Focus on Middlemen in Student Aid Reform


As the cost of college spirals upward, federal aid has becomecrucial to more and more students. Today, 6 million students, or 40 percent of those in postsecondary education, rely on Uncle Sam to help pay their tuition bills.

This student aid system is flawed, and the Clinton administration wants to fix it.

In the boldest reform proposal since the inception of the present system in the 1960s, the president is calling for colleges and vocational schools to make federally-funded loans directly to students rather than relying on banks and other lenders. Such a step, Secretary of Education Richard Riley argues, would save taxpayers money and allow students to borrow at lower interest.

But for months, the 8,000-plus banks, secondary markets and other institutions that finance and administer the $57 billion federal student loan program have laid siege to the Clinton plan. They have hired a raft of big-name Washington lobbyists to convince Congress that the U.S. Department of Education is incapable of managing a direct lending program. They have paid high-profile economists to debunk the administration's cost-saving estimates. And they have warned darkly in letters to colleges that direct lending is "a dangerous experiment" that "threatens to jeopardize the flow of loan money to students" and place "a costly burden on schools."

They are justified in questioning the education department's likely stewardship of direct lending: As the department's inspector general's office has pointed out, budget cuts and bureaucratic inertia within the department have contributed to extensive waste, fraud and abuse in the student aid system in recent years.

But in many instances, the performance of the financial middlemen has been lacking, too. Their failings have been costly and have impeded efforts to reform the student loan system.

Congressional conferees are scheduled to take up the Clinton bill in coming days. A watered-down version favored by the Senate fails to address fully the problems wrought by the players in the aid system.

When the system was created in the 1960s, policy-makers envisioned that many lenders would participate and quasi-state agencies known as guaranty agencies would police lenders and reimburse them for loans that students failed to repay. But lenders balked at making low-interest loans to students, a high-risk group, and states didn't want to bail out lenders.

To lure lenders and guaranty agencies, the federal government was forced to offer substantial subsidies and to play the role of lender-of-last-resort to guaranty agencies when they couldn't collect on bad loans.

Overnight, financial institutions found themselves in the position making large, low-risk profits from the student aid system. The federal government paid $6.1 billion in 1991 to lenders and other financial institutions to manage $57 billion in student loans.

"There has been some disingenuousness" on the part of financial institutions which say that the large subsidies they receive are needed to make a fair return, acknowledged Roy Nicholson, the chief executive of United States Aid Funds, Inc., one of the largest players in the loan program. The Senate bill would cut the middlemen's subsidies somewhat.

But other problems have not been addressed. Two years ago, officials of Florida Federal Savings Bank, then the third largest student lender in the country, were convicted of ordering employees to falsify records to roughly 17,000 borrowers in a six-month period, then filing claims worth $35 million with guaranty agencies based on the false documents.

Last year, the education department's inspector general scrutinized a sample of 32 lenders and found a quarter of them had sought illegitimate subsidy payments from the federal government.

Investigations have turned up problems with guaranty agencies

as well. The education department recently reviewed a sample of 130 loans guaranteed by the California guaranty agency and found a key piece of information, the date students began repaying their loans, to be inaccurate in every instance.

A 1990 audit revealed that the Pennsylvania guaranty agency overbilled the education department by at least $778,000. The department didn't act to recover the money until last year, however, blaming heavy work loads and high staff turnover for the delay.

The department's less-than-aggressive policing encourages abuses by the middlemen. So do misplaced incentives.

Lenders, for example, have little motivation to pursue deadbeats aggressively because the system allows them to receive payment on virtually 100 percent of their bad loans.

And it's in the financial interest of the guaranty agencies not to go after scofflaws too aggressively. By law, they are permitted to get reimbursed for bad loans by the federal government, then pursue the bad loans further and retain 30 percent of the funds they recover. Guaranty agencies earned no less than $200 million, or 13 percent of their total revenues, this way in 1991.

Admits Mr. Nicholson, whose organization is the nation's largest guaranty agency, "There is no discipline placed on guaranty agencies to police the system." Indeed, an audit of one guaranty agency, the Northwest Student Loan Association, revealed that the institution had failed to communicate the payment schedule required by law with 84 percent of borrowers who failed to repay their loans.

The student loan system also suffers because many guaranty agencies have ties to financial institutions that they are supposed to regulate.

Such a relationship contributed to the bankruptcy in 1990 of what was then the nation's largest guaranty agency, Higher Education Assistance Foundation. At the time of the bankruptcy -- which cost taxpayers $200 million -- Richard Hawk was president of HEAF and chairman of the holding company that owned it. He was also owner of a for-profit company that serviced HEAF loans and, investigators say, routinely overcharged HEAF.

Congressional legislation that would have prohibited the officers and employees of guaranty agencies from having a financial interest in companies the agencies regulate was defeated last year in the wake of lobbying by the guaranty organizations.

A number of guaranty agencies are in financial trouble now. The Virginia agency, for example, owes the federal government $31 million for violations in 1990 and 1991, but the department is not ++ pursuing the funds, because to do so would bankrupt the agency.

Faulty record-keeping by financial middlemen has bogged down education department attempts to kick out of the loan program schools where large numbers of students fail to pay back loans. Bad student loans are likely to cost taxpayers $2.5 billion this year. But recently, a number of offending schools have won the right to stay in the student loan program by successfully suing the education department on the grounds that its data on the schools' default rate is inaccurate. The department relies on the lenders and guaranty agencies for the figures.

Lenders, guaranty agencies and other financial institutions are desperate to preserve their lucrative involvement in the student loan program. Threatened with the loss of their franchise by the Clinton direct lending proposal, they recently have backed calls for cuts in their subsidies.

But students' and taxpayers' interests aren't sufficiently served by subsidy cuts alone. Whether the Clinton plan is passed or not, Congress needs to address the problems of misplaced incentives and conflicts of interest.

Thomas Toch covers education for U.S. News and World Report.

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