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. 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. 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. 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. 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. 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.