increase by an estimated $2.6 million.

The VFA default rate incentive payment, one-half of the claims payments avoided with a trigger default rate below 3 percent, was identified in the VFA agreement as “50% of the savings in claim payments resulting from its default aversion activities under this VFA.” This calculation, however, fails to take into account two potentially significant factors. First, the federal cost of loan default is mitigated in part by subsequent collections on the defaulted loan. If the guaranty agency receives payment on a loan after the loan defaults it generally is allowed to retain 24 percent of the amount collected. The remaining 76 percent must be remitted to Education. Budget service staff looked to see how the present value of these payments would affect the present value of program costs for Subsidized Stafford loans. They concluded that the federal cost (aside from federal administrative costs) on a subsidized Stafford loan that defaults is on average about 47.5 percent of the amount of the loan. The comparable figure for the same loan without default, but with the VFA incentive payment was 51.7 percent. In other words, the incentive payment to California’s guaranty agency exceeded the present value of the federal cost of the default adjusted for the subsequent collections on the loan. Instead of benefiting from fewer defaults of loans guaranteed by the California guaranty agency, Education stands to benefit from increases in defaults until the guaranty agency’s trigger default rate reaches 3 percent. Above that point the guaranty agency would not receive an incentive payment and Education would not benefit from higher levels of defaults.

The second reason for questioning the provision’s definition of federal cost savings resulting from the VFAs default aversion activities is that the entire decline in default costs may not be solely attributable to the VFA. Default rates change for many reasons. According to guaranty agency and Education officials, declines in default rates are due to such factors as a change in definition of default from 180 to 270 days of delinquency brought by the VFA legislation, increased default aversion assistance activities by all guaranty agencies, enhancements in loan servicing methods, and a prosperous economy. The VFA incentive payment to California rewards the guaranty agency for any decline in default rates whether it is due to VFA prompted efforts or to other factors.

As shown in figure 2 below, generally guaranty agencies have seen declines in trigger default rates. Guaranty agencies that received VFAs and guaranty agencies that did not both saw declines in default rates from fiscal year 1997 to fiscal year 2000, with increases in fiscal year 2001. For example, the largest guaranty agency, USA Funds, Inc. had a higher default rate than California’s in fiscal years 1997 and 1998. However, by fiscal year 2001, its default rate was slightly lower than California’s.

Appendix V: GAO Contacts and Staff Acknowledgments

GAO Contacts

Staff Acknowledgments

In addition to the individuals named above, Jonathan H. Barker, Daniel R. Blair, Christine E. Bonham, Richard P. Burkard, Timothy A. Burke, Aaron M. Holling, Stanley G. Stenersen, and James P. Wright made key contributions to this report.