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Proposals to Eliminate and Preserve FFELP

President Obama, as part of his FY2010 budget proposal, has proposed to eliminate the FFEL program and switch all new federal education loan origination to the Direct Loan program starting July 1, 2010. The argument in favor of switching to 100% Direct Lending is primarily financial. The Office of Management and Budget scored the President's proposal as saving $41 billion over ten years (a reduction from an initial score of $47 billion) and the Congressional Budget Office scored it as saving $87 billion over ten years (a reduction from an initial score of $94 billion). The savings would be used to increase the maximum Pell Grant to $5,550 in 2010-2011 and to index it to the inflation rate plus 1% ever after, and possibly turn the Pell Grant program into a true entitlement.

Legislative Implementation

On July 15, 2009, Rep. George Miller, Chairman of the House Committee on Education and Labor, introduced the Student Aid and Fiscal Responsibility Act of 2009 (SAFRA). This legislation implements 100% Direct Lending and indexes the maximum Pell Grant to CPI-U + 1%. It does not, however, turn the Pell Grant program into a true entitlement as it maintains the current distinction between mandatory and discretionary funding. The discretionary funding could be adjusted each year as part of the annual appropriations process. Although the legislation includes a requirement that the mandatory portion of each year's maximum Pell Grant must be at least the same as the previous year's mandatory portion of the maximum Pell Grant, it would be possible for the appropriations committees would be able to keep the maximum Pell Grant flat or even reduce it if they wished and to divert funding to other priorities. In addition, the legislation would keep the Pell Grant eligibility cutoff at 95% of the maximum Pell Grant under discretionary funding (i.e., 95% of $4,860), so the number of eligible students would not increase with increases in the overall maximum Pell Grant.

Alternative Proposals

President Obama's proposal has been met with opposition from lenders and colleges that participate in the FFEL program. They have offered their own proposals that would achieve significant savings while preserving the FFEL program.

The three main proposals are:

Sallie Mae's Proposal to Preserve FFELP

Education Lender Community Proposal for an Alternative to 100% Direct Lending

Friday the 13th Group

All three proposals involve variations on making the liquidity provisions of the Ensuring Continued Access to Student Loans Act of 2008 (ECASLA) permanent.

The Sallie Mae and Community proposals force all lenders to participate in the program and make the changes permanent in order to achieve the necessary savings. These proposals would switch from providing low-cost financing and special allowance payments to explicit fees for originating the loans. Under ECASLA, lenders that have a lower cost of financing than the CP + 50 facility offered by the US Department of Education are free to continue originating federal education loans on their own and are not required to sell the loans to the US Department of Education. About one third (32%) of the lenders do not participate in ECASLA, mostly large banks with access to customer deposits as a lower cost source of funding. These lenders are opposed to these proposals (and also to 100% Direct Lending), as the proposals would significantly reduce their profit margins.

The Friday the 13th Group proposal comes from a large independent coalition of financial aid administrators. Their proposal does not include draft legislative language, but in effect would make ECASLA permanent without requiring lenders to participate and without substituting fees for the spreads currently received by lenders. Because this proposal does not require all lenders to participate, the savings would likely be less than two-thirds of the savings under 100% Direct Lending. In addition, the proposal preserves the self-terminating aspect of ECASLA. When the capital markets recover enough that lenders can obtain liquidity at a cost less than the CP + 50 financing offered by the US Department of Education, lenders would stop relying on the US Department of Education as a source of funds. This would effectively eliminate savings to the federal government at some undetermined future date.

The National Association of Student Financial Aid Administrators (NASFAA) has also offered its own proposal, which would be functionally similar to the 100% Direct Lending proposal but with capital raised through special purpose Education Financing Bonds instead of US Treasuries. The NASFAA proposal would likely yield less savings to the federal government than 100% Direct Lending without any significant improvements or benefits to current FFEL program participants. It does not appear to offer any really new ideas and is light on specifics.

Analysis of the Proposals

A spreadsheet model of the savings from 100% Direct Lending demonstrates that both the Congressional Budget Office (CBO) and Office of Management and Budget (OMB) overstate the potential savings from 100% Direct Lending. It also demonstrates that the potential savings is extremely sensitive to economic assumptions such as projections of interest rates and loan volume. While both 100% Direct Lending and these proposals will yield significant savings to the federal government, it is unclear how much savings will actually be realized by the federal government or which proposals would yield greater savings.

From a borrower perspective, the differences between the FFEL and Direct Loan programs are relatively minor.

Servicing Contracts and Default Aversion

The US Department of Education awarded Direct Loan program servicing contracts to Sallie Mae, Nelnet, Great Lakes and AES/PHEAA. These are among the lenders with the greatest servicing capacity and experience. While the servicing contracts reduce the fees per borrower for borrowers who are delinquent or in default, the contracts do not otherwise adequately address default prevention. The contracts also skin the servicers to the bone, with a weighted average servicing fee of about $1.66 per borrower per month, about one third less than the weighted average $2.55 servicing fees lenders were receiving as part of FFELP securitizations in early 2008. This makes it highly likely that the US Department of Education will have to eventually issue supplemental contracts for default aversion and other activities beyond anything addressed by the College Access and Completion Fund.

In addition, the structure of the servicing fees will likely cause the servicers to recommend the income-based repayment program (IBR) to borrowers instead of the economic hardship deferment or forbearances. Not only does IBR function identical to the economic hardship deferment and forbearances when the borrower's income is less than 150% of the poverty line, but the servicing fees are slightly higher for borrowers who are using IBR and hence technically current on their loans.

The cost of defaults dominates over the costs of servicing, so it is essential that servicer default rates be comparable. Differences in the mix of borrowers according to level and control of institution, institution location and borrower state of residence can have a significant impact on default rates. The only way to ensure an apples to apples comparison between servicers is to avoid the potential for selection bias by randomly assigning borrowers to servicers. All of the proposals suffer from problems in the assignment of borrowers to servicers. The Sallie Mae and community proposals give lenders a lock on the servicing of loans they originate, and also allow colleges to choose servicers. The 100% Direct Lending proposal includes a carve-out for non-profit servicers, guaranteeing them the ability to service loans from borrowers in their state. While there's nothing wrong with providing non-profit servicers with an opportunity to compete for servicing contracts, establishing fee ladders to accommodate the amortization of fixed costs over a smaller pool of borrowers, or guaranteeing a minimum contract size, it is essential that the non-profit servicers also be subjected to random assignment of borrowers. Otherwise one cannot be certain whether one servicer's lower default rate is due to the servicing of loans from borrowers from a particular state or due to superior default aversion activities.

Which Proposal will Pass Congress?

Members of Congress are most likely to be influenced by three main concerns:

Job loss and shifting of jobs from one district to another
The potential for execution risk, especially at small colleges with one-person financial aid offices, colleges with home-grown administrative systems and graduate-only institutions that do not currently use the Common Origination and Disbursement (COD) system. There is also some concern about the ability of administrative software vendors to handle a spike in technical support volume from 4,000 colleges switching to the Direct Loan program all at once.
Whether the Pell Grant program will become a true entitlement or not.

100% Direct Lending is likely to pass the US House of Representatives but may have a more difficult time passing the Senate. In all likelihood the final shape of the legislation will be determined in the conference committee. Some elements of each of the various proposals may be incorporated into the final enrolled legislation.