Guaranty Agencies

In February, President Obama proposed eliminating the Federal Family Education Loan (FFEL) Program and shifting all new federal student loans to the Direct Loan Program. Both programs provide the same loans to student borrowers (i.e. Stafford loans), although they are administered in different ways. While media coverage has focused on the lenders that operate the FFEL Program, federal student loan guaranty agencies have been largely ignored. Guaranty agencies are private non-profit or state government entities that administer federal insurance and collect on defaulted student loans. Yet any significant changes to the FFEL Program will affect these little-understood entities.

To help inform the debate on federal student loan reform, the New America Foundation's Education Policy Program today released "Rethinking the Middleman," a policy paper that provides an overview of the history and current responsibilities of guaranty agencies, a critical analysis of the federal payments these entities receive, and recommendations for reforms.

The paper includes the following:

[In recent months we have cast a critical eye on federal student loan guaranty agencies by taking a closer look at a few specific agencies to show how concerns about conflicts of interests and misaligned financial incentives operate in practice. Previous entries can be found here, here, here, here, and here. Today, our series continues with a look at the actual amount of subsidies and payments provided to these agencies.]

Guaranty agencies are paid to perform three basic functions within the Federal Family Education Loan (FFEL) Program: provide default insurance for lenders; work with delinquent borrowers to help them avoid default; and collect on or rehabilitate defaulted student loans. Though each individual purpose is important; entrusting a single agency to carry out all of these functions creates opportunities for conflicts of interest. Even worse, the financial payment structure provides guaranty agencies with the greatest compensation for letting a student loan default -- the worst possible outcome for borrowers and taxpayers.

According to the U.S. Department of Education, guaranty agencies received $1.57 billion from the federal government in fiscal year 2008 for dealing with defaulted student loans and working with borrowers. Guaranty agencies also ended the 2008 fiscal year with an additional $1.63 billion worth of federal assets held in trust to reimburse lenders for losses on defaulted loans.

A breakdown of the distribution of federal payments to guaranty agencies reveals why taxpayers and policymakers should be concerned about these companies' financial incentives. As the table below shows, 60.5 percent, or $948.8 million, of the federal payments guaranty agencies received in the 2008 fiscal year were for the collection and rehabilitation of defaulted student loans. (The Department of Education does not separate these payments out so we don't know how much agencies got for each function.) By contrast, they received only $177.3 million for helping keep borrowers out of default. In addition, guaranty agencies received $203.9 million to cover the cost of processing and issuing the initial default guarantee on new loans and another $237.9 million for maintaining existing loan accounts.

A few weeks ago, we wrote about how the financial crisis had gummed up the federal student loan rehabilitation process, leaving thousands of borrowers stuck in default. We are pleased that the U.S. House of Representatives recently tackled this issue as part of its technical amendments to the Higher Education Act reauthorization legislation Congress passed last year, and especially heartened that it did not turn the rehabilitation fix into a boon for guaranty agencies. But as we wait for the Senate to consider its own version of the legislation, lawmakers need to ensure that the final bill includes important changes the House made that would finally turn the rehabilitation process into a true benefit for borrowers.

Loan rehabilitation is designed as a one-time way for borrowers who have defaulted on their federal student loans to return their debt to regular repayment status. Successful rehabilitation requires borrowers to work with their guaranty agency -- the entity that takes control of the loan once a lender files a default claim -- to establish a new payment plan. Borrowers are then expected to make nine out of 10 monthly payments, after which their loan can be considered rehabilitated if it is sold to an eligible lender.

Creating a pathway for borrowers with defaulted loans to return to good standing provides numerous benefits for those individuals. The borrower, for example, is once again eligible for federal student aid and can take advantage of flexible student loan payment plans, such as income-based or income-contingent repayment. Even more important, the default is expunged from a borrower's credit record, making it easier for that person to obtain other consumer loans, such as those for a house or car.

Higher Ed Watch continues its series that takes a closer look at individual federal student loan guaranty agencies. The introductory post can be found here. The first post, on the Georgia Student Finance Commission can be found here. Today, the series continues with the Northwest Education Loan Agency.

The Northwest Education Loan Association (NELA) is a nonprofit guaranty agency based in Seattle, Washington that serves as the designated guaranty agency for both Washington and Idaho.

In operation since 1978, NELA was the 13th largest guarantor (out of 35) in the 2008 federal fiscal year, overseeing 176,773 loans worth $799.1 million. It was, however, the smallest guaranty agency to act as a designated guarantor for multiple states.

Unlike the Georgia Student Finance Commission (GSFC), which is basically a state agency, NELA is a private, nonprofit guarantor. It is, however, anything but independent. In late 2004, Sallie Mae, the country's largest student loan provider, essentially took over the guaranty agency's operations. This arrangement raises serious conflict of interest concerns, calling into question how a guarantor can carry out its federal oversight responsibilities over a lender that effectively controls it.  As we have seen in similar cases, these types of close-knit relationships between lenders and guarantors can leave borrowers vulnerable to abuse.

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Briefly Noted...

Around this time of year our friends at the Congressional Budget Office (CBO) begin work on an important but overlooked document: the Budget Options report. As most readers know, the Congressional Budget Office provides official cost estimates for legislation considered by Congress. While these estimates play a key role in congressional deliberations, CBO doesn't provide them for just any policy proposal. Only bills formally considered by congressional committees are guaranteed an estimate. Requests by members of Congress for other estimates wait their turn in a long line. And CBO doesn't do estimates requested by anyone other than a member of Congress.

The Budget Options report, however, is the one exception to this process. Usually published in February of odd numbered years, the report contains CBO sanctioned cost estimates for all sorts of policy proposals, including a handful on higher education. Higher Ed Watch has learned that CBO is open to suggestions on which proposals it includes in the report, and so we've come up with a few for 2009. Although CBO does not take any position on the policies in the report, the cost or savings information it provides will help inform the public debate on these important higher education issues.

Recommendations for CBO's 2009 Budget Options Report

• Reform Guaranty Agency Role, Change Subsidies to Competitive Grants

As we have said previously, the role student loan guaranty agencies play in the Federal Family Education Loan (FFEL) program is anachronistic, inefficient, ill-defined and riddled with conflicts of interest that harm taxpayers and students. Their primary function is to serve as middlemen, using federal funds to reimburse lenders for loan defaults. Guaranty agencies are also supposed to oversee lenders, but this role is often compromised because of their close ties with loan companies. Even guaranty agencies' most useful activities, loan default prevention and rehabilitation, are weakened by conflicting federal incentives and ties to lenders. [See, for instance, this report from The Chronicle of Higher Education.]