Footing the Tuition Bill: The New Student Loan Sector

Footing the Tuition Bill

Footing the Tuition Bill The New Student Loan Sector

Edited by Frederick M. Hess

The AEI Press

Publisher for the American Enterprise Institute WA S H I N G T O N , D . C .

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Library of Congress Cataloging-in-Publication Data Footing the tuition bill : the new student loan sector / edited by Frederick M. Hess. p. cm. Conference at the American Enterprise Institute. Includes bibliographical references. ISBN-13: 978-0-8447-4253-3 ISBN-10: 0-8447-4253-8 1. Student loans—United States. 2. Student financial aid administration—United States. I. Hess, Frederick M. II. American Enterprise Institute for Public Policy Research. LB2340.2.F64 2007 378.3'62—dc22 2007014011 12 11 10 09 08 07

1 2 3 4 5 6

© 2007 by the American Enterprise Institute for Public Policy Research, Washington, D.C. All rights reserved. No part of this publication may be used or reproduced in any manner whatsoever without permission in writing from the American Enterprise Institute except in the case of brief quotations embodied in news articles, critical articles, or reviews. The views expressed in the publications of the American Enterprise Institute are those of the authors and do not necessarily reflect the views of the staff, advisory panels, officers, or trustees of AEI.

Printed in the United States of America

Contents

LIST OF ILLUSTRATIONS

ix

ACKNOWLEDGMENTS

xi

INTRODUCTION, Frederick M. Hess The Federal Loan Landscape 7 A Quick Guide to Key Actors 9 An Anachronistic System? 12 Overview of the Volume 15

1

1. HIGHER EDUCATION’S STUDENT FINANCIAL AID ENTERPRISE IN HISTORICAL PERSPECTIVE, John R. Thelin 19 Principles and Precedents: The Historic Roots of Financial Aid 20 The Principles and Pilot of the 1944 GI Bill 22 The 1947 Truman Commission Report: Access and Affordability 24 Some Landmark Developments of the Past Half-Century 26 The High Tide of Federal Student Financial Aid Programs: The 1972 Reauthorization of the Higher Education Act 28 Readjustments of Federal Student Aid Programs, 1978–90 34 Closing the “Tuition Gap” in Statewide Higher Education Planning: State Scholarships and Independent Colleges 35 Recent Trends 37 Conclusion: Connecting Past and Present in Policy Analysis 40 2. OPPORTUNITY COSTS: THE POLITICS OF FEDERAL STUDENT LOANS, Andrew Rudalevige Federal Student Loans: Actors, Organizations, and Issues 45 Institutions of Higher Education 46

42

vi FOOTING THE TUITION BILL Students 50 Lenders and Guarantors 52 The Higher Education Act, Forty Years On 59 The Path (Dependence) Ahead 68 Muddling Through 69 Fiscalization and Polarization 70 What’s Next? 72 3. PRIVATE LENDING AND STUDENT BORROWING: A PRIMER, Christopher Mazzeo Defining Private Loans 76 Profiling the Private Loan Industry 79 Understanding the Growth of Private Loans 83 Loan Limits and Rising Tuition 84 College Choice 86 Who Are Private Borrowers? 89 Recommendations for Federal and State Policymakers 91

74

4. THE DEMAND SIDE OF STUDENT LOANS: THE CHANGING FACE OF BORROWERS, Bridget Terry Long and Erin K. Riley 99 College Loan Programs: The Supply Side 103 The Evolution of Federal Student Loan Programs 103 Current Federal Student Loan Programs 103 State and Institutional Loan Programs 107 Private Loan Options for Students 107 College Loans for Parents and Other Loan Options 108 The Characteristics of Borrowers 109 Borrowers by Attendance Pattern 110 Loan Demand by Type of Institution 114 Borrowers by Income and Dependency 118 Borrowers by Race or Ethnicity 125 Concerns about Student Loans: Too Much or Not Enough Debt? 126 Trends in Cumulative Debt 126 Measuring the Burden of Debt 128 Too Much Debt? Concerns about the Effect of Debt Burden 130 The Loan Limit Debate 132 Not Enough Debt? The (Un)Willingness to Take Out Loans 133

CONTENTS vii Debt and College Dropouts 133 Conclusions 134 5. THE SUPPLY SIDE OF STUDENT LOANS: HOW GLOBAL CAPITAL MARKETS FUEL THE STUDENT LOAN INDUSTRY, Joseph Keeney Student Loan Volume and Growth 137 The Student Loan Industry 138 Key Metrics: The Art and Science of Loan Losses 140 Key Metrics: Loan Value 143 Student Loan ABSs: A New and Rapidly Growing Asset Class 145 Student Loan ABS Investors 147 The Nuts and Bolts of Student Loan Securitization 149 Market Risks and Opportunities 150 Disclosure and Compliance 153 International Student Loan Market 154 Summary 156 6. MARKETING OPPORTUNITY: CHALLENGES AND DILEMMAS, Richard Lee Colvin Sallie Mae: “We’re Big and We’re Competitive” 165 First Marblehead: Behind-the-Scenes Giant 170 Banks and Private Loans 174 Consolidators: A New Kind of Business 175 MyRichUncle 176 Questions Raised 180 7. THE END OF AUTONOMY: HOW THE ROLE OF THE FINANCIAL AID OFFICE IS CHANGING, Alan Greenblatt An Accidental Profession 184 An Era of Free Agency 188 Losing Clout 190 Going Private 191 What’s Best for Students 194 Interactions with the Loan Industry 196 Access and Influence 200 Conclusion 201

136

157

182

viii FOOTING THE TUITION BILL 8. THOUGHTS ON THE INDUSTRY’S PAST AND PRESENT: AN INSIDER’S PERSPECTIVE, Richard George The Perspective 204 A Brief Outline of Context 205 Concentration 205 Integration 206 Securitization 207 Consolidation 207 Private or Alternative Loans 208 An Alternative Path 211 A Necessary Reform 215 Conclusion 222 9. PROJECTIONS FOR THE STUDENT LOAN INDUSTRY, William D. Hansen Federal Financial Aid Overview: Grants and Loans 223 Alternative Market Mechanisms 226 Impact of the Deficit Reduction Act 230 New Policies and Needed Reform 232 Growth in Alternative Student Loans 237 Considerations for the Future 240 Proposal #1: Repeal Tax Benefits and Increase Support for Pell Grants 241 Proposal #2: Privatize the Perkins Loan Program 243 Proposal #3: Auction the FDLP Portfolio 244 Proposal #4: Private Philanthropy 246 Conclusion 247

203

223

APPENDIX A: KEY DEVELOPMENTS IN THE FEDERAL LOAN SECTOR

251

APPENDIX B: COMMONLY USED ABBREVIATIONS AND ACRONYMS

257

NOTES

261

ABOUT THE AUTHORS

297

INDEX

301

List of Illustrations

TABLES 1 3-1 3-2 3-3

Summary of Federal Loan Programs 10 Distribution of Private Loans by Stafford Borrowing 86 Distribution of Private Loan Borrowers 88 Characteristics of Private Loan–Takers by Stafford Loan Status 92 4-1 Undergraduate Borrowing in Federal Stafford Loan Programs, 1994–95 to 2004–5 104 4-2 Undergraduate Students Who Received Loans by Attendance Patterns, 2003–4 110 4-3 Undergraduate Students Who Received Loans by Institution, 2003–4 112 4-4 Percentages of Undergraduate Students Receiving Loans by Income, 2003–4 114 4-5 Average Undergraduate Loan Amounts by Income and Dependency Status, 2003–4 116 4-6 Students Who Received Loans by Income Accounting for Attendance Pattern or Institution Type, 2003–4 120 4-7 Percentages of Undergraduate Students Receiving Loans by Race or Ethnicity, 2003–4 120 4-8 Average Undergraduate Loan Amounts by Race or Ethnicity, 2003–4 122 4-9 Students Who Received Loans by Race or Ethnicity Accounting for Attendance Pattern or Institution Type, 2003–4 124 4-10 Cumulative Average Amounts Borrowed by Full-Year Undergraduates, 1992–93 to 2003–4 127 ix

x FOOTING THE TUITION BILL 4-11 Cumulative Average Amounts Borrowed through PLUS Loans for Full-Year Undergraduates, 1992–93 to 2003–4 129 5-1 TERI Net Defaults Paid by Cohort Year 142 5-2 Global Postsecondary Education Market 155 8-1 FFELP Loan Originations by Top 100 Lenders 206 9-1 General Differences between the Five Models 228 FIGURES 4-1 Loans Used to Finance Postsecondary Education, 1994–95 to 2004–5 100 4-2 Percentages of Full-Time, Full-Year Undergraduate Students Receiving Any Grant or Loan, 1989–90 to 2003–4 101 4-3 Average Annual Grant and Loan Amounts Received by Full-Time, Full-Year Undergraduate Students, 1989–90 to 2003–4 102 5-1 Value Chain for First Marblehead Corporation 139 9-1 Estimated Student Aid by Source, Academic Year 2004–5 224 9-2 Average Tuition, Fee, and Room and Board Expense versus Dependent First-Year Federal Loan Limit 231 9-3 Growth in College Costs Compared to Household Income, 1994–2005 234 9-4 Growth in Student Loan Market: Alternative Loans Are the Fastest Growing Segment of the Market 238 9-5 Current Growth Rates Project a $25–30 Billion Alternative Student Loan Market by 2008 239 9-6 Federal Education Tax Credits and Tuition Deductions 243

Acknowledgments

It should come as no surprise that in recent years, college access and affordability have drawn enormous attention from parents and students, civil rights organizations, state and federal policymakers, and colleges and universities themselves; these issues speak directly to such bedrock American values as opportunity and social mobility, and are especially pertinent in an era when the college diploma has become the indispensable key to economic success. Largely escaping scholarly scrutiny, however, has been the mushrooming role played by private loans in financing college. That void has made the production of the contributions in this volume particularly significant, but it has also made the effort exceptionally challenging. With that in mind, I am indebted to all of the individuals who contributed to or assisted with the compilation of this volume. Primarily, I thank the contributing authors who wrote the conference papers that were presented at the American Enterprise Institute (AEI) on September 25, 2006. I’d also like to thank the discussants who participated in that conference and provided invaluable feedback on the initial drafts. They include Sandy Baum of the College Board, Don Betterton of Betterton College Planning, former California secretary of education Alan Bersin, Sarah Ducich of Sallie Mae, Christopher G. Cronk of Banc of America Securities, Terry Hartle of the American Council on Education, consultant Arthur M. Hauptman, John A. Hupalo of First Marblehead Corporation, Catherine B. Reynolds of EduCap and Loan to Learn, and Robert Shireman of the Project on Student Debt. At AEI, Hilary Boller and Juliet Squire did an admirable job of assembling and editing the papers for publication. Morgan Goatley and Rosemary Kendrick also provided vital assistance. Christopher Mazzeo (author of chapter 3) would like to thank Jonathan Reichsl, who assisted in the writing of this chaper, as well as Robert Shireman

xii FOOTING THE TUITION BILL for his help in the early stages of research for this chapter and Derek Price, Sara Goldrick-Rab, Hilary Boller, and Juliet Squire for their thoughtful comments on earlier drafts. As always, my thanks go to the American Enterprise Institute, and especially its president, Christopher DeMuth, for unwavering support and for providing an environment of collegiality and remarkable intellectual freedom. Funding for this project was generously provided by EduCap and by the Pew Charitable Trusts, and for it I offer my sincere gratitude. Finally, I’d like to thank Samuel Thernstrom, Lisa Ferraro Parmelee, and Tim Lehmann for the wonderful work they did in translating the manuscript into the volume you hold before you.

Introduction Frederick M. Hess

In twenty-first century America, college is no longer a luxury or the preserve of the upper classes. Today, in a nation where the brawn economy has given way to the brain economy, educational success is often touted as much for its impact on lifetime earning as on knowledge or learning. Whereas in 1972 workers with high school degrees earned 64 percent as much as those with bachelor’s degrees, by 2002 they earned just 50 percent as much.1 In popular debates, such complex calculations are often reduced to the observation that college graduates will, on average, earn $1,000,000 more than high school graduates over the course of their working lives.2 Moreover, supporters of publicly funded higher education argue that society reaps substantial economic, civic, and social benefits from college attendance. In 2006, the in-state cost of four-year public colleges was $12,796 a year if one adds room and board to tuition and fees.3 At a four-year private college, the average cost of tuition and fees was $22,218—or $30,367 with room and board.4 Given that the typical student takes five to six years to complete a degree at a four-year college, the costs are higher than they initially appear. Meanwhile, the main federal loan program caps the available loans for individual students at $23,000 over the course of a lifetime. The federal grant and loan programs, which were crafted in the 1960s and ’70s to provide “universal” access in an era when perhaps a quarter of high school graduates would pursue college,5 are unequal to today’s burgeoning collegegoing population, and were never designed to ensure the range of choices that many families and students desire. Given the consensus that college attendance is both important and expensive, it is no surprise that college access and affordability have become pressing concerns in the past decade. 1

2 FOOTING THE TUITION BILL In the past fifteen years, the cost of college has consistently outstripped both inflation and growth in household income—with costs from 1997 to 2006 increasing 5.2 percent a year for private four-year colleges and 6.0 percent a year for public four-year colleges.6 By comparison, the Consumer Price Index increased at the much slower rate of about 2.5 percent a year and median household income at less than 1.0 percent a year between 1996 and 2005.7 Coupled with low levels of household savings and the greater importance of a college degree in the new economy, these increases have lent questions about college access a heightened saliency. Concerns about college access and affordability have been aggravated by changes in student demographics. Most significantly, college-going has undergone a revolutionary expansion in the past half-century, with the percentage of eighteen-year-olds attending quadrupling since the 1950s. In 1950, about 13 percent of Americans went on to postsecondary education; today, the proportion is about 53 percent.8 Moreover, in 1999–2000, nearly three-quarters of students enrolled in postsecondary education were “nontraditional” students, meaning they delayed enrollment, worked full-time, were considered financially independent, had children, or lacked a high school diploma.9 Two-thirds of those students were enrolled in two-year institutions.10 Designed for families borrowing to fund an eighteen-yearold’s four-year college education, traditional loan programs are not necessarily well suited to the needs of the nontraditional student population. Finally, there are concerns that the existing aid programs aren’t targeting money to those who need it most. Today, less than 60 percent of every dollar of federal aid is provided on the basis of student need.11 In practice, the federal loan program has become a middle-class subsidy to help students attend the institution of their choice or compensate for a lack of savings by middle-class families, or a tool to help middle-class families manage investments and cash flow. There are many ways to address college affordability. The most familiar steps are pressuring institutions to rein in costs, providing more subsidies to institutions, or increasing public and private grants for students. Richard Vedder’s book, Going Broke by Degree, advocates for controlling costs, while calls for an increased federal role in subsidizing students and college have featured prominently in such popular volumes as Tamara Draut’s Strapped and Anya Kamenetz’s Generation Debt.12 While these various strategies are

INTRODUCTION 3 certainly deserving of consideration, they are not our focus here. For one thing, such measures are either politically combustible or highly expensive, and are unlikely to make much headway in the contemporary political and fiscal environment. They have also been widely discussed by policymakers and scholars in recent years and are fairly well understood. Taking a different tack, this volume instead explores what the swelling use of nontraditional private loans means for college affordability. Loans are often derided as an undesirable mechanism for financing college because they force students to enter the workforce with accumulated debt and because the business of loaning money to students is a tricky one, given their only collateral is their potential future earnings. Loans also have their virtues, however. They require students and families to shoulder some responsibility for the cost of postsecondary education, can make students more sensitive to the prices that colleges charge (thereby encouraging price competition), and avoid general subsidies that entail raising taxes to fund college attendance for well-off students. This volume offers no easy answers to the challenge of college affordability or the provision of loans. However, in focusing upon one of the more intriguing developments in higher education finance—the emergence of a robust private, “nontraditional” loan sector—it explores how higher education lending works today and considers what this could mean for public policy. In practice, the discussion regarding college “affordability” often blurs the distinction between two considerations. One is the issue of whether academically qualified, low-income students are able to obtain the money needed to pursue postsecondary education, and the other is the question of whether students, of whatever economic circumstances, are able to attend the postsecondary institution of their choice. The first question is one of access, and primarily important for low-income families, while the second is a matter of educational choice, and most relevant to middle-income students who are weighing more expensive alternatives against cheaper, instate public institutions. Historically, college aid programs were introduced to help ensure all students access to a postsecondary education. Today, with these programs increasingly serving middle-class families who desire aid, it is reasonable to ask whether conventionally subsidized and guaranteed federal loan programs continue to make sense. Subsidized higher education, proponents argue, yields significant public benefits in terms of economic growth and civic health. That conviction

4 FOOTING THE TUITION BILL underlies the substantial investment that states and the federal government make in funding public postsecondary education and in providing students with grants and subsidized loans. For instance, in 2005, states provided $65.3 billion for public higher education. The 2006 amount worked out, nationally, to a subsidy of $5,800 per full-time student. The result was that the typical family paid only about 37 percent of the actual cost of tuition for students enrolled in public colleges and universities.13 Meanwhile, in 2004–5, the federal government devoted $90.1 billion to financial aid, including grants, loans, work-study, and tax benefits.14 These expansive subsidies mean that in 2005–6, for instance, the median public two-year college charged just $2,272 a year in tuition and fees and the median four-year public college just $5,836 a year.15 Since two-year and four-year public institutions enroll three-quarters of all students in postsecondary education,16 most students are obtaining their schooling at quite a modest price. Nonetheless, persistent inflation in the cost of higher education—as well as the added expense of room, board, and transportation; the reality that most students take more than four years to complete a four-year degree; the fact that even $5,800 a year is an enormous stretch for some families; and the fact that one-quarter of students attend much pricier private institutions—helps explain why the cost of college has become a pressing concern. Today, the median student graduates from a public college owing $15,500 and from a private college owing $19,400,17 and the federally guaranteed, subsidized loan programs don’t provide enough loans to satisfy the existing desire for them. The squeeze is made more pressing by the lackluster saving habits of American households. The typical American household today has a negative personal savings rate—with the government reporting in 2005 that Americans spent more money than they earned.18 This constitutes the lowest savings rate since the Great Depression and has created a substantial appetite for borrowing.19 For instance, during the course of the economic expansion that ran from 1991 to 2001, household debt more than doubled, to $7.2 trillion.20 For all these reasons, those students and families who do not qualify for need-based aid are increasingly turning to a once marginal source of financial aid: private loans that are neither subsidized nor guaranteed by the federal government. Fifteen years ago, such loans were nearly nonexistent. In

INTRODUCTION 5 1996–97, they amounted to about 6 percent of all borrowing for college. Five years ago, they constituted about 10 percent of all borrowing.21 In 2004–5, they made up 18 percent of the total volume of federal loans.22 This accelerating shift marks the rise of a new order in college financing. The private-loan providers have met the need for increased financial aid. But because policymakers, advocates, and the higher education community have remained fastidiously focused on the traditional federal grant and guaranteed-loan programs, little thought has been paid to how these new arrangements are altering, complementing, or upending the existing financial system; what they can teach about retooling familiar arrangements; what safeguards they require; or how sensible policymakers might reimagine federal guarantees, subsidies, and regulations to encourage these providers to promote college affordability and access. Those skeptical of nontraditional loans have two looming concerns. The first is that some students (especially those who appear to be poor credit risks) might not be able to find lenders willing to lend them the money they need to pursue a postsecondary education. The second is that predatory lenders may be taking advantage of naïve or ill-informed students by encouraging them to borrow more than is prudent. Of course, more optimistic accounts concede that while there will always be a demand for federal grants to serve low-income students, private lenders will find ways to serve students with varying needs, and self-interested incentives will prevent lenders from making loans that students will find difficult to repay. Nontraditional lenders, fueled by the profit motive and operating in a freer marketplace, may offer more convenient and customer-friendly assistance and provide families with a degree of choice not available under the conventional programs. The surging share of private loans, provided by both traditional major players and an array of newer providers, raises a host of provocative questions. Are increased ease and availability of loans a positive development in a sector that has too frequently been unresponsive to consumer needs, or do they encourage ill-equipped teenagers to borrow more than they ought to for college? Are collegiate financial aid offices useful gatekeepers that can scrutinize proffered deals and usefully steer students to competitively priced and reliable lenders, or are they choke points that screen out unfamiliar names, limiting choice and stifling healthful competition? Does the

6 FOOTING THE TUITION BILL reliance of private-loan providers on credit checks and risk-based interest rates represent a sensible innovation, or does it raise the risk that family credit histories may become barriers to college access? The contributors to this volume explore these questions in their full complexity, providing careful analysis in lieu of pat answers. Journalistic accounts of loan providers frequently feature hard-luck stories about unfortunate individuals, depicting students who find themselves with burdensome debt or regretting choices they have made. For instance, in 2006, The Chronicle of Higher Education told the story of Kristin Hough, a social-service worker who, $60,000 in debt, felt forced to change careers in order to afford monthly payments of $535 on her private student loans.23 Also in 2006, USA Today highlighted the risks faced by uninformed borrowers in reporting the story of Jeremy Hynd, who discovered upon graduation, during an attempt to consolidate his loans, that they were private and carried a variable interest rate subject to steep increases.24 Such stories can provide a useful service and an important check on unsavory practices. They can also, however, amount to emotional, media-friendly stories of economic injustice that provide an unbalanced or overly simplistic take on thorny questions of individual judgment and how properly to balance opportunity and responsibility. Regardless, these stories typically do little to illuminate the complexities of the nontraditional loan landscape. Keep in mind that federal loan programs include two key components: a subsidy that makes loans cheaper for students than they would be otherwise, and a guarantee that encourages banks to provide loans. The rationale for the subsidy is straightforward. As Andrew Rudalevige discusses in chapter 2, the guarantee was introduced in the 1960s because it was feared that few lenders would want to enter a market where they were supplying loans to customers (students) who had no collateral, uncertain prospects, and an indeterminate financial condition. The guarantee, of course, raised concerns that loan providers might be lethargic about collecting on loans (because they were guaranteed repayment), or that they might collect profits while the taxpayers took on all the risk (by underwriting the government’s guarantee). In the 1990s, reformers sought to reduce the default rate and to have the government provide “direct loans” so as to remove banks from their lucrative “middleman” role. The mass of aspiring loan providers and the growing private loan market today, however, raise the questions of whether the entire

INTRODUCTION 7 notion of a federal guarantee might be an anachronism, and whether taxpayers still need to insure loans to provide a functioning market. This volume is not a treatise on college cost or an exploration of the broad issues of higher education finance. Rather, it considers the world of college loans, primarily the nonguaranteed, unsubsidized loan sector, to see what changes might be advisable to redesign our familiar system for the arrangements of the twenty-first century.

The Federal Loan Landscape Since the nontraditional loan sector has emerged around and within the cracks in the traditional federal student loan system, it is useful to review briefly the major programs before proceeding. The history and politics of higher education loans are told much more fully in chapters 1 and 2 by John Thelin and Andrew Rudalevige, respectively. For the most part, efforts to reform the loan system in recent decades have consistently focused on tweaking—rather than reexamining—the principles adopted for political reasons in the mid-1960s. The Federal Perkins Loan Program, then called the National Defense Student Loan Program (NDSL), is the oldest of today’s federal aid programs. Enacted as part of the 1958 National Defense Education Act, NDSL funds were channeled directly to colleges.25 Colleges then partially matched the dollars in order to create a revolving fund to distribute aid. The Perkins Loan Program entailed $1.26 billion in federal expenditures in 2004–5. That figure represents only a tiny fraction—about 2 percent—of annual federal loan spending. Over time, the Perkins model has been dwarfed by the Federal Family Educational Loan Program (FFELP), born as the Guaranteed Student Loan Program (GSL) in Title IV of the Higher Education Act (HEA) in 1965. GSLs, later renamed Stafford loans, were expected to provide middle-income students with access to loans. Interest on GSLs was subsidized (with the federal government paying all of it while a student was in school and half thereafter), and, to protect lenders and ensure there were providers willing to issue them, loans were guaranteed through federal support for state-based funds administered by guaranty agencies.26 In 1992, Unsubsidized Stafford Loans were created for middle- and high-income

8 FOOTING THE TUITION BILL families. For these loans, eligibility was not contingent on income. While these loans were deemed “unsubsidized,” they still provided favorable loan conditions to borrowers.27 The GSL program loans comprised 70 percent of federal loan volume in 2004–5, when the government doled out almost $18.8 billion in subsidized and $14.8 billion in unsubsidized loans.28 At its outset, the GSL program attracted little interest from states or lenders. Students were not an attractive clientele: They were mobile and high-risk borrowers. Moreover, they required relatively small loans. The paperwork and administrative burden made such loans more expensive for banks to process than the larger loans used to purchase homes or launch businesses. Finally, these risky, expensive loans were heavily regulated by the government. Not surprisingly, lenders were reluctant to provide them. In response, when reauthorizing the Higher Education Act in 1972, Congress created the Student Loan Marketing Association (SLMA, or “Sallie Mae”) as a government-sponsored enterprise (GSE) to generate a secondary lending market. In 1976, the creation of other secondary-market organizations beyond Sallie Mae was authorized—today there are some three dozen—and additional support was given to guaranty agencies. These changes boosted loan supply; additional congressional measures soon expanded demand. The Middle Income Student Assistance Act (MISAA) of 1978 removed the income cap on GSL eligibility, allowing any student to receive subsidized loans while in school.29 In 1980, the new Parent Loans for Undergraduate Students Program (PLUS) allowed parents to take out additional, separate loans under the Stafford Program. By 2005, these constituted 14 percent of Stafford borrowing. The number of parents taking out PLUS loans more than doubled in the decade after 1995, reaching 8.3 million in 2005.30 In 1986 and again in 1992, Congress raised limits for Stafford loans and eliminated them for PLUS loans. The increase in the population eligible for loans helped to boost industry profits, even as the purpose of the loan programs drifted away from the initial justification of low-income access and focused increasingly on providing middle-class students with enhanced college choice.31 As tuition continued to rise, both families and banks moved to take advantage of what longtime House Education Committee chair William D. Ford, a veteran Capitol Hill Democrat, described as “a whole decade [spent] piling on bribe after bribe after bribe” to build the loan program.32

INTRODUCTION 9 In 1992, the creation of a pilot program of “direct lending” sought to bypass private lenders by providing loans from treasury funds through the colleges themselves. Supporters of direct lending argued it was simpler for students and cheaper for taxpayers, since the government would earn interest on its funds as loans were repaid without having to provide subsidies to private lenders or state guarantors. Direct lending took over about a third of the loan market by 1996, though it has declined since then.33 After forty years of adjustments and additions to federal financial aid programs, the Stafford, Perkins, and PLUS loans today operate under the characteristics described in table 1. Legislation that is pending in the 110th Congress, introduced by the new Democratic majority in the House of Representatives, would alter these provisions. If enacted, the College Student Relief Act of 2007, HR 5, would cut interest rates from 6.8 percent to 3.4 percent over five years.34 The legislation would be up for reauthorization six months after the final reduction takes effect,35 but it has the potential to cut $4,400 in interest payments over the life of an average student debt of $13,800.36 Such changes may modestly reduce the burden on some borrowers but leave in place the antiquated and inefficient system that is unequal to the needs of twenty-firstcentury students and families.

A Quick Guide to Key Actors Actually providing federal loans or private loans is a complex business, with nearly all of the actors and activities involved in nontraditional loans also involved in the federal loan programs. While these complications mean that any schematic will be overly simplistic, it may be helpful to the general reader to sketch the basic sequence of actors involved in the loan process. When a student is accepted to a college, that college’s financial aid office decides how much of the school’s sticker price the student will pay. After accounting for merit- and need-based grant aid from various sources as well as work-study, the financial aid office guides the student to the institution’s approved loan options, most frequently through the Stafford Program.37 If the college participates in the direct-lending program, the Stafford loan is funded by the government and comes directly through the financial aid

10 FOOTING THE TUITION BILL TABLE 1 SUMMARY OF FEDERAL LOAN PROGRAMS Program

Annual/aggregate amounts

Eligibility

Repayment and interest

Federal Stafford Loan

$2,625 first-year undergraduates (as of July 1, 2007, will increase to $3,500) $3,500 second-year undergraduates (as of July 1, 2007, will increase to $4,500) $5,500 each remaining year at the undergraduate level $18,500/year for graduate students (as of July 1, 2007, will increase to $20,500) Independent students qualify for higher limits $23,000 undergraduate aggregate $65,500 combined undergraduate/graduate aggregate.

Undergraduate and graduate students Enrolled at least half-time Must have determination of eligibility/ineligibility for federal Pell Grant Must determine eligibility for federal Subsidized Stafford Loan before applying for federal Unsubsidized Stafford Loan Subsidy based on need Unsubsidized funds may be used to replace Expected Family Contribution (EFC).

Begins six months after cessation of at least half-time enrollment Fixed rate of 6.8 percent Prior to July 1, 2006, maximum of 8.25 percent interest.

Federal Perkins Loan

$4,000/year undergraduates $6,000/year graduates $20,000 undergraduate aggregate $40,000 combined undergraduate/graduate aggregate.

Campus-based loan program Funds awarded by institution Undergraduate and graduate students First priority given to students with exceptional financial need Must have determination of eligibility/ineligibility for federal Pell Grant.

Begins nine months after cessation of at least half-time enrollment 5 percent interest.

Federal PLUS Loan

No annual or aggregate amounts, except parents may not borrow more than the difference between the cost of attendance and estimated financial assistance.

Parents of eligible dependent undergraduates who are enrolled at least half-time No adverse credit history Must not be in default on a federal loan Must be U.S. citizen or eligible noncitizen.

Begins sixty days after final disbursement Fixed rate of 8.5 percent Prior to July 1, 2006, maximum of 9 percent interest.

SOURCE: National Association of Student Financial Aid Administrators, “What Financial Aid Is Available?” 2004, www.nasfaa.org/SubHomes/DoItAffordIt/affordit2.html (accessed February 2, 2007); Mark Kantrowitz, “The Smart Student Guide to Financial Aid,” 2006, http://finaid.org/loans/studentloan.phtml (accessed June 23, 2006). NOTE: Programs administered by the U.S. Department of Education. Not all schools participate in all programs.

INTRODUCTION 11 office. If it does not, the student is directed to a list of one or more “preferred lenders.” The student need not borrow from a lender on that list but often will, in part because the college has generally negotiated lower fees from that lender. That originating lender, may, in turn, sell the loan to a “secondary-market organization,” such as Sallie Mae or the Pennsylvania Higher Education Assistance Agency (PHEAA). Some of these, like PHEAA, are tax-exempt, state-chartered institutions; others, like Sallie Mae or Nelnet, are for-profit corporations. A newly popular method of raising low-cost capital, discussed in chapter 5, is asset-based securitization, where loans are pooled and securities sold against the assets they represent. Lenders may do this inhouse or contract with financial organizations like First Marblehead Corporation, which specializes in securitization transactions. Lenders may also contract out the servicing of a loan. The agency receives fees from the government, plus 1 percent of the loan from the borrower as a reinsurance fee (though until July 2006, agency reserves meant that fee was often waived to encourage borrowers to choose one lender over another). Some students wind up taking out more than one education loan over time, from one or more lenders. The law allows them to consolidate these loans. After interest rates were made variable in the 1990s, and especially after rates dropped to historic lows in recent years, this proved to be an attractive option. In response to the new demand, a new industry of “loan consolidators” sprang up. When students fail to repay loans, a well-practiced series of actions is initiated. It is worth noting that late payments incur large fees; the law allows lenders to garnish wages to fulfill repayment; and, in most cases, even bankruptcy does not provide a haven against repayment requirements. Guaranty agencies and secondary-market organizations counsel students to keep them out of default, seek to “rehabilitate” loans, and, finally, seek to collect defaulted loans, either directly or through contractors. For doing so they keep a portion of those repayments (the rest goes to the federal government, which has already reimbursed the agency for repaying a portion of the lender’s losses). Other collection agencies of the more traditional sort, which buy defaulted loans for pennies on the dollar, also have a share of this business. For decades, these sequential functions were kept distinct, and federal policy dealt with each discretely. But banking technology and practices have

12 FOOTING THE TUITION BILL evolved dramatically since the 1970s, encouraging providers to engage in multiple roles when the law allows. On this crowded and changing landscape, the growth of nontraditional loans has upset traditional relationships, created new opportunities, and raised new concerns.

An Anachronistic System? Many limitations within the current system of college grants and loans are the remnants of programs designed in the 1960s and early 1970s, a time when college-going behavior, the importance of a postsecondary education, and family attitudes toward debt were somewhat different from today. Whereas in 1950 households owed just thirty-five cents for each dollar of disposable income, by 2001 they owed over a dollar for each dollar of disposable income.38 The emergence of an expansive, sophisticated credit market has been integral to the development of the American economy in recent decades. The availability of credit has permitted families to manage (and, sometimes, mismanage) wealth in a manner that was not possible four decades ago. Robert Samuelson, the noted economist and Newsweek columnist, has opined, Of course some people over-borrow, and some financial institutions lend abusively. Still, the democratization of debt has generally been a good thing. Millions of families can now borrow for college, cars and clothes. The biggest boom has been the expansion of homeownership, up from 44 percent of households in 1940 to 69 percent today. . . . At heart, America’s appetite for credit reflects national optimism. We presume that today’s debts can be repaid because tomorrow’s incomes will be higher.39 Despite these sea changes in American education, economic conditions, and credit in recent decades, today’s debates regarding college affordability and student aid focus on tweaking the loan programs established more than a quarter-century ago rather than asking whether these might be usefully reinvented for the new century. Understanding the role and dynamics of the nontraditional loan sector is important in its own right for policymakers,

INTRODUCTION 13 loan providers, and postsecondary institutions, but it is at least as important to examine this sector for developments and experiences that might suggest new directions for the federal programs. Since the 1990s, without the benefit of subsidies or government intervention, an array of loan providers has emerged to finance postsecondary education alongside grants and subsidized student loans. This phenomenon has been barely examined and is understood by few individuals outside the industry. Nonetheless, the new providers are growing at an extraordinary pace, and they could well be the source of more than a third of all student loans within the next five to eight years. Whereas today’s entrepreneurs have had to push their way into the industry, it may be possible to alter the landscape so as to render the sector more hospitable to high-quality, new ventures while policing against dubious practices. Such a development might reveal ways to provide student-friendly financing through machinery fundamentally different from the federal loan programs—and it offers a sensible, limited way to experiment with promising loan strategies, such as repayment rates linked to academic performance and major or “income-contingent” loans (in which students receive the money to pay for college and then, rather than incurring a specific debt that may outstrip their postcollege income, repay the loan based on their future earnings). These developments are touched upon by Joseph Keeney in chapter 5. While nations, including New Zealand and Australia, have experimented with this model, serious consideration has been hamstrung in the United States by our attachment to established programs and arrangements. The “nontraditional” loan sector, encompassing recognized players and newer entrants, has become a hub of dynamic activity in a traditionally sleepy sector. These providers have experimented with new efforts at marketing and loan provision, revolutionizing the way loans are offered, bringing unprecedented attention to customer service, and raising questions about the role of postsecondary financial aid offices in restricting the loans that colleges make available to their students. At the same time, some of the new entrants have raised concerns about shady practices or aggressive marketing that may encourage students to borrow excessively. Examining the nontraditional loan sector has the advantage of shifting our gaze from the familiar machinery of college finance and offers the

14 FOOTING THE TUITION BILL opportunity to think differently about longstanding assumptions. It permits us to ask whether reforms intended to address college affordability and access ought to focus on making a 1960s-era financing system work better, or whether it is now possible fundamentally, and fruitfully, to rethink that system. How might the nontraditional market, private-public partnerships, the private sector, and fresh thinking better serve the ends of making an affordable college education universally available? What statutes, practices, or arrangements inhibit new providers, inflate costs, and make it harder for students to get the best available financing—and what might do the opposite? How might public officials, institutions of higher education, or policythinkers shape this growing industry? We can ask whether the evidence suggests broadly subsidized loans are necessary or equitable, or whether taxpayer-funded loan guarantees are still necessary to ensure an adequate pool of lenders. Might it be time to revisit assumptions about the role college-goers, parents, and taxpayers should be expected to bear when it comes to financing college education? Might it be possible to provide loans in a fashion that makes students and families more price-sensitive, rewarding colleges and universities that control costs? Is it possible to do so without inviting abuses and while protecting students and families against illicit practices? Rethinking the use of federal monies and guarantees may offer ways to improve college access, ease, and affordability. For all their imperfections, credit markets use tools, knowledge, and technology—such as sophisticated risk-assessment models, secondary-loan markets, and the Internet— to enable tens of millions of Americans to afford homes, automobiles, and other expenses in ways not possible in 1965 or 1970.40 Are there ways in which these tools might similarly be employed to make college more affordable and college financing more convenient, while fostering responsible behavior among lenders, borrowers, and institutions of higher education? Such discussion raises a variety of concerns about unintended consequences, and it is far too early to characterize blandly the increasing reliance upon private loans as either a menace or a promising development. In this volume, the effort is to understand better the new developments and what they mean for policy and the future of college access. The contributors to this volume have consciously avoided rehashing hoary arguments, such as those over the merits of direct loans, in order to

INTRODUCTION 15 revisit some of the assumptions of a student finance system designed for a different era. A particular question is whether established practices, like the actions of financial aid offices and the rules governing federal loans, inhibit new providers and inflate costs, or whether they are sensible ways to provide access and protect students from unscrupulous practices.

Overview of the Volume Chapters 1 and 2 of this volume sketch the history and politics of the student loan sector and how these developments have made “nontraditional” loans increasingly important. John R. Thelin, an education historian at the University of Kentucky, tracks the history of student loans since the inception of the American university in the seventeenth century. While acknowledging the transformation in the early twenty-first century of the student financial aid enterprise by the emergence of new lending programs from established banks and numerous new providers, he observes that the energy of these innovations, although spectacular, actually fits coherently with a four-century tradition of providing student financial aid in the United States. Thelin provides the context for contemporary higher education programs with his analysis of earlier policy deliberations, especially in federal programs that were introduced as part of the 1972 Higher Education Reauthorization Act. In chapter 2, Andrew Rudalevige, a political scientist at Dickinson College, discusses the political topography of student aid. He argues that, as student loans have become a lucrative, modernized industry, the grand promises of universal access made during the Great Society have been subsumed by “the politics of market share.” While college aid was once relatively nonpartisan, it is now characterized by fiscalization (in an era of budget deficits) and partisan polarization. The system is stable; it “muddles through”; but Rudalevige contends that a full debate of its opportunity costs has been distinctly absent from recent reauthorizations. Chapters 3 and 4 provide a broad look at the demand side of the student loan equation—the borrowing patterns of today’s students—and at the student loan sector as a whole. Analyst Christopher Mazzeo provides an overview of the student loan industry in chapter 3, with a particular

16 FOOTING THE TUITION BILL emphasis on the growth of the private loan market. The chapter provides a primer for readers concerned about higher education outcomes who might be less familiar with the policy issues surrounding student financial aid. Mazzeo also tracks the growth of private loans in recent years, finding it a reaction to a convergence of factors that include rising college costs, federal loan limits that have failed to keep up with these costs, and an overall reduction in grant and scholarship dollars available to middle- and lowincome students. Yet he finds little research on why students are increasingly taking out these loans or on the implications for state and federal policy. Mazzeo summarizes what is known—and not known—about the growth of private lending and discusses how policymakers might think about and respond to these developments. In chapter 4, Bridget Terry Long of Harvard University’s Graduate School of Education and consultant Erin K. Riley examine the general landscape of student loans. They provide a thorough understanding of the demand side of student loans, including how much and from what sources students borrow, what types of students are the most avid borrowers, and how the rate and nature of borrowing has changed in recent years. They conclude with a discussion of cumulative debt and the resulting debt burden, which is becoming an ever greater concern for students and families as well as policymakers. Chapters 5, 6, and 7 look at various players in the student loan industry. Chapter 5 examines the process and players in securitization and how it works in the case of private loans. Joseph Keeney, CEO of School Choice Investments, explores the supply side of the student loan industry, focusing on the securitization of student loans that are packaged and sold to global capital markets investors. He explains how student loan value is created, how it is intermediated through the financial system, who the investors are, and how the securities are structured. Keeney discusses the factors that will determine the future growth and stability of the student loan market and highlights rapid worldwide enrollment growth as a future driver of private capital flows into higher education. For lay readers befuddled by the workings of this industry, Keeney provides a telling sketch of the industry and its dynamics. In chapter 6, Richard Colvin of Columbia’s Teachers College examines the structure and strategies of the companies that are influencing the student loan industry with their efforts to expand the use of private loans. Profiling

INTRODUCTION 17 the most established players, Sallie Mae and First Marblehead, as well as the startup instigator-company MyRichUncle, this chapter looks at the innovations in the myriad loan programs introduced to the industry by private lenders. These include direct-to-consumer marketing, website accessibility, and the expansion of private lenders into the origination, securitization, and servicing processes behind nontraditional loans. Colvin also considers the possible pitfalls of private lending, showing how students can fall prey to the higher interest rates of private loans, and examines the tension between the profitability of private loans and the fiscal feasibility of increasing federal money available for subsidized loans and grants. In his exploration of a sector characterized by caricature or confusion, Colvin offers insight into what these firms are really like. Chapter 7 examines the role played by university financial aid offices and the effect of their role as gatekeepers. Important intermediaries exist between lenders and students in the student loan industry who comprise an often overlooked group of players in this process. Alan Greenblatt, an award-winning journalist with Governing magazine, explores the role of financial aid administrators on campus. As middlemen and midwives to the financial aid process, they enforce the federal rules, determine the composition of the financial aid package each individual student will receive, and decide which lenders will cut what checks. Historically overlooked and left to their own devices, financial aid offices are today receiving increased attention. Greenblatt depicts the challenges faced by these offices as they adjust to a world where university administrators push officers to be more proactive as part of the admissions process, where lenders are starting to market directly to students, and where the portion of college education financed by private loans is soaring. Finally, in chapters 8 and 9, two veteran thinkers on higher education loans offer some fresh thinking on future directions and potential policy choices. In chapter 8, Richard George of the Great Lakes Higher Education Corporation identifies two paths ahead. One continues on with today’s explosive growth of private loans marketed primarily through direct-toconsumer channels. George fears this course will erode the historical relationship between lenders and schools and compromise the counseling provided by financial aid offices and guaranty agencies, at a time when the complexities and consequences of borrowing make such counseling ever

18 FOOTING THE TUITION BILL more important. He calls instead for the creation of an unrestricted, market-based loan program that reallocates federal dollars, so as to focus on low-income students while reconstituting guaranty agencies to serve as “borrower advocates.” In chapter 9, William Hansen, one of the founding partners of the Chartwell Education Group and a former U.S. deputy secretary of education, concludes the volume with suggestions for addressing the challenges of revamping student loans for a new era. While policymakers and institutional leaders identify the federal student aid programs as the way to sustain access, choice, and opportunity in higher education, Hansen notes that the increasing cost of higher education has not been met by federal and state governments. He discusses how to ensure that students from lowincome families do not take on excessive education debt; how to rethink the design and distribution of the federal subsidy for lenders; how to provide an avenue for the private market to supplement federal support for middle- and upper-income families; and how to encourage families to prepare and save for higher education. In the end, this volume does not purport to offer any easy answers or quick fixes. Rather, it is envisioned as one effort to foster serious discussion about the student loan industry, its machinery and inner workings, and, ultimately, its potential to help ensure that every American has the opportunity to pursue his or her dreams.

1 Higher Education’s Student Financial Aid Enterprise in Historical Perspective John R. Thelin

Over the past half-century, the vocabulary of student financial aid programs has worked its way into the rite of initiation associated with applying to— and paying for—undergraduate education. Prospective students and their parents have come to know well that “packaging” refers to the practice of combining three types of college financial aid: grants, loans, and work-study. The same financial aid language of student consumers is used by policymakers. Because the principle of “packaging” has also characterized deliberations by members of Congress, state legislatures, college and university admissions offices, lending agencies, and philanthropic foundations, revising the size and proportion of each type of aid has been central to creating and then periodically reshaping student financial aid programs and policies. And over the past forty years, each time Congress has reviewed budgets for reauthorization of the Higher Education Act (HEA), it has increased substantially the allocations for student loan and student grant programs. This has transformed student financial aid into the second-largest area of federal support for postsecondary education, trailing only federal research and development grants and contracts. The result is that student financial aid programs have become central to the economics of American higher education. In 2005, they awarded a total of $142 billion in aid.1 How did a network of government agencies and private lenders come together with colleges, foundations, and donors to create a substantial student financial aid enterprise that has no counterpart in higher education elsewhere? 19

20 FOOTING THE TUITION BILL Principles and Precedents: The Historic Roots of Financial Aid Since the seventeenth century, American colleges have provided financial aid in order to make college affordable to able students with modest incomes. Well into the mid-1900s, this tradition was practiced as a “cottage industry,” in which each college operated on its own. The aid included some scholarship grants, but most often took the form of work-study jobs in college dining halls.2 Colleges were restricted in their ability to provide campus jobs and scholarships for students. Drawing from institutional endowments was one means—but this had limited appeal, since most endowments were small and generated minuscule income. Since boards of trustees were reluctant to spend down endowment principal, college presidents were left to search for external resources. The solution was to rely on a “college agent,” whose dual responsibility was to attract both donors and paying students.3 The college agent was empowered to use numerous tactics. These included offering “perpetual scholarships” for a donor’s grandchildren and later heirs in order to gain immediate college funding. Another trick of the collegiate trade was to offer on-the-spot financial aid to gain a partially paying student. The widespread use of such practices showed that all American colleges were largely dependent on tuition payment and small pledges to maintain financial solvency. In the late nineteenth century, college finances were precarious, with expenditures threatening to run ahead of income. With most colleges in fear of declining enrollments because a college education lacked appeal for young adults, tuition-discounting became a common practice. The closer one got to the start of classes, the more a college would lower its tuition in a last-ditch effort to enroll paying students—a strategy comparable to the late-twentieth-century commercial practice of airlines offering reduced airfares at the last minute to standby passengers. Filled seats, whether in a classroom or aircraft, were good business, even when consumers did not pay full price. An important departure from these scattered attempts to provide financial aid was the founding of the American Education Society (AES) in 1820.4 It included a major agency (the AES—an incorporated foundation), which had sufficient resources to award financial aid to a large number of

STUDENT FINANCIAL AID ENTERPRISE IN PERSPECTIVE 21 students at numerous colleges, and it relied on regulations. To this end, the AES created its own formidable bureaucracy in which its staff required student aid applicants to fill out numerous forms and affidavits and comply with detailed requirements and terms. The conditions for receiving AES financial aid narrowed eligibility to those college students who pledged to serve as Congregationalist missionaries after having earned their Bachelor of Arts degrees. The program, which at first awarded only scholarship grants, eventually diversified to offer loans as well. By 1838, about 1,100 students—roughly 15 percent of undergraduates in New England colleges—were AES scholarship beneficiaries. Representing the peak of organized philanthropy for student financial aid, the AES was not typical of how most colleges went about arranging for scholarships and loans to make higher education affordable and attractive. It was a marvel of effective organization that would, a century later, become an influential model for major foundations. But in its own lifetime during the first half of the nineteenth century, it did not make a major impression on the financing of American higher education. Given the paucity of large-scale financial aid agencies, most colleges prior to the mid-twentieth century scrambled to enroll students and balance the budget each year. By the late 1800s they had drifted into a strategy of holding tuition charges low and keeping financial aid expenditures lean. Financial aid programs until after World War II were noticeably similar at colleges nationwide, but there was little that one could call a “national” policy on student financial aid. Unlike current programs, they did not involve the federal government. And although American colleges and universities enjoyed unprecedented philanthropic gifts between 1870 and 1910, most large donations were earmarked for lavish campus construction, not student financial aid. Even when donors provided money for scholarships, the gifts often were a nuisance for college administrators because of donors’ idiosyncratic restrictions. Conditions that the recipient had to major in music, for example, or be from a certain locale limited the college in awarding aid to truly worthy students. For most American families, expectations about college affordability in 1900 were markedly different than they would be in 1970 or 2000. Going to college remained uncommon even among children of the middle class. A widespread practice was for parents to designate one son among their

22 FOOTING THE TUITION BILL several children who would be groomed to go to college, with all family members pitching in to raise money for expenses. Though prices were not steep, paying them demanded family sacrifice. An expensive tuition charge, associated with such historic, prestigious colleges as Harvard and Yale, was $110–$150 per year—a fairly constant amount from 1880 to 1920. Despite the practice of keeping tuition low, most American families could not afford to absorb the forgone earnings while a son or daughter enrolled in college. Hence, even after World War I, only about 5 percent of Americans between the ages of seventeen and twenty-one went to college.5

The Principles and Pilot of the 1944 GI Bill Affordability and enrollment changed after World War II, when American colleges became unwitting partners in federal programs. For President Franklin D. Roosevelt and the U.S. Congress, the challenge was to adjust wartime production to a peacetime economy that would avert the civil strife of disgruntled military veterans arriving home without jobs. As early as 1943, both Congress and the cabinet had given thought to such postwar recovery plans, but they did not yet include colleges in any central role. In 1944, Congress turned most of its attention to drafting a bill that showcased a program guaranteeing each veteran an unemployment benefit of $20 per week ($195 in 2000 dollars) for one year. This became part of Public Law 346, the Servicemen’s Readjustment Act, which emphasized strategies to suspend the reentry of returning GIs into the labor market so as to allow factories adequate time to retool from manufacturing tank treads to automobile tires. A belated addition to the bill pushed by a few legislators and the American Legion added education benefits. Disagreements between the Senate and House over mixing education with employment benefits stalled the bill. The compromise version passed by one vote in a joint conference. The 1944 bill guaranteed military personnel a year of education for ninety days’ service, plus one month for each month of active combat duty, with a maximum award for forty-eight months of educational benefits. Up to $500 a year would be paid directly to the college for tuition, fees, books, and supplies (at a time when private colleges charged about $300 per year tuition and state universities considerably less).

STUDENT FINANCIAL AID ENTERPRISE IN PERSPECTIVE 23 Single veterans were to receive a subsistence allowance of $50 a month, married veterans $75 a month. When indexed for inflation in terms of dollars in 2000 this was worth $4,800 a year for tuition, with an allowance of $489 a month for a single veteran, or $734 a month for a married student.6 Few expected much of the government’s college plan. A feature article in the August 18, 1945, issue of The Saturday Evening Post observed that GIs were rejecting educational programs in favor of seeking jobs. However, the appeal of the educational benefits abruptly changed. By fall 1945, 88,000 veterans had been accepted for participation. GI Bill college enrollments surpassed 1 million by 1946, and benefits paid out by the federal government exceeded $5.5 billion—the equivalent of $48 billion in 2000. By 1950, more than 2 million of the 14 million eligible veterans—or 16 percent—had used the benefits to enroll in postsecondary education. Hence, many campuses doubled enrollments between 1943 and 1946. At the University of Wisconsin, 11,000 GIs enrolled, pushing the size of the student body from 9,000 to 18,000. Rutgers University grew from 7,000 to 16,000 by 1948. Stanford’s enrollment increased more than twofold, from 3,000 to 7,000. The Servicemen’s Readjustment Act was innovative. It was an entitlement, which meant that all eligible veterans were guaranteed educational benefits. GIs could choose to apply not only to four-year public and private colleges and universities, but also to junior colleges and trade schools, as well as to graduate professional schools. While tuition and benefits payments were “portable” by the student to the institution of his or her choice, institutions had to be federally approved for the funds to be transferred to a campus bursar. This bureaucratic caution was warranted, as veterans became prey for “diploma mills” that often were little more than a post office box and a brochure making false promises of a bona fide educational program.7 Given these unfortunate outgrowths of the American tradition of unregulated higher education, the federal government’s challenge in administering the GI Bill’s scholarship program was twofold: First, a federal agency was needed to protect servicemen from such unscrupulous institutions, and, second, Congress sought an office to be a steward for accountability in spending taxpayers’ dollars for the scholarship awards. Since government agencies really did not want to get into the business of certifying colleges, the federal government agreed to accept as a proxy the institutional evaluations

24 FOOTING THE TUITION BILL rendered by colleges and universities themselves as part of existing voluntary regional accreditation associations. The GI Bill was a temporary accommodation for postwar economic readjustment. Even its proponents did not see its scholarship program enduring indefinitely; yet its success provided compelling support for those who wished to alter American higher education by using federal financial aid to promote affordable access. In the late 1940s, the GI Bill became a model for higher education policy discussions, most notably the 1947 report of President Harry Truman’s Commission on Higher Education, Higher Education for American Democracy.8

The 1947 Truman Commission Report: Access and Affordability President Harry Truman’s Commission on Higher Education had the task of “examin[ing] the functions of higher education in our democracy and the means by which they can best be performed.”9 Truman, in his letter of appointment to commission members on July 13, 1946, asked the commission to concern itself with ways and means of expanding educational opportunities for all able young people; the adequacy of curricula, particularly in the fields of international affairs and social understanding; the desirability of establishing a series of intermediate technical institutes; the financial structure of higher education with particular reference to the requirements for the rapid expansion of physical facilities.10 The commission’s recommendations ultimately would provide the blueprint for subsequent federal policies involving student financial aid and the long-term expansion of postsecondary education. The novel economic argument introduced in the report was that the United States devoted too little of its gross national product to investment in postsecondary education. It concluded with plans for capital investment and taxation to make educational expansion feasible. Immediate reforms were sparse because no existing federal programs or agencies were required to implement the report’s recommendations. Release of the commission

STUDENT FINANCIAL AID ENTERPRISE IN PERSPECTIVE 25 report also suffered from its timing because it was presented just as Truman’s national defense policies were facing a hostile Congress and an unsupportive press. Hence, higher education reforms dropped in presidential priority. It would be ten to twenty years before the report’s influence would shape federal education programs as part of John F. Kennedy’s New Frontier and, later, Lyndon B. Johnson’s Great Society civil rights initiatives. Meanwhile, innovations in large-scale higher education aid programs took place under the auspices of numerous state governments, private foundations, and individual colleges and universities in the early 1950s. Both Democratic and Republican governors and legislators cooperated with state university presidents in California, Illinois, Minnesota, New York, and other states to persuade taxpayers to support higher education. State legislatures in the Midwest and West provided annual appropriations that made college education affordable by providing state subsidies that brought down the price of tuition at state universities far below the actual dollar cost. California, for example, continued its policy of “no tuition charge” at all its public colleges and universities at the same time enrollments rose to three times pre–World War II levels. This reflected a statewide aim to provide affordable, accessible higher education in which high school graduates continued their formal studies. As a result, the portion of high school graduates going to college increased persistently to about 50 percent—a substantial change from about 15 percent at the start of World War II.11 The example of the GI Bill, with its emphasis on grants to students, was extraordinary—and in sharp contrast to the kinds of financial aid offered by colleges from their own resources. This essential difference between the federal student aid program and the student aid provided by colleges themselves was glaring. Even at the best-endowed colleges and universities, during the decade after World War II the practice of emphasizing student loans dwarfed campus awards of grants. For example, between 1948 and 1956, Harvard relied primarily on repayable loans, while grants and direct scholarships were minuscule. In a typical year, the Harvard financial aid office allocated $500,000 for student loans—with only $10,000 dedicated to scholarship grants.12 At Yale in the 1950s the admissions office gave few scholarship grants. Applicants were reminded that going to college meant paying for college. This was reinforced by the emphasis on campus jobs.13

26 FOOTING THE TUITION BILL Some Landmark Developments of the Past Half-Century In 1954, a major breakthrough in standardizing college student financial aid came from the private sector with the creation of the College Scholarship Service (CSS) by 155 independent colleges and universities in New England and the Mid-Atlantic region who belonged to the College Entrance Examination Board (CEEB). The CSS’s contribution was a uniform inventory for estimating student financial need, known as the Financial Aid Form (FAF). This brought consistency across institutions and applicants. Standardization coincided with commitment of academically selective colleges to be both systematic and generous in awarding scholarship grants to students of high ability who demonstrated a need for financial assistance. When college officials adopted simultaneously two policies that were enhanced by creation of the CSS and its FAF—“need-based” aid and “needblind” admissions decisions—colleges then were able to be effective in identifying and financially supporting high-ability students, regardless of family income. According to economist Robert Archibald, The creation of the CSS was a major step for private institutions. The information it collected on the finances of the student and his or her parents allowed the CSS to determine the student’s financial need. The CSS worked with the institution to develop a common methodology for this calculation. In principle, if the colleges to which a student had applied used the CSS formula to determine financial need and provided financial aid awards commensurate with this need, financial considerations would be removed from the student’s decision about which college to attend.14 After the Soviet Union’s successful launching of Sputnik in 1957, student aid received an unexpected boost from the federal government. Congressional hearings were dominated by the question whether American schools and colleges could keep pace internationally with the education of future scientists and scholars. The answer was that federal dollars were necessary to do so. Congress quickly passed the National Defense Education Act (NDEA) in 1958 to maintain national achievement in sciences, engineering, and mathematics.15 It included federally backed loans for student

STUDENT FINANCIAL AID ENTERPRISE IN PERSPECTIVE 27 aid via an appropriation of $295 million for four years, subject to reauthorization for an additional four years in 1962.16 (A summary of some key developments in federal loans is provided in appendix A.) The NDEA student loan program relied on cooperation of the federal government with institutions of higher education. Those colleges and universities whose applications for participation were approved were given monies that the institutions would then award as loans to students in designated areas of study. The federal government provided 90 percent of the loan capital, with participating campuses contributing 10 percent. The initial round of the NDEA included Title IV for student loan programs. Title IV funded 1,500 fellowships per year for students preparing to teach at the college or university level, with each recipient receiving funding for three years of advanced study. Although the NDEA program relied on loans, in practice their provisions often made them closely resemble grants. If, for example, a loan recipient pursued college teaching, loans were forgiven at the rate of 10 percent per year of teaching. Although it was scheduled to end in 1966, Congress reauthorized the NDEA and increased its annual appropriations year after year, reaching $310 million per year by 1979. The NDEA loan program was the prelude to the National Defense Student Loan Program (NDSL), later renamed the Federal Perkins Loan Program. The NDEA made student aid part of domestic programs, namely civil rights legislation, with passage of the Economic Opportunity Act of 1964. This included the Educational Opportunity Grant (EOG)—a landmark in federal student aid that was a direct grant rather than a repayable loan. Over the next decade the program’s name was changed to the Supplemental Educational Opportunity Grant (SEOG). The EOG Program justified federal sponsorship of student financial aid by presenting it as an antidote to nationwide poverty, but by 1965 this rationale changed, as federal involvement in student aid gained high priority in its own right. The principle was that federal grant programs were to provide financial aid for lower-income students, while federal loan programs were to assist middle-income students. This was demonstrated in various provisions of the Higher Education Act of 1965,17 especially in the creation of the Federal Family Education Loan Program (FFELP). Between 1966 and 2006, the FFELP issued more than 134 million student loans, representing more than $416 billion.

28 FOOTING THE TUITION BILL The 1965 Higher Education Act’s Guaranteed Student Loan Program (GSL) expanded the 1958 NDEA loan program. Also, it brought state governments and commercial banks, not just individual universities, into the federal partnership. The GSL worked by serving as a partner with those states that had established student loan guaranty agencies. The federal government would cover 80 percent of the state’s losses in guaranteeing education loans obtained by students from banks and other commercial lending institutions. According to Alfred B. Fitt, general counsel of the Congressional Budget Office (CBO), the hope was that this federal-state partnership for student loan guarantees would attract private capital through banks and other lenders into the student loan market.18 The federal government agreed to pay lenders 6 percent on loans for borrowers who were enrolled in approved college programs and who came from families with annual income under $15,000. GSL terms prompted thirty states to create student loan guaranty agencies between 1964 and 1969. These were the linchpins among federal offices, student borrowers, and banks as lenders. One disappointment was that subsequent participation by banks was sluggish. The federal government’s attempt to jump-start the program in 1967 by raising interest rates paid to lenders from 6 percent to 7 percent made little difference. Evidently, most banks considered undergraduate loans to be risky business. By 1969, congressional supporters of the GSL sought innovations to animate the program. As we shall see, this reform initiative led Congress to create the Student Loan Marketing Association, better known as “Sallie Mae.”

The High Tide of Federal Student Financial Aid Programs: The 1972 Reauthorization of the Higher Education Act Between 1968 and 1972, congressional proposals for higher education funding coincided with the rise of what was called “student consumerism”—the notion that college applicants were a formidable presence in higher education’s market economy. Its connotation was that undergraduates were dissatisfied with the quality of education they were receiving.19 The concept was not new; in fact, it dated back to the 1930s, when Harvard administrators talked among themselves about students as “paying

STUDENT FINANCIAL AID ENTERPRISE IN PERSPECTIVE 29 customers.”20 What was new was that, by 1970, undergraduates were vocal and organized in their criticism of the “impersonality of the multiversity.”21 Students were not only an economic force who made choices about where to enroll; now they were also acknowledged by Congress as a political force, with voting power and influence on public opinion. Higher education administrators and trustees increasingly, albeit reluctantly, acknowledged that students were making a successful claim to being the principal concern. Further, college officials were starting to take heed of students’ purchasing power because college was becoming a “buyer’s market,” in which colleges competed with one another for paying students to fill classrooms and dormitories. Congressional acknowledgment of students as consumers and as voters changed higher education in the early 1970s by making the federal government a source of financial aid. Heretofore the bulk of federal funding had been focused on sponsored research at a small number of powerful universities, along with periodic special projects for capital construction. Even though the 1947 Truman Commission report had emphasized affordable tuition charges, fulfilling that recommendation had received little attention from federal programs. We have seen that between 1964 and 1971 the new federal programs for broad-based student financial aid had emphasized loans. Grants—direct monetary awards that students did not have to repay—usually were restricted to competitive graduate fellowship programs and some entitlements for children of military veterans. But congressional resistance to direct student grants changed as undergraduates gained visibility and as the recognition of the rising price of college grew in the late 1960s. The swing from federal emphasis on competitive research grants toward undergraduate, need-based financial aid came about gradually and unexpectedly. In the mid-1960s, the high-powered research universities were confident that generous funding from U.S. agencies for research eventually would be supplemented by direct institutional aid.22 However, between 1965 and 1972, campus unrest and declining congressional trust in the ability of university administrators to run their own institutions cooled the mutual admiration between capitol and campus. Established research universities faced another source of tension: grumbling among members of Congress who felt that their favorite universities had been underserved at the federal trough. Concentration of research-grant dollars into a small number of prestigious

30 FOOTING THE TUITION BILL institutions rankled legislators from such regions as the South, which lacked institutions in the elite circle of “federal grant universities.”23 This unbalanced patronage weakened congressional consensus in support of emphasizing peer-review research programs at the established research universities. Congress started to show some interest in funding alternatives. The limited role of major universities and such groups as the Association of American Universities (AAU) and the American Council on Education (ACE) in the 1972 reauthorization of the Higher Education Act (HEA) was due in part to a tradition of restraint in which colleges considered political lobbying to be inappropriate for academic institutions. Although they had a presence in Washington, D.C., they did not have a record of effective lobbying. They had little involvement in the 1958 initiatives both by Congress and the Eisenhower administration in drafting the NDEA. This lack of involvement was illustrative of the fractured character of American higher education, and members of Congress often found it difficult to identify a unified higher education “position” on issues.24 So, between 1969 and 1972, when congressional subcommittees started to consider a commitment to need-based student grant programs, established universities and their associations were caught off-guard. Most national higher education groups did not endorse legislation that proposed portable student financial aid rather than direct federal subsidies to institutions.25 To the extent that these groups lobbied Congress, they tended to rely most heavily on their longtime advocate in the House, Representative Edith Green (D-Ore.). According to political scientists Lawrence Gladieux and Thomas Wolanin, many higher education lobbyists failed to recognize the rising influence of Senator Claiborne Pell (D-R.I.). By 1970 he had become the Senate’s higher education leader in his role as chair of the Senate Subcommittee on Education. In Senate Bill S. 659, Senator Pell favored a new emphasis on student financial aid as a means to increase access and affordability in higher education. His vision of an innovative student aid program emerged without much interaction with the higher education establishment and represented a missed opportunity on the part of the latter, who had failed to be alert to this change in the congressional leadership. In 1972, as part of the reauthorization of the Higher Education Act, Congress approved the Basic Educational Opportunity Grant (BEOG). It was later renamed the “Pell Grant” in honor of Senator Pell, who, according to

STUDENT FINANCIAL AID ENTERPRISE IN PERSPECTIVE 31 congressional lore, came up with the idea for the program in 1968 while coming off the slopes after an exhilarating ski run in the Swiss Alps.26 Senator Pell’s novel contribution to the discussion was his use of a systematic formula rather than crude data on family income as a way to identify students whose financial need calculations indicated they were eligible for federal grants. Central to this was the concept of cost of instruction (COI) minus parents’ income tax as a formula to calculate student financial need. Pell’s formula lent itself to coordination with standardization guidelines put in place by the CEEB need-analysis format that had been pioneered fifteen years earlier. Public policies meshed with practices developed by private colleges and their associations to provide uniform, systematic evaluation of student financial aid applications. The BEOG was a quasi-entitlement. Eligibility required that a student be enrolled in an accredited institution of postsecondary education fulltime (defined as twelve credit-hours per semester) and maintain good academic standing. A student who met these conditions could, in 1972, qualify for a maximum of $1,250 per year (equivalent to about $5,100 in 2000 dollars). The financial aid was portable. This meant that although the money would be deposited into a college account upon enrollment, it was actually awarded to the individual student, who would carry the federal award to the college at which he or she chose to matriculate. This “portability” provided hundreds of thousands of student recipients with both college affordability and choice. The reciprocal effect on colleges and universities was that they now had to compete to attract student applicants who would bring their Pell Grant dollars to the bursar’s office. Much to the delight of Congress, the Pell Grant program provided a politically attractive alternative to the proposal that the federal government give direct aid to colleges and universities. The drawback of the “direct institutional aid” strategy was that those institutions not singled out for federal monies would be disgruntled. Congress also was sensitive to controversies associated with the giving of direct institutional support to colleges and universities with religious affiliations.27 Passage of the 1972 higher education reauthorizations and new programs also was due in part to an unexpected development: namely, the lack of opposition by the Nixon administration. A year earlier the presidential administration had stated it would support the BEOG only if it replaced existing campus-based student

32 FOOTING THE TUITION BILL aid programs. Congress supported the BEOG idea, but did so without eliminating the programs the administration had targeted. How to explain this quick turn of events? The answer was that in 1972, the Nixon administration showed little opposition to the final version—in part because of its preoccupation with other matters facing the executive branch. The new legislation increased affordable access to undergraduate education by connecting the portable student grant programs to campus recruiting efforts. Henceforth, each college had an incentive to be responsive to student applicants, an impetus driven by a federal grants program that emphasized student choice as to where to enroll—and hence where to carry the federal grant award. During its first year, the Pell Grant Program received an appropriation of $122 million and awarded grants to 176,000 full-time undergraduates. In 1974 appropriations jumped threefold, to $475 million. Recipients increased to 567,000. In 1979 the program received an appropriation of $2.1 billion and provided grants for over 2.5 million undergraduates. By 1990 the program served 3.0 million students, with awards totaling $4.0 billion per year (about $5.2 billion in 2000 dollars). In 1997–98 those figures had increased to 3.8 million students, with an average Pell Grant award of $1,923 each (about $2,050 in 2000 dollars), for total funding of $3.8 billion (about $4.0 billion in 2000 dollars). The 1972 reauthorization of the Higher Education Act showcased grants as a form of college student aid. At the same time, student loan programs also gained an important new structure. The FFELP was extended by creation of a “government-sponsored enterprise” (GSE)—the Student Loan Marketing Association (known as SLMA or “Sallie Mae”). SLMA quickly became a part of the larger higher education bill.28 The appeal of Sallie Mae was its potential to provide a solution to an unexpected problem faced by the GSL program in 1969. The direct loans from the government constituted by the GSL put a substantial, ongoing burden on the federal budget. The reform strategy was to have the federal government reduce its debt by insuring private lenders, an innovation made possible by establishing a secondary market for GSL. In 1970, the Nixon administration had floated the idea of creating a National Student Loan Association, but dissatisfaction with its details on the parts of both parties in Congress led the administration to withdraw its proposal.

STUDENT FINANCIAL AID ENTERPRISE IN PERSPECTIVE 33 According to Alfred B. Fitt, in his 1979 testimony before the House’s Subcommittee on Postsecondary Education, In layman’s terms, what Sallie Mae does is two things: 1) it buys student loans from banks and other lenders, thereby becoming the owner of the loan and the one responsible for collecting it when due, and 2) it lends money to banks, up to 80 percent of the face value of the student loans made by that bank, with those loans being the collateral to ensure that Sallie Mae will be repaid. In either case, the effect is that the bank’s funds are no longer tied up in its student loan portfolio, and the funds received from Sallie Mae can be turned into more student loans or other kinds of investments a bank may want to make.29 The Student Loan Marketing Association was championed by Senator Peter Dominick (R-Colo.) and gained support for two reasons: First, Dominick was a member of the Senate Subcommittee on Education chaired by Senator Pell; each assisted the other by joint support of the BEOG and student loan marketing proposals. The remarkable feature of the Senate subcommittee was its bipartisan support for student aid, both grants and loans. This was crucial because it moved student loans into the mainstream of the federal–business–bank partnership. The lack of controversy that characterized the inclusion of Sallie Mae in the higher education aid planks was the remarkable feature of the deliberations. Such debate as there was about the future of federal support for higher education took place between two Democrats, Senator Pell and Representative Green, with Green favoring great emphasis on direct funding to colleges and universities, as opposed to Pell’s advocacy for funding portable student financial aid. Meanwhile, Senator Dominick’s student loan marketing plan was attractive across parties because it provided an alternative to Republicans’ interest in pushing for tuition taxpayer credits; also, it brought private lenders into the federal plan. The large scope and success of the federal student financial aid programs did not mean the end of or even a reduction in the various federal research grant programs offered by United States departments and agencies. The legislation did establish student financial aid—along with sponsored research and development—as one of the two enduring planks of federal

34 FOOTING THE TUITION BILL support for higher education. Its other legacy was that, since most postsecondary institutions in the country were receiving monies via the Pell Grant Program, they now were subject to the conditions of federal regulation that went along with accepting such monies. Most significantly, the 1972 reauthorization act positioned the federal government’s higher education policies and programs to give serious attention to college access as part of civil rights and social justice.30

Readjustments of Federal Student Aid Programs, 1978–90 Starting in 1978, federal financial aid programs changed from emphasis on grants for students with financial need toward providing readily available student loans to middle-income students. The Middle Income Student Assistance Act (MISAA) of 1978 was attractive both to banks and to students from prosperous families because, according to a Brookings Institution summary, it “brought college loans to the middle class by removing the income limit for participation in federal aid programs.”31 It was a compromise that once again spared Congress from dealing with a demand for tuition tax credits. Higher education groups were successful in the reauthorization of 1980 in their push to expand this kind of financial aid for middle-class students. However, the inauguration of Ronald Reagan as president in 1981 halted this momentum. As Lawrence Gladieux noted, “Many provisions of the 1980 reauthorization were repealed in the 1981 budget reconciliation, need was reintroduced as a condition of eligibility for guaranteed loans, and an origination fee of 5 per cent was imposed on borrowers as a cost-cutting measure.”32 The congressional changes from 1978 to 1980 signaled growing concern from colleges and universities that federal student aid programs perhaps were starting to veer from commitments set in 1972. All institutions, including public universities with low or no tuition charges and relatively affluent independent institutions with large endowments, monitored student financial aid expenditures as part of larger budget operations. After several years of double-digit inflation starting in 1975, both the price (to students) and the cost (to institutions) of providing a year of full-time undergraduate education had increased substantially. In 1970, for example,

STUDENT FINANCIAL AID ENTERPRISE IN PERSPECTIVE 35 tuition plus expenses at a high-priced independent college was about $4,000. In little over a decade this rose to about $10,000 in 1981. College admissions deans expressed concern that the award amounts and eligibility requirements for the Pell Grants had not kept pace with these changes. The result was that an academically selective and high-tuition independent college in 1981 typically relied on 70 percent of its students to pay full freight so that 30 percent could receive adequate aid to meet their demonstrated financial needs.33 An increased commitment to student financial aid meant cutbacks and tradeoffs in other areas of university operations, such as reductions in library hours and student activities, deferment of salary raises for incumbent faculty and staff, and freezes on new hires. The campus budget crunches brought renewed appreciation for the role of federal financial aid programs in making it possible for colleges to edge toward a guarantee of meeting the full financial need of accepted applicants. Without the federal grant, loan, and work-study programs, all colleges and universities were hard-pressed to achieve a “need-blind” admissions and “need-based” financial aid policy. College officials observed that institutional resources dedicated to financial aid were increasing while the annual percentage increases in federal dollars in the form of BEOG grants were slowing down. College officials claimed that they would not be able to continue providing their customary financial aid packages if federal student aid programs were not increased substantially.

Closing the “Tuition Gap” in Statewide Higher Education Planning: State Scholarships and Independent Colleges Although the nationwide federal student grant programs received the bulk of press coverage in the 1972 reauthorization of the HEA, the reauthorization also included some important inducements to bringing state governments into partnership with the federal government. For example, creation of the so-called “1202 commissions” provided the funding and structure for state-level higher education planning that would be synchronized with federal agencies and programs. An explicit condition of the 1202 commission legislation was that state coordinating agencies were required to include independent colleges and

36 FOOTING THE TUITION BILL universities in their planning and policies. Presidents of independent colleges had mixed feelings about these proposals. On the one hand, inclusion carried with it some threat to the independent institutions’ tradition of autonomy. At the same time, being part of state-federal planning was attractive because, as long as federal and state financial aid policies gave some concern to students’ choice of college as part of affordable access to higher education, government agencies were prompted to include private as well as public colleges in their student aid programs. There was precedent for such inclusion immediately after World War II, when state governments found they could fulfill their responsibility to a new, expanding generation of college-bound high school graduates by quickly finding adequate classrooms and dormitories to accommodate them. As of 1969, twenty states already had need-based student financial aid programs. The California Scholarship Program, for example, essentially provided academically strong high school seniors with tuition vouchers for the colleges of their choice within the state. A student who was awarded a California State Scholarship and offered admission at both Stanford and Berkeley was assured by the California Scholarship Commission that the state scholarship would cover the tuition charge at whichever college the student chose. This saved the state from having to build even more new state colleges, because many scholarship recipients would be enrolled in existing independent colleges. It also gave students optimal choice and allowed the independent colleges to compete for students on the basis of educational choice rather than the price of tuition. These state scholarship programs gained additional support from state governments in the 1970s as a way to make college affordable to a new surge of college-bound high school graduates. In addition to the needbased programs such as California’s expanded Cal Grants program, fifteen states, including Virginia and Massachusetts, had tuition assistance grant (TAG) programs. In these, when a high school graduate enrolled in an independent college in his or her own state, the college received a set amount (about $1,000 in 1980) for that student. The success of these programs was an indication that by 1975, organizations such as the National Association of Independent Colleges and Universities (NAICU) and their state counterparts, such as the Association of Independent California Colleges and Universities (AICCU), had become

STUDENT FINANCIAL AID ENTERPRISE IN PERSPECTIVE 37 effective in student financial aid deliberations in both Washington, D.C., and state capitals. Their presidents succeeded in bringing sustained attention to the so-called “tuition gap”—the differential between public and private institutions in tuition charges. Their argument was that the actual cost of educating an undergraduate at an independent college, as distinguished from the “price” charged to a student, was comparable to (and sometimes less than) the cost at a public institution. At the same time independent colleges and their associations were making effective arguments in the public policy forum, presidents and boards of state universities were concerned that their state appropriations were falling behind inflation and essential institutional costs. By the early 1990s public institutions faced dual pressures from their legislatures: State governments, strapped for funds, prompted state colleges to keep tuition charges low, while at the same time state subsidies per undergraduate were flat or even reduced. This led such spokespersons as President Thomas Wallace of Illinois State University to advance a bold new approach in which public institutions were urged to “emulate” the financing model used by private institutions, a plan that was called the “high tuition and high aid” model. Its real and symbolic importance was that it marked the end of an era in which state legislatures would, as a matter of course, approve substantial per-capita student appropriations for public higher education.

Recent Trends As noted in the preceding section, starting in 1981 federal student financial aid programs became an object of scrutiny by the Reagan administration. Secretary of Education William Bennett, for example, gained nationwide press coverage for his episodic exposés of student aid recipients who allegedly were enjoying spring break revels at Florida resort beaches. Another source of congressional concern was the finding that college costs were rising faster than the rate of inflation, as measured by the consumer price index.34 Double-digit inflation provided only a partial explanation for the rising costs. By 1985, college costs rose when institutions competed with one another to “buy the best.”35 Attracting academic talent, whether students or professors, called for spending, which fueled cost escalation,

38 FOOTING THE TUITION BILL especially at elite universities. This phenomenon led to concerns that some colleges were inflating their costs. In response to these issues, the major policy transformation in federal student aid programs was the pronounced shift from grants to loans. In 1992 Congress approved the Higher Education Act, whose main provision was the unsubsidized loan program. This arrangement permitted students at any income level to obtain federally guaranteed college loans. The following year, Congress passed the Budget Reconciliation Act—an omnibus bill that included provisions for the Federal Direct Loan Program (FDLP), allowing students to borrow money for college directly from the government rather than from banks. Along with these changes the federal government responded to concern over high default on student loans, leading to increased scrutiny of patterns and categories of institutions showing poor loan payment performance by their students and alumni. In the past decade a major development has been the expansion of private loans (known as “private label loans” or “alternative loans”). The student financial aid industry now includes corporations that offer students both federal student loans and information about and access to the private loan market. According to the Institute for Higher Education Policy and The Education Resources Institute (TERI), by 2003 the total volume of private loans had surpassed the amounts awarded annually under the Federal Student Educational Opportunity Grant (FSEOG), federal work-study. Nevertheless, private loans still comprised only a small portion, about 10 percent, of total student loan volume.36 Whereas 28 percent of undergraduates borrowed via student federal loans, only 4 percent borrowed via private loans. The private loans showed inordinate growth in borrowing by graduate and professional program students. This vigorous growth in the private lending market was apparent in 1997 as Sallie Mae obtained permission to dissolve its charter as a GSE, enabling it to perform a broader range of activities related to higher education. These changes did not go unnoticed in the national press. According to an editorial in the St. Louis Post-Dispatch, the privatization of student loans tended to favor lenders rather than help college students. The editorial favored federal programs in which students borrowed directly from the U.S. Treasury, in place of the system in which private lenders lent money upfront to schools, which then made loans to students—and then sold the loans

STUDENT FINANCIAL AID ENTERPRISE IN PERSPECTIVE 39 back to lenders at a premium. The editors’ concern was that the reprocessed loans carried an increased interest rate, while the private lenders benefited from federal subsidies they received for servicing these loans.37 Taking stock of student financial aid that took shape by the late 1990s requires careful distinctions. For example, as we have seen, one trend was the shift toward student loans. As economist Robert Archibald has pointed out, federal programs for student grants and student loans were about even in 1976, but the next two decades showed a persistent increase in loans in both dollars and proportion. In 1985 the disparity was 27 percent grants and 70 percent loans. In 1992 the gulf started to increase again, so that by 1998 the split was 17 percent grants and 82 percent loans.38 The changing proportions tended to mask the fact, however, that the decline in grants as a proportion of the federal programs hardly meant a decrease in federal student grant funding. Between 1995–96 and 2004–5, federal Pell Grant expenditures increased from $5,472,000 to $13,090,000 in actual dollars— an increase of more than 26 percent annually.39 Both loans and grants increased substantially each year, with loans rising at a higher rate. The addition of new loan programs and the expansion of existing ones were comparable to new layers being placed atop the growing federal grant base.40 Furthermore, the profile of student financial aid over the past decade is altered when one considers all sources. Thanks in large measure to the contributions made from institutional resources by colleges and universities themselves, and from state governments, grants to undergraduates remained about equal to the proportion of loans from all sources—with each representing about 46 percent of total student financial aid in 2004–5. This brings us to the situation that was facing students as consumers in the year 2006. A new concern is that the 2005 reauthorization of the Higher Education Act included provisions that changed the terms of interest rates. Editorials in major metropolitan newspapers nationwide emphasized such themes as “Robbing Joe College to Pay Sallie Mae” and sounded the alarm, “College Loan Rates May Jump.”41 Even those articles that were relatively benign on the changes in loan programs expressed concern that students faced “bewildering choices.”42 At the same time, an extensive private student financial aid enterprise consolidated its place in the financing of American higher education, both as an option for students and parents and also as a lobbying presence in Washington, D.C. On balance, federal student loan

40 FOOTING THE TUITION BILL programs have been popular with politicians and bankers, while creating headaches for student applicants and for the federal agencies and campus officials responsible for their administration and accountability.

Conclusion: Connecting Past and Present in Policy Analysis One impression that emerges from a review of the scholarly literature and policy papers published in the late 1970s is that little attention was given to loan programs as part of federal financial aid legislation. This holds for two outstanding books: Lawrence Gladieux and Thomas Wolanin’s 1976 study of the 1972 Higher Education Act, Congress and the Colleges, and the 1978 Scholars, Dollars and Bureaucrats, by Chester E. Finn Jr. It’s not that the topic was overlooked. Rather, it was mentioned in passing, without much controversy. Authors, along with participants in congressional hearings and subcommittees, showed a remarkable consensus: Student loan programs were accepted as part of the federal student financial aid umbrella. There was little disagreement in creating such structures as Sallie Mae. Yet there is little evidence that advocates of student financial aid or economists and political scientists anticipated the dramatic expansion in the scope and scale of federal and state loans as part of the “packaging” mix. Consensus about loan programs as a pervasive yet secondary component as late as 1978 resulted in little attention being paid to the topic in the ensuing years. My reading of the historical documents and congressional subcommittee deliberations suggests that neither the policy architects nor the policy analysts intended or foresaw the subsequent real and proportional growth of student loans as the primary plank in federal student financial aid programs. The sequel to this was belated surprise when scholars discovered that loan programs—including student loan indebtedness—had quietly yet persistently grown to become the main event in higher education’s financial aid enterprise. As befits my analysis as a historian of higher education, the temptation is to conclude that this oversight of student loan programs in such works as Congress and the Colleges and Scholars, Dollars, and Bureaucrats was symptomatic of a lack of historical perspective. After all, except for programs started in 1972, loans have long surpassed grants both at the government

STUDENT FINANCIAL AID ENTERPRISE IN PERSPECTIVE 41 and campus levels as the most common form of student aid. However, this conclusion would be wrongheaded, because it makes little sense to justify the contemporary dominance of federal student loan programs by invoking the historical precedent that student loans also were predominant in some earlier year, such as 1900 or 1940. In those years there was no federal legislation dedicated to helping Americans attend and pay for college. Analysis of student aid programs in 2007 needs to be grounded in the deliberate decisions made as part of what the late Clark Kerr called “the great transformation of American higher education from 1960 to 1980.”43 The pivotal historical fact that still should shape our discussions is that, starting with the federal civil rights legislation of 1964, followed by the HEA of 1965, and reinforced by the 1972 reauthorization of the HEA, the federal commitment has been to making college affordable and accessible. The enduring, important research questions that call for attention from a variety of perspectives and disciplines are, “How is the national commitment to access, affordability, and choice in going to college best fulfilled?” and “What is the appropriate mix of various types of grants and loans which ought to characterize federal programs and public policies in the present and future?” Making certain that the story of the student loan enterprise is part of the historical record on higher education programs is a sorely needed addition to our policy analyses. This ought to include acknowledgment of private and commercial lenders as partners in the federal student aid programs. It is also important to conclude with the historical reminder that the central aim of federal student aid programs is not to build a healthy commercial loan industry. We need to keep in mind the distinction between means and ends, between essential and secondary goals of the Higher Education Act. The landmark legislation that signaled a nation’s commitment to universal higher education calls for foremost attention to whether students have affordable access and choice. The role of private lenders in this commitment is important and understudied. Yet it remains secondary to asking how we as a nation assist students in going to college.

2 Opportunity Costs: The Politics of Federal Student Loans Andrew Rudalevige

As he signed the Higher Education Act (HEA) in November of 1965, President Lyndon B. Johnson told the assembled crowd that its passage was “a historic moment” and proclaimed the “obligation of your Nation to provide and permit and assist every child born in these borders to receive all the education that he can take.”1 Though such grand oratory is hardly gone from discussions of higher education, four decades later the Great Society’s promises have played out in practice on less exalted turf. Politics, after all, is mostly about who gets what, when, and how. These days, with so much “what” on the table—more than $90 billion a year is spent in federal aid to help students fund higher education expenses—it is not surprising that a wide array of actors care deeply about the “how” and the “when” as well.2 This chapter seeks to explicate what they want, and how the politics of student aid plays out—for them, and for the American polity. The political topography of student aid is now shaped largely by fierce debates over the scope and shape of the student loan regime. Over time, federally funded student aid has skewed toward subsidized loans rather than more expensive outright grants, which, despite rising appropriations, have lost considerable buying power since the late 1970s. Even so, the loan regime is a costly proposition. The $62.6 billion spent supporting federal loan programs in 2004–5, as lawmakers considered reauthorization of the HEA, had nearly doubled in real terms since the HEA’s 1998 renewal and tripled since the cycle before that, in 1992. Another $17.3 billion (more than the entire 42

OPPORTUNITY COSTS 43 Pell Grant budget) was lent privately without subsidy—a figure that was just $1 billion ten years ago and is rising sharply.3 With college costs continuing to rise, more students eligible for loans than in the past (including, as of 2006, graduate students), and millions of additional students expected to enroll in postsecondary programs over the next decade or so, today’s atmosphere foments what one close observer calls a “perfect storm for increased lending.”4 Political storms track closely alongside. For many years, higher education was an oasis of bipartisanship, or rather nonpartisanship, viewed in Washington as a public good that everyone should support. The 1965 decision to base the system on private lenders necessitated other decisions, each of which established a cast of actors with certain roles and set the parameters for later debate. This broad structure of the loan regime remained relatively stable, absorbing even the potentially revolutionary notion of direct government lending in the early 1990s. Rather than being periodically rethought, HEA loan programs grew “by accretion—much like a coral reef.”5 (A summary of some key developments in federal loans is provided in appendix A.) Nonetheless, over time, important changes occurred within this stable infrastructure—changes in the types and behaviors of the organisms on the reef. Technologies marched past traditions, and both students and capital became more mobile. More actors—borrowers, parents, lenders, schools— entered more parts of the loan market, in more places. National competition grew for students and their loan dollars, and grew fierce. As a result, the whole aura of the program has changed.6 The key interests in higher education politics want more resources for higher education generally; in that sense, this is not a zero-sum game. But those interests are no longer monolithic. Lenders, broadly speaking, want to maintain a guaranteed return on their loans; but student lending is more competitive than ever, with old boundaries between financial institutions increasingly eroded. Students want lower interest rates and fees and the ability to consolidate their loans on favorable terms; but the student population is now far more varied than the traditional set of eighteen- to twenty-one-year-olds headed away from home for the first time. Schools want to be part of an easily administered system that seamlessly channels aid to their students; but traditional colleges and universities now find themselves competing for those students, and for aid dollars, with a new breed of for-profit institutions. The

44 FOOTING THE TUITION BILL issues may be obscure and technically complex—from budgetary scoring procedures to the “single-holder” rule—but they have enormous potential impacts on students and families, as well as on educational providers and financial institutions. As student lending has become a mature industry, then, it has come to act like one, complete with its own subindustry of organized interests and lobbies. Heavily regulated, with even rates of payment and return legislated and subsidized, the student loan market’s battles over market share naturally carry over to the political arena, where present-day debates are increasingly aligned with party politics and competition. A simple (and, to be sure, sometimes simplistic) heuristic is that, as the business of student aid has evolved, the parties’ positions and constituencies have carried over from other, older battles over the relationship between government and the economy, with Republicans instinctively supportive of competition and private enterprise in lending and in academe and Democrats instinctively skeptical of for-profit industry while supportive of increased government funding and participation in the aid arena. Such fights are real but probably tractable—if policymakers are willing or able to enlarge the pie. What hardens the lines is their residence in the wider context of partisan polarization, especially over fiscal policy. The most recent reauthorization of federal student loan policy, the Higher Education Reconciliation Act (HERA), was passed as part of the Deficit Reduction Act (DRA) of 2005, and the combination of these two measures is both purposive and telling.7 Even the newly Democratic 110th Congress quickly found its promises for loan relief constrained by deficit politics; zero-sum budgetary pressures have seemingly foreclosed conversations on the broader aims of the HEA itself. The politics of market share are occasionally vicious, but rarely visionary. What follows fills in this framework by providing a brief description of the actors and issues involved in the world of federal student loans as it explores the way in which those actors are organized within the loan regime. It tracks those interests through the most recent efforts to reauthorize the HEA—then puts loan politics in the broader context of American policymaking and ponders its future.

OPPORTUNITY COSTS 45 Federal Student Loans: Actors, Organizations, and Issues A multiplicity of actors has been created, served, or empowered by federal loan policy. As Michael Mumper has observed, “The allocation of federal student aid involves a wide variety of tasks, and a substantial industry has developed around each activity.”8 The inhabitants of the student loan landscape include colleges and students, of course, but also lenders, secondary markets, guaranty agencies, consolidators, consultants, marketers, debt collectors, and even specialists in asset-based securitization. Confusingly, many of these roles are beginning to blur together, or to be played by the same institutions. But consider the basic sequence of actors involved as a loan is issued and paid off. College financial aid officers direct students to their loan options, funded either by the government (if the institution participates in the direct lending program) or, more often, by a lender participating in the Federal Family Education Loan Program (FFELP). If the latter, that originating lender almost always sells the loan to a secondarymarket organization,9 which itself may work with specialized financial organizations to underwrite their holdings or contract out the loan’s servicing. Students who take out more than one education loan over time may consolidate them into one, perhaps using an entity created for such work. No matter who holds an FFELP loan, it is recorded, tracked, and insured against default by a guaranty agency. Of course, not all students repay their loans. At that point, debt management operations go to work, whether run by guaranty agencies and secondary-market organizations or by collection agencies. This section discusses the issues important to each set of actors in this process, keying in on the recent reauthorization process while providing relevant recent history. The story describes an array of organized interests striving for access and influence. But, as students of interestgroup politics know, not all groups are created equal. Some are hard to create in the first place—especially those representing large, diffuse populations—while smaller groups with direct material interests in an outcome tend to overcome barriers to collective action more effectively.10 Thus, in the student loan arena, lenders have found it easiest to organize, while students themselves have found it hardest. Colleges fall somewhere in between.

46 FOOTING THE TUITION BILL Institutions of Higher Education. Colleges and universities do not form a particularly coherent category, given the 6,400 or so institutions of higher education with students eligible for federal financial aid under Title IV of the HEA. Of these, 2,100 are public, with 600 four-year schools and 1,500 two-year schools splitting nearly 80 percent of the 15 million–strong collegiate population. Another 1,500 or so are private, four-year nonprofit institutions, while 2,300 are for-profit or “proprietary”; the latter enroll just 4 percent of all students, though this figure is growing fast, and their students account for a disproportionate share of loan dollars.11 This diversity translates into a myriad of overlapping organizations representing the higher education community. Take, for example (among many others), the Association of American Universities (AAU), representing large research universities; the National Association of Independent Colleges and Universities (NAICU), including the AAU group plus other selective fouryear schools; the National Association of State Universities and Land-Grant Colleges (NASULGC); the American Association of State Colleges and Universities (AASCU), for four-year public institutions not represented by NASULGC; the American Association of Community Colleges (AACC), for two-year schools; and the Career College Association (CCA), for the forprofits. Other associations cut across these groups, along functional or professional lines, ranging from the American Association of Collegiate Registrars and Admissions Officers (AACRAO) to the National Association of Student Financial Aid Administrators (NASFAA). But while divisions among these latter groups—college presidents versus financial aid officers, for example—can certainly occur, the most common cleavages run along institutional lines. As Chester E. Finn Jr. observed long ago, each HEA program benefits certain types of postsecondary institutions and students more than it does others. Thus . . . each has both zealous defenders and zealous critics. Although the multiplicity of programs and the complexity of the system diffuse some of the conflict that would otherwise develop, student aid is the area of federal policy in which the fiercest battles are waged among colleges and universities.12 The American Council on Education (ACE) is the umbrella organization for the “traditional,” or nonprofit, institutions, charged with bringing

OPPORTUNITY COSTS 47 order to potential chaos. An ACE representative told an interviewer in the 1990s that “we try to keep the various parts of higher education from killing each other in public.” Dr. Terry Hartle, now the group’s head of government relations, recently affirmed that “there is a community, it is organizable, and usually we get organized.”13 When that happens, the higher education community has a strong hand to play in higher education politics. (The proportion of members of Congress who attended NAICU member schools normally ensures at least some access.) The ability of peak organizations to get everyone on the same page, though, varies across the dozens of issues encompassed by the full sweep of the HEA. One issue in the most recent reauthorization that succeeded in uniting and galvanizing schools was an effort by Representative Howard “Buck” McKeon (R-Calif.) to penalize those that failed to rein in tuition increases. On student loans, however, the traditional colleges found it harder to assert a distinctive point of view in that process. They wanted more grant aid, to be sure, and for any savings realized by adjusting the loan program to be funneled back into the overall student aid budget. But as specific details were hammered out, it was not clear, as congressional staffers viewed it, that they “saw this as their fight.” One industry observer suggested they were “conscientious objectors” as the loan battle progressed; certainly, discussions over a common position started late. In part, that was a matter of practical politics. Colleges wanted their students to have ready access to enough aid to pay tuition; to this end, a stable system was more important, within limits, than the tweaking of rate formulae; and from this vantage, the present system, however imperfect, met this goal. Here some higher ed associations could find common ground with financial institutions: The Coalition for Better Student Loans (CBSL) brought together ACE, NAICU, AAU, NASULGC, and NASFAA with the Consumer Bankers Association (CBA) and other lenders to lobby for increased annual loan limits for students, lower loan origination fees, longer repayment periods, federal money for loan forgiveness, and changes to loan consolidation.14 But this alliance attracted dissent as well. Higher loan limits, for example, while probably the issue most critical to the elite four-year colleges, were not widely supported by lower-cost public institutions or community colleges, and were opposed by student groups. Consolidation,

48 FOOTING THE TUITION BILL in turn, though representing a large (and largely hidden) cost to the loan program, was an issue of interest mostly to traditional lenders fighting off new consolidation specialists, spurring charges that schools had been coopted by their close relationship with their lending partners.15 Further, while some on campus were certainly tuned in, “student loan issues are so complex that when you dig beneath the surface people run screaming from the room,” as one participant put it. This made it hard to get full engagement on those issues. When “education-majors-playingbanker” negotiate with “real bankers,” as another, rather less sympathetic, observer suggested, the latter have the advantage in shaping the policy formulation process. Still, even a higher education community unified, energized, and saturated with bond traders would have faced difficulties. The Republican majority in Congress generally distrusted academe’s claim to speak for the public interest, did not welcome the traditional schools’ input, and (in one lobbyist’s view) “dealt them out” of the reauthorization as “persona non grata.” That designation was long-festering, and it cut both ways. Nasty exchanges in the press over the cost-containment issue in 2003 only hardened the divide. In 2004, one insider noted wryly, the Washington-based higher education associations “played a ‘Texas hold ’em’ game,” banking that President George W. Bush would fail to be reelected. In the end, they “went all in—and lost.” Like any unsuccessful gambler, they then lost their seat at the table as well.16 Further, at other important tables—those that sell for $2,000 a plate at Washington campaign receptions—the traditional higher education associations have rarely had a place setting. As one lobbyist noted, the colleges “do not play by modern political rules.” They do not organize political action committees (PACs), host fundraisers, or seek to mobilize local voters. Indeed, they have not seen themselves as political operatives or even, at heart, as trade associations, but rather as conveyors of the public good and institutional policy memory. Whatever its virtues, that approach means, as one Capitol Hill staffer concluded, that “members [of Congress] are not afraid of them.” On the other side of the “proprietary”/“traditional” divide, though, the CCA has been assessed as, “of all the higher-education groups, the most sophisticated at lobbying.”17 The growth of the for-profit schools in the last

OPPORTUNITY COSTS 49 decade has been impressive, driven in part by the distance-learning enabled by increasingly refined telecommunications technology and pedagogies. And their lobbying strategy has kept pace. Largely unified, and under no illusion about the material interests at stake, the for-profit community has embraced the modern political rulebook. In the 2003–4 election cycle, for example, some $350,000 was donated by proprietary institutions to House members on the Education and the Workforce Committee, 80 percent of it to Republicans, and 80 percent of that to the campaign accounts and leadership PACs of then chair John Boehner (R-Ohio) and vice-chair McKeon. The general assessment of the issue network expressed in interviews with the author is that the for-profits “play the insider game as well as any industry in Washington.”18 In some areas—higher loan limits, for example—the interests of the non- and for-profit institutions converged, and here the proprietary schools let the “traditional” community lead the way. That allowed the for-profits to focus instead on a variety of key, low-salience changes that would enable them to regain their footing in the HEA a decade after the 1992 reauthorization cracked down on loan defaults and correspondence schools. Senator Sam Nunn’s (D-Ga.) 1990 investigation into the loan industry was scathing, reporting “overwhelming evidence that the [federal program], as it relates to proprietary schools, is riddled with fraud, waste, and abuse.”19 Various (largely successful) efforts were made to lower default rates and to cut off Title IV funding to “diploma mills” that failed to provide the skills students needed to get the jobs that in turn would enable them to pay off their loans. Two legacies were the so-called “90-10” and “50 percent” rules. The latter restricted access to Title IV funds (that is, HEA loans) for schools offering more than half their courses offsite or enrolling more than half their students in such courses. The 90-10 rule required schools to receive at least 10 percent of their funding from a source other than Title IV, so as to require that an institution have some form of organizational integrity outside of the federal student aid it received.20 Fifteen years later, the proprietary schools hoped to repeal these rules. Distance-learning had eclipsed the 50 percent rule, they argued, and policing of loan fraud precluded the need for 90-10. Furthermore, they hoped to have their courses accepted as transfer credits at traditional schools, and to create in law a single definition of higher education institutions. David Moore, the CEO of Corinthian Colleges Inc., testified that the latter “would

50 FOOTING THE TUITION BILL send an important signal to these students that for-profit institutions represent an equally valid option for the pursuit of their higher education and training”; not coincidentally, such a change could also open up funding under the other titles of the HEA to for-profits.21 Most of these changes were opposed by the traditional schools, which happily pointed out media reports of proprietary schools’ legal and ethical missteps.22 Still, as one legislative staffer argued, given that “student cohorts are shifting very quickly, why should Yale and Harvard be driving [policy]?” The Republican majority’s disconnection from traditional higher education ensured a sympathetic hearing for the proprietary schools. “More and more,” the CCA’s Nancy Broff noted, “we’re seen on Capitol Hill—or by the Republican leadership at least—as an important part of the solution, rather than as part of the problem.”23 Students. In 2004, close to ten million undergraduate students and their parents held federal loans. The sheer size of that cohort represents immense potential political firepower—but in practice that power has often proved diffuse and difficult to focus. Raising the salience of student aid issues, even to students, is not an easy job; the label “student” itself encompasses a membership in constant flux, and one, in any case, generally focused on campus concerns more than national policy. Unlike their French counterparts, American students are not organized into a movement ready to blockade the streets at a moment’s notice. Instead, two groups serve as the principal channels for students on Capitol Hill. The United States Student Association (USSA) dates back, through predecessor organizations, to 1947; today it claims representation for “millions of students” and status as “the recognized voice for students” in Washington.24 In practical terms, it shares that status with the U.S. Public Interest Research Group (US PIRG), created in the early 1970s as the national advocacy office for state-level PIRGs. The state PIRGs have campus chapters with steady financial support underwritten by dues assessed upon students at each campus. Those funds are distributed by statewide boards run by students and subsidize permanent staff in state capitals and Washington. USSA, by contrast, has shorter-term staff who rotate through its governmental relations positions every year or so; that turnover is good for representativeness, but perhaps less so for representation.

OPPORTUNITY COSTS 51 “Students have the least of everything—resources, access . . . ,” one congressional staffer noted. And certainly USSA and US PIRG were looked upon warily, at best, by Republican policymakers, who perceived the groups as allied with Democrats, particularly in the House. Combined with a decade’s worth of growing polarization, that meant that the student groups could be dismissed by the GOP, fairly or not, as serving partisan, rather than public, needs—as not representing “real” students, especially nontraditional ones. Republicans did not want to write off students per se, or the votes of their middle-class parents, but they saw student interests differently than the student groups did. On loan issues, for instance, they thought on-campus financial aid administrators (that is, NASFAA) served as a more reliable proxy for student interests. Thus, the national student groups took an outsider’s approach—both US PIRG and USSA relied heavily on grassroots mobilization efforts, many of them Internet-based, to pressure policymakers. Waging debate through the press ran the risk of hardening battle lines rather than spurring negotiation. But it took advantage of the groups’ two most useful tools: a healthy dollop of moral authority, and what one lobbyist called “a good microphone.” Media stories on student loans, after all, required student comment, and the Washington, D.C.–based groups were easy to find and ready to provide it.25 During the most recent HEA reauthorization, student groups sought to use their microphone to advocate for increased grant aid and lower interest rates. Rates, it should be noted, had long been the object of congressional tinkering. They shifted from fixed to variable in 1992, which turned out to be a good deal for students over time as market rates dropped sharply. In 2002, however, new legislation established that rates would remain variable for lenders but become fixed for students (at 6.8 percent) as of July 1, 2006. Given projected increases in interest rates, student groups saw this as a good deal at the time; by the 2005 reauthorization, that was no longer the case, and they sought a better one. To this preference were added generous terms for loan consolidation and opposition to higher loan limits. These arguments centered on debt burden as the crucial variable, since debt was increased by larger loans (especially to the extent that these facilitated tuition increases), and eased by generous consolidation terms (especially with low variable rates). “The

52 FOOTING THE TUITION BILL conversation about affordability,” PIRG’s Luke Swarthout noted, “can’t end until the last loan payment is made.”26 These priorities put the student groups at odds not only with their usual antagonist, the lenders, but also with their usual ally, the traditional higher education community. The latter suggested that the student groups’ stands on consolidation and loan limits were shortsighted, arguing that low-interest loan consolidation provided “debt relief for former students” at government expense, but no additional access to higher education looking forward.27 Loan limits, likewise, had not been raised since at least 1992, and while raising them would likely raise debt levels, it could also help recruit and retain future first- and second-year students. One result of this disagreement—and of traditional higher education’s own concurrent lack of access, as noted above—was that student groups actively sought out other allies to provide entrée to the moderate Republicans who could scuttle the reauthorization. Once the HEA bill became entangled in the budget reconciliation process, such partners included labor activists concerned with pension benefit regulation and environmentalists fighting oil drilling in Alaska. This last may have given new resonance to the notion of an “outside” strategy. Lenders and Guarantors. Large federal expenditures on student aid are a relatively recent phenomenon. The Federal Family Education Loan Program (FFELP) was born in the 1965 HEA as something of an afterthought, seized on by President Johnson as a “tactical diversion” to forestall the creation of generous tax credits for education spending. Guaranteed student loans (GSLs, now called Stafford loans) were expected to provide middleincome students not eligible for the HEA’s need-based grant programs with access to loan capital. Interest was subsidized, rates were fixed, and loans were to be guaranteed through federal support for state-based funds administered by guaranty agencies like those already existing in several states.28 But students were mobile, small-dollar, high-risk borrowers—not an attractive market. As time went on, then, the government added more resources and incentives to the mix. The statutory interest rate rose and was joined shortly thereafter by a supplemental rate of return for lenders called the “special allowance.” A reinsurance program was created to protect state and nonprofit guaranty agencies against defaulted loans; later, they were assured

OPPORTUNITY COSTS 53 full reimbursement of defaulted loan balances. In 1972, Congress created the Student Loan Marketing Association (SLMA, or “Sallie Mae”) as a quasipublic enterprise charged with generating a secondary lending market in the student loan industry, buying extant loans and thus creating liquidity for new loans. Others were authorized, too, and there are now some three dozen secondary-market organizations. These changes boosted loan supply, while additional amendments would soon explode demand. In 1980, for example, the new Parent Loans for Undergraduate Students Program (PLUS) allowed parents to take out additional, separate loans; by 1992 new, “unsubsidized” Stafford Loans were opened to all students, regardless of need.29 As the population eligible for loans increased— and tuition rose—both families and banks moved to take advantage. An important development in the early 1990s was the creation of the Federal Direct Loan Program (FDLP), which bypassed private lenders by providing loans from treasury funds disbursed and serviced by colleges themselves. Supporters of direct lending argued this was simpler for students and cheaper for taxpayers, since the government would earn interest on its funds as loans were repaid, but would not have to provide financial institutions with extra subsidy payments. Traditional lenders and secondary-market organizations, naturally, were less enthusiastic. But the idea appealed substantively to new president Bill Clinton, who found, too, that bashing banks proved politically potent. Still, efforts to replace the FFELP entirely with direct lending fell short, and colleges were allowed to choose which program they wanted to utilize. Direct lending captured about a third of the loan market by 1996.30 That figure, however, is now down to approximately one-quarter. Indeed, the market for student loans has become increasingly competitive in the past decade—both between direct lending and FFELP, and within the population of FFELP lenders. Yet that competition takes place within a heavily regulated arena: FFELP loans are the only form of credit with rates set in law, with such generous terms for debtors or guarantees for creditors. These two characteristics mold each other—that is, the fact of competition shapes what lenders want the regulatory regime to provide, and the government’s promises help attract lenders to the competition. Lenders frequently threaten to leave FFELP, and a few have, indeed, made that choice. Lenders receive a relatively narrow yield per loan.31

54 FOOTING THE TUITION BILL Thus, profits sufficient to keep shareholders happy require a large volume of loans. This is possible, to be sure—Sallie Mae’s total return to investors grew by some 26 percent a year over the period 1995–2005, according to the 2006 Fortune 500 profile of SLM.32 But seeking that volume stokes the fires of competition, which may express itself through diversification into other areas of the industry, or through seeking efficiencies. Or it may attempt to shape government policy to create a “level playing field” (assuming one that tilts toward oneself is not available). A number of organizations serve the range of financial institutions involved in student loans. The Consumer Bankers Association (CBA) represents traditional retail financial institutions. The heart of the National Council of Higher Education Loan Programs (NCHELP), in turn, is the nonprofit agencies—that is, the secondary-market organizations (again, institutions that buy extant loans, freeing up primary lenders for additional loans) and those guarantors that remain independent operators—but it comprises 160 members, including lenders, loan-servicers, and collectors. NCHELP thus cares not only about HEA issues, but also about the loan program’s administration between reauthorizations. By its own calculation, it does somewhat less lobbying than its sister organization, the Education Finance Council (EFC). EFC’s core members are thirty secondary-market organizations, most of them state-chartered agencies. But it counts another sixty-plus companies from across the FFELP landscape as affiliates. Thus, all three organizations have overlapping memberships. And, given that the substantive parameters of the loan regime are common to all FFELP members, the lending community generally starts on the same page when it comes to Title IV issues. On the basics, as one Capitol Hill staffer observed, “They’ve been very good at sticking together.” Not surprisingly, lenders prefer more profit to less, and more protections against default to fewer. They are thus strongly committed to maintaining their specialallowance yield guarantees and maximizing the reimbursement they receive when a loan defaults (which, they argue, ensures access to credit for a lessthan-creditworthy population). With their higher education allies in the Coalition for Better Student Loans (CBSL), they favor higher loan limits. And, since direct lending by the government eliminates the need for most of the FFELP infrastructure, the FFELP community strongly opposes the expansion of FDLP. In its immediate wake, direct lending had actually done

OPPORTUNITY COSTS 55 a favor for the lending industry; it “woke us all up,” notes one insider. But since 1993, FFELP lenders have fought back against FDLP’s intrusion into their market share, and done so quite effectively. In the 2005–6 reauthorization, that meant opposing efforts to give incentives to colleges to move from FFELP to FDLP, and favoring technical changes that, depending upon whom one asked, either helped equalize the terms of the two programs or hindered FDLP from effective competition with FFELP. If, on these fundamental issues, lenders have been united, the 2005–6 reauthorization nonetheless revealed clear fault lines within the industry. One such divide resulted from classic balance-of-power politics: It pitted Sallie Mae, whose privatization33 brought a huge new player to the frontend business of loan origination, against everyone else. Sallie Mae holds some $102.3 billion in loans—about a quarter of the market, and about the size of the entire FDLP—with Citibank its closest FFELP rival at $24.6 billion. As a quasi-public secondary market, SLMA was allowed to buy loans and service them, but not to work on the front or back ends of the lending sequence—that is, in loan origination or collection. Its executives found this decreasingly profitable as succeeding reauthorizations shaved lender yields; and the 1993 debate over direct lending was a threat to the corporation’s very reason for being. Sallie Mae therefore began to look for ways to diversify and, eventually, to privatize. SLM Corporation, as Sallie Mae is now officially known, expanded rapidly along the way, becoming a market leader in loan origination and working with or acquiring other companies to boost revenue streams throughout the life (and death) of a loan.34 SLM contracts to provide administrative services for various guaranty agencies, as well as to service loans for other lenders. At the back end, USA Group, bought by SLM in 2000, manages nearly 20 percent of the nation’s defaulted loan portfolios for six guarantors, joined in 2004 by the Arrow Financial Services loan-collection business, whose website notes its “full range of recovery solutions across a variety of asset classes.”35 SLM is affiliated with both NCHELP and EFC, and often works with CBA. But its bulk has sometimes encouraged it to see its interests differently than other lenders see theirs. And it has led to charges that “Sallie Mae is on the march to monopoly,” especially as the corporation has sought to expand further by buying competitors such as the Pennsylvania Higher Education Assistance Agency (PHEAA; see below). SLM, in turn, argues that its size

56 FOOTING THE TUITION BILL makes it a target; that market share is consistently very fluid; and that accusations of monopolization simply serve political or competitive ends.36 Another split is between nonprofit and for-profit agencies. As noted above, the guaranty agencies and secondary-market organizations arose in historical circumstances in which loan capital was scarce and expensive. Lending’s sequential functions were considered structurally separate, and federal policy dealt with each discretely. As the loan market developed, though, it outpaced the agencies’ original function. Indeed, when asked what guaranty agencies do, one observer replied that “people have been wondering that for twenty-five years.” The agencies have been seeking to evolve their role, and in the 1998 reauthorization they made major gains in financial flexibility.37 In 2005–6, they were happy simply to protect those gains, though they also hoped for two other things: to uncap the total pool of administrative fees paid by the government, and, more existentially, to gain a designation in statute that they would serve as central access points for a wide array of information on postsecondary education within their territory. But by now such designations may be beside the point. Banking technology has evolved dramatically since the 1970s, and what is torn asunder by statute may yet be joined by the logic of the market. The SLM acquisitions noted above are only some of the mergers prompted by industry players seeking the greater economies of scale (and higher profits) that higher volumes and diversified functions can produce.38 Some state nonprofits have likewise transcended their origins as localized entities to explore the wider competitive market beyond their old territories; PHEAA, for example, operates as American Education Services (AES) to originate and service loans nationally. Thus, between organizations ostensibly labeled “lenders” and those labeled “secondary markets” or “guaranty agencies” stands only what those in the industry call a “very blurry line. . . . Everyone wants to be everything because that’s how they have to work,” given the role of loan volume in reducing unit costs and increasing profitability. “The more parts of [the market] you’re in, the better.” This heightens the stakes for all of these actors, as was made clear when SLM offered $1 billion to buy PHEAA in December 2004. Within two weeks, PHEAA had distributed a fifty-seven-page booklet to Pennsylvania legislators, colleges, and news outlets, complete with a list of SLM’s top-salaried

OPPORTUNITY COSTS 57 employees, entitled “Sallie Mae Executive Greed.” The agency warned of “a profit-hungry monopoly controlling the costs of student aid,” charging that Sallie Mae would destroy competition, raise loan fees, lay off workers, and (in PHEAA board chair Elinor Taylor’s phrase) “gobbl[e] up any organization that stands between students and a quest for bigger profits.”39 Harrisburg’s congressman even introduced the “Student Loan Marketplace Equity Act” to require the industry’s “dominant lender”—that is, Sallie Mae—to pay an annual surcharge on its loan portfolio to the government. This represented a potential assessment of more than $250 million.40 Sallie Mae in turn accused PHEAA of “throwing a boulder in a glass hut,” pointing out the agency’s control over access to the lucrative Pennsylvania loan market and charging PHEAA, whose twenty-member board includes sixteen state lawmakers, with bloat and inefficiency at taxpayer expense. Hundreds of millions of dollars, SLM claimed, were stored in PHEAA accounts or given in executive compensation rather than being returned to student aid programs.41 Though SLM ultimately withdrew its bid, state budgets were tight, and Pennsylvania Governor Ed Rendell’s ears naturally perked up at the claim of fallow cash reserves. So did those of the governors of Illinois and Missouri, who suggested selling the assets of their own loan agencies to SLM or other corporations in order to fund new education-related capital and scholarship projects. Their proposals set off similar firestorms in those states, too—in part fueled by PHEAA, which owns loan-servicing contracts nationally through its AES subsidiary and competes with SLM and its subsidiaries in a number of states. The vehemence of the battle underscores the fact that student loan politics have spread to all levels of government.42 A related issue that split the industry was the question of how strongly to defend efforts to repeal the so-called “recycling” of “9.5 percent loans.” Before October 1993, lenders using certain tax-exempt bonds were guaranteed a minimum return of 9.5 percent on those loans, which continued past that date as creative (but quite legal) refinancing mechanisms used to extend the original bonds. As interest rates to borrowers edged downward to historic lows (to under 3 percent by 2004), paying the spread proved to be an expensive proposition for federal taxpayers. Controversy over the practice thus grew alongside its profitability.43

58 FOOTING THE TUITION BILL The issue was particularly important to nonprofit institutions, which had wider access to such financing. They used the windfall to fund incentives such as fee and rate cuts to potential borrowers. (PHEAA, for example, received over two-thirds of its income in 2004 from 9.5 percent loans, and was the first lender to waive all origination fees for students.) Defenders of the loans conceded that the “talking points in favor are terrible,” but that the practice should continue, or at least be phased out gradually. The subsidy, they argued, was channeled fully back into student benefits at the local level, far more effectively than those funds would otherwise be allocated by the federal government, and it forced competing for-profits to cut costs to students as well. For-profit lenders argued instead that the practice could not be defended either substantively or perceptually, and that the excessive returns gave the industry a “giant black eye.” (Nonprofit officials darkly wondered in turn if Sallie Mae’s real reason for wanting to eliminate the subsidy was to lower the sale price of potential takeover targets like PHEAA.)44 A third cleavage opened over loan-consolidation procedures. As noted above, as interest rates plummeted in the early 2000s, variable rates on student loans dropped accordingly. Students thus consolidated their loans in record numbers, even before graduating from school, a strategy that locked in the low rate for the life of the loan. A new and aggressive assortment of freestanding entities emerged to market and/or service consolidation loans, often utilizing the direct-lending program as, in effect, a refinancing mechanism.45 This, too, was extraordinarily expensive to taxpayers, since as interest rates rose again, the variable rates paid to lenders far exceeded the new fixed rates being paid by borrowers, and the government subsidized the difference. Traditional lenders argued this was a bad use of resources, while consolidation lenders argued that the traditional lenders simply feared the new competition. Student groups, naturally, liked the savings students could reap from low-cost consolidation. Consolidators also urged repeal of a regulation called the “single-holder rule” that limited their ability to recruit borrowers. This rule required that any lender who held all of a given student’s loans be the consolidation lender as well; since it benefited loan originators, traditional lenders wanted to keep it. The threads of political and marketplace competition are thus hard to untangle. The various lending groups did unite in relying heavily on insider strategies; the changes they seek have important fiscal ramifications, but are

OPPORTUNITY COSTS 59 largely technical and unfamiliar to most Americans. The key, then, has been not to sway the public but to utilize access to officials. That, in turn, has meant—though sometimes the requirement is resented—having what one observer called “money in the game.” Lenders, broadly defined, surely do. Their efforts have been targeted especially toward leadership and party organizations, and former education chair John Boehner’s relationship with the lending community has been criticized as particularly tight. For example, Sallie Mae hosted a party for Boehner during the 2004 Republican National Convention, and his leadership PAC received over $200,000 from individuals affiliated with the FFELP industry in the 2003–4 campaign cycle.46 Such contributions are seen as crucial, but not so much to change votes as to gain a hearing. They serve, as one lobbyist has suggested, to “separate the men from the boys.” In this area, the loan industry is all grown up. Indeed, in December 2005, Boehner told those gathered at a CBA meeting to “relax. Stay calm. . . . Know that I have all of you in my two trusted hands.”47 Nonetheless, if there was calm across the student aid community at that point, it was a dread calm. To see why, we must turn to the process that prompted Boehner’s attempts at reassurance.

The Higher Education Act, Forty Years On The recent attempts to reauthorize the Higher Education Act—and the resultant HERA of 2005, which reauthorized HEA’s Title IV student loan provisions—usefully trace the interplay between the interests described above and American political institutions.48 The first thing to note about the 2005–6 HEA process is that the 1998 reauthorization expired in 2003. As early as 2001, the House Education and the Workforce Committee launched what it called the “FED UP” initiative—short, sort of, for “Upping the Effectiveness of Our Federal Student Aid Programs”—to solicit input from parties interested in reauthorization. Yet it was not until 2005 that the reauthorization bill moved forward. Why so long? The cynical answer is that it is always better for campaign fundraising if legislation is pending rather than complete. But probably the delay flowed more from a sort of benign ambivalence: No crisis drove the

60 FOOTING THE TUITION BILL process the way loan default rates had in 1992, or interest rates in 1998. Reauthorization was needed, legally, but it was no one’s top priority. The sluggishness also stemmed from a sequence of substantive objections by different constituencies. The disagreements traced above undercut any consensus that might have made the bill easier to formulate legislatively. Indeed, the traditional higher education institutions soon came to feel that being ignored was preferable to sustained Republican attention: Cost containment proposals in a 2003 bill creating a “College Affordability Index” would have required schools to report detailed data on their costs and aid packages, placing those that consistently raised their charges above the rate of inflation on “affordability alert status” that could lead to federal audits and restrictions on their Title IV eligibility. In the 2004 version, colleges continued to object to a broad array of new accreditation and reporting requirements, as well as to enhanced transfer-of-credit provisions, various pro-proprietary changes, and mandates to “promote . . . diverse [ideological] viewpoints” they felt infringed on academic freedom.49 Generally, House hearings on HEA reauthorization focused on these sorts of hot spots within the field, examining incremental change within a tight fiscal framework rather than the broader themes and principles underlying the federal relationship with higher education. Few rank-and-file House members dug into the technicalities of the aid regime, leaving the field to representatives Boehner and McKeon, widely considered the most knowledgeable of the committee Republicans on this topic.50 Expertise was marshaled in many cases less to persuade uncertain legislators, if they existed, than to support an approach to reauthorization confidently grounded in a set of principles and preferences centered on private-sector delivery and competition.51 When a 2004 committee hearing asked, “Are Students at Proprietary Institutions Treated Equitably Under Current Law?” chairman Boehner didn’t keep his listeners in suspense: “The answer,” he noted early in his opening statement, “is ‘no’. . . . There is a problem when innovation is stifled through outdated regulations.”52 More generally, as one staffer put it, “We wanted to make sure all students had access to some form of higher ed. . . . You as a student should not be punished depending on where you choose to go to school.” Such principles obviously favored certain constituencies, but it is simplistic to argue that they were first determined by those constituencies.

OPPORTUNITY COSTS 61 House debate was also marked by the rejoined battle between direct lending and FFELP, a front in the broader partisan war reopened in part by the fact that the consideration of HEA took place in the context of dire fiscal constraints. Direct lending is “scored” as a cheaper program than its FFELP stablemate by government budget analysts, adding real political attraction beyond its substantive merits. But an effort by committee members (mostly Democrats) to give colleges fiscal incentives to switch to direct lending was defeated along near-perfect party lines, as dueling expertise was utilized to buttress preexisting positions.53 If a measure was philosophically objectionable, but ostensibly saved huge amounts of money, how to judge? The answer was to marshal plausible arguments that the Congressional Budget Office’s math was wrong. The committee reported that it was increasingly concerned that the subsidy estimates for the [FDLP] do not reflect the program’s true cost. . . . Any claim of budgetary savings from shifting loan volume among the student loan programs is premature. This will remain the case so long as a flawed and incomplete system of accounting remains in use.54 One reason Sallie Mae had input during the House process, according to a non-SLM lobbyist, was because it could provide a “walking textbook on the budget of student loans” that systematically critiqued that “flawed . . . system of accounting” for pro-FFELP members of the committee. The textbooks Democrats used came with fewer votes. On the Senate side, the Health, Education, Labor, and Pensions (HELP) Committee did not consider a specific bill until well into 2005, after Michael Enzi (R-Wyo.) took over the committee helm from Judd Gregg (R-N.H.). Enzi forged a working agreement with ranking member Edward Kennedy (D-Mass.), saying the committee would work on the 80 percent of issues they could agree on and leave those that divided them for consideration on the Senate floor. Notably, while the House Education and the Workforce Committee website had a small link marked “Democrat views,” and for a time headlined links jointly “highlighting House Republican action on student aid” and “exposing House Democrat election year hypocrisy,” the Senate HELP site gave roughly even treatment, textual and photographic, to both the chairman and ranking member.55

62 FOOTING THE TUITION BILL The bipartisan Enzi approach—“the 80-20 thing,” as one Senate staffer put it; “Kenzi” or “Kenzidy,” as the merger became known in the lobbying community—was not always popular, even within the Senate (where other staffs thought Enzi’s had “lost their marbles”). But it took advantage of Kennedy’s thirty years of experience in the HEA and his desire, always, to be a legislative player. And it recognized the institutional fact that the Senate rules empower minority members far more effectively than do those in the House. After marathon cloistered staff meetings during the summer recess, negotiations yielded a bill in late August 2005 that was introduced jointly by Enzi and Kennedy and approved by the full committee after forty minutes of consideration. The reconciliation version was passed with similar harmony in October. Kennedy’s price for support was the creation of a Provisional Grant Assistance Program (Pro-GAP), which took $7.25 billion in savings from the student loan programs to fund mandatory supplemental aid to low-income students—in effect, rescuing Pell Grants from funding stasis by providing a self-funding mechanism. Kennedy called it “a good bipartisan compromise.” The cooperative spirit, however, would dissolve when the Senate and House entered their conference committee over reconciliation—and as the locus of Republican decision-making shifted from Enzi back to Gregg, who as budget chair became the lead Senate negotiator.56 As these parallel narratives suggest, the aid debates became more contentious as budget issues rose in substantive and political prominence. President George W. Bush’s first budgets—drafted during a brief fling with surplus politics—increased Pell Grant funding and left the loan programs largely alone. Unlike its K–12 counterpart, higher education was not high on the administration’s agenda, downgraded even bureaucratically within the Department of Education.57 By the start of Bush’s second term, though, with stark deficits at hand and worse looming, he was looking for savings. To be sure, the president consistently favored the privatesector FFELP over direct lending; as the fiscal 2006 budget message put it, “The administration is strongly committed to the lender-based guaranteed [FFELP] and expects it to continue as the primary source of loans to students in the years ahead.” As noted, though, under the government’s own budget-scoring rules, FDLP was the less expensive program, and FFELP itself was not considered a model of efficient competition. After all, the president continued,

OPPORTUNITY COSTS 63 the Federal Government assumes almost all of the risk for the loans, while Federal subsidies to intermediaries—lenders and guaranty agencies—are set high enough to allow the less efficient ones to generate a profit. These problems lead to unnecessary costs for taxpayers and prevent the program from achieving the efficiencies the market is designed to provide. Bush therefore urged lowering lender reimbursement on defaults, a “loan holder fee” that would “recover excess earnings,” and decreased government support for guaranty agencies. All told, the administration’s proposed cuts to the student aid accounts netted out to about $7 billion.58 That ante rose when Congress passed a budget resolution in April 2005 requiring some $35 billion in cuts in the mandatory spending programs that drive federal spending. The Education and the Workforce Committee was originally instructed to find nearly $13 billion of that from within its jurisdiction. This “reconciliation” process—so-called because it reconciles statutory requirements with the money made available to meet them—thus decisively shaped HEA’s new features. Without reconciliation’s incentives—and constraints—it is “unfathomable” (as one administration observer put it) that anyone “would have thought of the compromise reflected” in the new law. Ambition stirred this pot as well. When House majority leader Tom DeLay (R-Tex.) resigned his position in late September 2005, chairman Boehner’s interest in taking DeLay’s job seemed to hinge partly on an audition: Could he deliver his committee’s assigned savings? A Plan for Fiscal Responsibility, released in October, did just that. It hiked the committee’s anticipated savings from the proposed five-year total of $8.5 billion to over $14 billion.59 The Senate bill, in order to fund its new grant programs, targeted lending even more stringently: It found nearly $20 billion in savings in loan subsidies and interest-rate changes.60 CBSL suddenly “became the Coalition for Bitter Student Loans.” Particularly painful to lenders was the proposed loss of $7.8 billion in “floor income,” that is, the extra money they had collected when their variable rates of return were below the rates set for students. The new bill required that lenders retain income associated with their variable rate and rebate the difference between it and students’ payments to the government. The Senate grant programs were similarly slashed.61

64 FOOTING THE TUITION BILL Many of these changes, described more fully below, remained in the conference committee report. In the end, $12 billion was removed from the student aid budget, representing $20 billion in savings or revenue enhancements offset by $8 billion in new grant programs, increased loan limits, and fee reductions. As the proposal moved toward a final vote, debate shifted from a closely held inside process to the outside airwaves. Student groups and colleges were particularly peeved that program efficiencies were being poured into deficit relief instead of back into aid programs; in response they resurrected a decade-old slogan charging a “raid on student aid.”62 Kennedy groused, “The [HELP committee] portion of the Senate bill . . . took a balanced approach, and made sure that all the children who needed our help got an increase in aid. That is not what came out of conference.”63 Since the measure was a reconciliation bill, however, opponents’ options for stalling it were truncated: Senate debate was time-limited, the ability to filibuster (and thus force a sixty-vote cloture hurdle) suspended. Only fifty-one votes were required—exactly what the package received. The House vote was similarly close. Student groups ramped up media and mobilization efforts, hoping to persuade moderate Republicans to vote against their leadership. Their rhetoric did begin to take hold: “Students Suffocate under Tens of Thousands in Loans; Higher Interest Rates Hurt Those Forced to Borrow,” one USA Today headline proclaimed. But House leaders responded by using that chamber’s majority-friendly procedures to move the bill with dizzying speed. The conference report was filed at 1:13 a.m. on December 19, its rule governing debate was reported at 2:28 a.m., and the bill itself hit the floor at 5:04 a.m. It passed an hour later by a blearyeyed vote of 212 to 206.64 What did that vote enact? And how did HERA’s features dovetail with the policy preferences discussed above?65 Most prominently, perhaps, lenders’ floor income was eliminated; the recycling of 9.5 percent loans was stopped, except for certain, very small nonprofit lenders (one of which happened to be in Wyoming); and the much-discussed shift back to fixed interest rates was allowed to take effect. Students with Stafford loans thus moved to a 6.8 percent fixed rate on July 1, 2006; for most PLUS loans, rates were raised from 7.9 percent to 8.5 percent.66 Students, of course, had hoped to keep variable rates and cap them at 6.8 percent. The House, for a time, suggested a cap of 8.25 percent. But

OPPORTUNITY COSTS 65 the conferees found that CBO savings estimates too strongly favored fixed rates to meet the savings targets without them. And while the “singleholder” rule favored by traditional lenders was repealed,67 consolidation loans made after July 1, 2006, reflected these fixed rates, making consolidation less attractive as a vehicle for refinancing loans. Students in school are no longer able to consolidate; and using the direct lending program as a mechanism for obtaining a second bite at consolidation has been restricted. On the other hand, the origination fees on Stafford loans were phased out over a five-year period, leaving just a 1 percent guaranty fee in place by July 1, 2010. As proponents of direct lending, including student groups, tirelessly pointed out, expanding that program would have saved just as much or more as the fixed rate, according to Congressional Budget Office projections. Thus, FFELP lenders who doubted the CBO figures were quite pleased that, given the temptations of reconciliation, these efforts were defeated. Administrative funds for direct lending (that is, its salary and expense accounts) were shifted out of the mandatory category and into the competitive pool of discretionary appropriations. Lenders wound up guaranteed 97 percent of loans in default (down from 98 percent in previous law); for lenders named to “exceptional performer” status, the level of default insurance only dropped from 100 percent to 99 percent. Guarantors’ retention of collection fees was cut somewhat, while the percentage of a borrower’s wages that could be garnished for repayment was increased, and the cap on guaranty agencies’ administrative fees was removed. Increases in loan limits, albeit smaller than what schools and lenders of all stripes favored, were ultimately enacted. Starting in 2007, Stafford loan limits for first-year students rose from $2,625 to $3,500 (the first increase since 1986); second-year limits went from $3,500 to $4,500 (the first increase since 1992). However, the aggregate lending limits were left constant at $23,000. In an important, if little-noticed, shift, graduate and professional students were made eligible for PLUS loans. As noted, the grants that had greased the skids of Senate bipartisanship were dramatically altered in conference. Expensive new programs for undergraduates—especially those without a merit component—were anathema to the House. A new “Academic Competitiveness Grant” for Pell-eligible firstand second-year students thus replaced Kennedy’s income-based Pro-GAP

66 FOOTING THE TUITION BILL grants, requiring students to have completed a “rigorous” high school curriculum (as determined by the Department of Education) and to maintain a 3.0 collegiate grade-point average. For junior and senior science and math majors, a package of National Science and Mathematics Access to Retain Talent (SMART) grants pushed by Senate majority leader Bill Frist (R-Tenn.) was retained. But together the programs received an outlay of just $3.7 billion over five years, instead of the $9.5 billion the Senate had provided. Finally, while in HEA committee deliberations the for-profit schools were partially successful in obtaining their desired regulatory changes,68 the reconciliation process required that only budget-relevant provisions receive expedited debate in the Senate. The 50 percent rule was modified to exclude distance-education courses. But most of the provisions dealing with proprietary schools were “Byrd-ed out” of the bill (under the exclusionary rule named for the West Virginia senator). They await further action.69 All this has an “on the one hand, on the other hand,” feel to it, and correctly so. As noted above, those most loudly against HERA were congressional Democrats and student groups, who saw student aid—and thus students, and thus higher education generally—as the big loser of the reconciliation process. It was “a bill Scrooge would love. Bah humbug!” orated Senator Kennedy, as a US PIRG memo charged that “Student Loan Cuts Hit Families, not Lenders.” Representative George Miller, ranking Democrat on the Education and the Workforce Committee, would later introduce the “Reverse the Raid on Student Aid Act of 2006.”70 But the GOP fired back. “Don’t believe the hype,” said Representative Ric Keller of Florida. “Not one student in America will receive less financial aid under our bill.” Chairman Boehner told his committee that “students do just fine under the proposal. The lenders out there, they’re bleeding. If they weren’t all bandaged up, they’d be bleeding all over the floor.”71 Indeed, most lenders also felt that each subsequent bill was, from their vantage, “worse and worse.” For the front-end lenders, the increased loan limits were useful but small, and the shift in consolidation procedures too late to matter much. Against this were the loss of floor income and the decrease in default reimbursements. Guaranty agencies welcomed the renewed statutory purpose implied in a provision designating them as a central clearinghouse for college access, as well as the removal of their

OPPORTUNITY COSTS 67 account-maintenance fee cap. But nonprofits bemoaned the loss of 9.5 percent loan recycling, and consolidators the loss of their guaranteed growth. Still, stock prices for big lenders ticked upward immediately after the bill’s final passage. Stability had returned to the field, and the overall hit could surely have been worse; despite the efforts of FDLP proponents, FFELP lenders could continue to do business and make a guaranteed yield. If anything, FFELP gained ground against direct lending through the lowsalience rules changes that amend its long-term administration. Strong support from large state universities means that direct lending will survive. But whether for good reason (competitive merit) or bad (structural inequity), the service quality gap will continue to grow in favor of FFELP.72 The reauthorization cycle to date is likewise a mixed bag for institutions of higher education. Many of the provisions to which the traditional colleges and universities most objected were not included in HERA, because they were not loan- or budget-related. But the September 2006 report of the Education Department’s Commission on the Future of Higher Education reemphasized the data-gathering and cost-containment issues stressed early on in the HEA process, and there will likely be little more money in return for any new mandates implemented on those fronts. Proprietary schools also await attention to their major issues, but they receive glowing treatment in the report and are as happy as the traditional schools (perhaps more so) about increased loan limits.73 On the student side, it is true that the benefits former students could gain from consolidation were restricted. The cost of PLUS loans certainly rose. And in the Stafford Program, students had hoped for a variable interest rate capped at 6.8 percent. From that perspective, a fixed rate of 6.8 percent is a rate increase. Still, as one legislative staffer understated, “In this political environment, [the students’ proposal] wasn’t going to work.” As interest rates rise, the 6.8 percent figure may turn out to be—as predicted back in 2002—a good, and usefully predictable, deal for students. (In fact, as of July 1, 2006, variable rates would have been 7.13 percent.) Loan limits have increased somewhat, and new grant money has been provided, if narrowly targeted. Graduate students now have access to a new pool of loans. Origination fees will decline over time. Thus, if the question of winning and losing is one simply of payments out of pocket, the pain is shared: The anti-HERA charge that “the bill generates

68 FOOTING THE TUITION BILL almost $13 billion from excessive subsidy payments that student and parent borrowers make to lenders” and “uses this money to pay for new tax cuts”74 depends largely on the fact that money is fungible. The subsidy payments were mostly from the treasury, after all, and so from all taxpayers, not just borrowers. One could argue just as truthfully that their reduction subsidizes not tax cuts but K–12 spending, Medicaid, the Iraq war, or the Alaskan “bridge to nowhere.” The loss of floor income to lenders doesn’t, in itself, help students, nor does it hurt them. That money could have been used within the higher education aid regime. That it was not is a policy choice, of whatever merit. As a result, while the true cost to students, and to everyone else in the student loan community, is significant, it is an opportunity cost—less in the distribution of the cuts themselves than in the decision to cut at all. It is hard to argue that access to higher education is a federal policy priority when decreases in its aid outlays made up by far the largest single share of what was, after all, only a symbolic attempt to slay the deficit beast. (The Deficit Reduction Act cut $39 billion over five years, while projected deficits over that time total $1.3 trillion.)75 Creative attempts to find a selffunding mechanism to expand grant aid within the federal budget were largely rejected. Instead, new efficiencies in the program had no benefit for those most directly involved. When asked if students would have made the same argument if the dollars taken from the loan program had been funneled instead to funding Pell Grants, PIRG’s Luke Swarthout noted, “That would have been a different conversation. It might not have been our preference, but we wouldn’t have run a six-month campaign about the raid on student aid.”76

The Path (Dependence) Ahead On its face, this sequence of events provides a case study exemplifying classic strands of the study of American politics. It describes a policy arena where interest groups strive against one another, using a variety of “inside” and “outside” strategies, and where complex formulae for divvying up “who gets what, when, where” change slowly and incrementally, generally reliant on a structure determined long ago and never fundamentally reworked.

OPPORTUNITY COSTS 69 Yet change has nonetheless caught up with the student loan policy world, swamped as it is by the tides of polarization and fiscalization sweeping through contemporary American governance. Muddling Through. Back in 1931, Herbert Hoover’s National Advisory Committee on Education complained that federal education policy “suggests a haphazard development, wherein policies of far-reaching effect have been set up as mere incidents of some special attempt to induce an immediate and particular efficiency.” The conclusion works as well for contemporary higher education, where choices largely represent “modifications and additions to existing policies”77 and the tweaking of subsidies and eligibilities, rather than the reconsideration of big-picture issues of cost and access. As in so many policy areas, the road chosen at the outset, however haphazardly, matters very much for the place one winds up. Charles Lindblom suggested nearly fifty years ago that government policymaking was mostly shaped by decisions already made—not grown from a new “root” but following an extant “branch.” This, he suggested tongue in cheek, was “the science of muddling through.”78 The path of the student loan regime was chosen forty years ago to ensure that loan capital was available to the relatively small number of students who would need to fill the gap between income and tuition but would not be eligible for grant aid. It was established as a market-based mechanism, partly because such a model already existed in several states, and partly as a political maneuver to avoid more extensive, expensive federal involvement through a tax credit. When the national model did not gain an immediate foothold, it was not changed but subsidized—first, to ensure that banks would find loan origination worth their while, and then to ensure a secondary market for those loans and to monitor their repayment. The system—split, however oddly in retrospect, among lenders, secondary-market organizations, and guaranty agencies—was not configured unreasonably for its time and technologies. Still, it created a market-based system that did not really allow for a free market. Over time, as banking technologies evolved dramatically in efficiency and sophistication, the different actors began to stray beyond their original boundaries and to become functionally indistinguishable as they sought economies of scale. The industry had outrun the structure, but the

70 FOOTING THE TUITION BILL structure remained. Since new efficiencies made for new profitability, the newly competing actors competed politically, too—not, mostly, to change the structure (in the way represented by direct lending, for example) but to tilt the market in their direction. Given the technical complexity of those debates, colleges, distracted by multiple demands, were unlikely to focus on fundamental changes to the system so long as it provided their particular species of student with enough funds to enroll. Most legislators, likewise, tuned in only when the pieces of the system faltered and required tinkering. In the meantime, the structure as a whole muddled through. This is not a story with much of a moral trajectory, full of virtue and villainy. Instead it presents actors working to secure their interests within the bounds of incentives and constraints set long ago. That is politics; and, as Lindblom noted, that is not all bad: Incrementalism is a practical system for a busy government with competing priorities and little consensus about goals, much less means. A congressional aide put it this way: The loan regime is “not as efficient or effective as it could be, but everyone involved knows what to expect year to year, and that stability has a lot going for it.” Millions get loans every year, and the vast majority of those loans are repaid. Making wholesale change, then, would be hard and, even in the face of new Democratic majorities, probably remains unlikely. Since 1993, when the last real challenge to the regime emerged, loan volume—along with actors’ stake in the current system—has risen greatly. With that comes another lesson of American politics: Interests battle much more fiercely over what they already have and might lose than over what they lack but might get.79 Fiscalization and Polarization. A focus on stability, though, understates the importance of larger shifts in the American polity to all areas of policymaking. Since the 1980s, we have witnessed what political scientist Kenneth Shepsle dubbed the “fiscalization of American politics,” where budgetary factors crowd out wider policy debate.80 With the exception of several years in the late 1990s, the federal budget has been in deficit since 1969, caught between escalating entitlements and steady constraints on revenues. Attempts to solve this problem have, in turn, been stymied by a deepening divide between partisan policy elites marked by increasingly harsh rhetoric. This polarization is not only about policy, but about

OPPORTUNITY COSTS 71 motives, too—which makes debate more venomous and agreement more difficult. Indeed, it is difficult even to agree on the very set of facts on which debate should be based. Both of these trends, themselves related, have affected the student loan arena. Should funding go to traditional universities, or online proprietaries? To front-end lenders, or consolidators? To nonprofit PHEAA, or for-profit Sallie Mae? Those questions changed character in the face of budgetary pressures. As budgets became a zero-sum game, the relative strength of interest-group organization became more crucial in determining the division of the pie. Yet the largest latent interest—the borrowers—was by its nature the one least coherent and thus the least represented in Washington. In 2005–6 the game turned not just zero-sum, but negative. The reconciliation process’s search for savings changed the debate from one of policy preferences to one of budget scores. The question of what saved the most became critical: “You live and die by their numbers,” one lobbyist commented. Yet even this, despite the comfortingly exact columns laid out in spreadsheet documents, was much contested—as a close observer put it, “It feels too much like magic.” In a way, the reality of subsequent spending did not matter so long as the predictive estimates could be used as ammunition during debate.81 The relative cost of direct lending, as noted above, was hotly disputed. Proponents stated flatly as a “fact” that “direct loans make money for the federal government,” pointing to CBO, Government Accountability Office (GAO), and Office of Management and Budget (OMB) documentation; FFELP opponents discussed instead the “artificiality of congressional scoring,” the shortcomings in the estimation formulae required by the Credit Reform Act, and the cost-shifting to colleges the scores leave uncounted. The debate goes on, but neither side can convince the other—it is, as one participant ruefully observed, “like being caught in an existential play.”82 As that comment suggests, loan programs, and higher education generally, have been doused by the rising tide of polarization. HEA, many observers note, was once relatively nonpartisan, but is now “like anything else,” with both sides “addicted to insult.” And in the rise of campaign donations as the ante for political access, fiscalization and polarization have joined together. Here, too, loan politics have converged with the wider political system, subsuming empiricism to ideology. Ironically, the skills

72 FOOTING THE TUITION BILL needed to critique the student aid regime constructively have risen with that industry’s complexity, while at the same time the political system is ever less well-equipped to handle analytic nuance. What’s Next? Even after the House passed the remainder of the HEA reauthorization in spring 2006, senators showed little interest in revisiting what one participant called a likely “piñata” for interests’ last, best whacks at reworking policy for this cycle.83 The task awaits the 110th Congress. Looking past this reauthorization, the picture is equally muddled. Will incrementalism continue—in the 2012 reauthorization, say? In 2017? The answer depends on the underlying trends and their resultant politics. There will certainly be more students, borrowing more—from both the Stafford and PLUS programs and from private lenders, especially given the substantial space federal decisions over time have given the private loan market. Those students will be going to a broader mix of traditional and forprofit schools. And they will be paying higher and higher tuitions. Will the middle class’s anxiety over paying for college lead to backlash—and, if so, will it be against the government, against lenders, or against schools themselves? So long as college is seen as worth the cost, as a return on investment, it seems unlikely that the system will change dramatically. At the margins, though, changes seem possible. Given the results of the 2006 midterm elections, direct lending will presumably receive renewed attention—especially if Democratic majorities are maintained, and joined by a like-minded president after 2008. More immediately, the Democratic Congress clearly inclines toward narrowing lender profit margins further and cutting student interest rates. Indeed, one of the House’s first actions in 2007 was to pass a bill halving HERA’s 6.8 percent interest rate to 3.4 percent, paid for by increasing lenders’ fees and trimming their guarantees and special allowance payments. New Senate education chair Ted Kennedy vowed to incorporate similar changes into his own Student Debt Relief Act. Kennedy also hoped to raise Pell Grant funding more significantly than in the House bill (which added $260 to the maximum award) or than the Bush administration which, urged on by the Spellings Commission, proposed a $550 increase (to $4,600) in its fiscal 2008 budget.84 Even if it became law, though, the 2007 House bill would apply to only a subset of Stafford loans, take five years to ratchet down loan rates, and

OPPORTUNITY COSTS 73 expire shortly thereafter, in January 2012. Nor is it clear how enhanced Pell Grant funding might be financed. One possibility was to cut other supplemental grant programs instead, thus “robbing Peter to pay Pell.”85 As this suggests, path dependence combines with budgetary constraints, other claimants on discretionary revenue, and the overwhelming scope of the national debt to make reimagining (or fully funding) federal higher education aid a tricky proposition. Still, with college costs and student debt rising, incrementalism comes with its own costs, not least to the original equity agenda of the Higher Education Act. Recall that early promise: to “provide and permit and assist every child . . . to receive all the education he can take.” Can high hopes be reconciled with high stakes? If so, we will need to move from the incremental to the monumental—to hold a conversation that makes reconciliation not about budgetary technicalities but about matching our ideals with reality.

3 Private Lending and Student Borrowing: A Primer Christopher Mazzeo

As demand for postsecondary education continues to expand, the issue of how students will come to finance their education has become a central and growing concern among federal and state policymakers. At the same time, rising college costs and reduced grant and scholarship dollars have increased student and parent reliance on loans to finance all or part of the cost of attending college. This demand for loans is, of course, not new; borrowing has been a significant factor in higher education finance at least since the creation of the federal Guaranteed Student Loan Program (GSL) in 1965. What is new is the prevalence of borrowing and the growing debt burden students and parents are taking on to pay for postsecondary education. According to the Project on Student Debt, nearly two-thirds of students at four-year colleges and universities in 2004 had some student loan debt; a decade earlier, this proportion was less than one-half of all students. Over the past decade, debt levels for graduating seniors have more than doubled at both private and public four-year institutions, with the average debt burden now at $19,200.1 A fast-growing portion of this debt comes from students and families opting to take out so-called “private label” loans—loans unsecured by the federal government—as a supplement, or in some cases as an alternative, to federal and state grants and loans. In 2005, $142 billion of aid was awarded. Of this, $62.6 billion was provided in federal loans, and students borrowed $13.8 billion in nonfederal loans.2 The private loan market was expected to grow to around $15 billion dollars by the middle of 2005,3 and 74

PRIVATE LENDING AND STUDENT BORROWING 75 had grown at an annual rate of 27 percent over the previous seven years.4 An analysis conducted for this chapter found that 6.1 percent of undergraduate students took out at least one private loan in the 2003–4 academic year, the most recent for which federal data were available.5 The growth of private loans appears to be a reaction to a convergence of factors, including rising college costs, federal loan limits that have failed to keep up with these costs, and an overall reduction in grant and scholarship dollars available to middle- and low-income students. Yet despite the growth in private lending and borrowing over the last fifteen years, there is little research on why students are increasingly taking out these loans, who these borrowers are, and the implications of this growth for state and federal policy. The purpose of this chapter is to provide an overview of these issues for state and federal policymakers and others concerned with the issues of higher education finance, affordability, and student success. Here we will summarize what is known—and not known—about the growth of private lending, and discuss how policymakers might think about and respond to these developments. We will also describe the evolution of the private lending industry and its growth in market share in recent years relative to the federal student loan program. The goal is to provide a “primer” for readers concerned about higher education outcomes who might be less familiar with the policy issues surrounding student financial aid. The focus of this primer is on private borrowing among first-time seekers of undergraduate degrees. Though much of the growth in private lending has come in the graduate and professional market, it is increasing rapidly among undergraduate students as well, and the greatest policy concerns around postsecondary access and debt center on this group. Undergraduates are also central to policy concerns because—despite perceptions—a significant portion of their demand for private loans comes from low- and moderate-income students and families. According to data from the 2003–4 National Postsecondary Student Aid Survey (NPSAS), over 45 percent of private borrowers had family incomes in the lowest two income quartiles,6 with roughly one-fifth earning less than $20,000 annually (see table 3-2 for detailed breakdowns).7

76 FOOTING THE TUITION BILL Defining Private Loans Private loans are those made by lenders to students and families outside of the federal student loan program. Federal student loans are generally available to all students, though eligibility for different loans varies based on such factors as enrollment intensity (half-time attendance or more), demonstrated financial need, and family’s credit history. Private loans, on the other hand, are made at the lender’s discretion and usually require undergraduate students to show a positive credit history or have a coborrower (generally a parent). Private loans are neither subsidized nor insured by the federal government and thus tend to have higher interest rates than federal loans. Because private loans are unsecured, they also generally have guarantee fee structures built into their repayment options, making them more expensive for students. Further, they are treated as “nondischargeable” under federal bankruptcy law, which aids lenders in seeking to collect on loan defaults. Aside from the above, private loans for undergraduates differ from federal student loans in three major ways. First, as noted, private loans engender more risk for both lenders and borrowers because they are uninsured by the federal government. In addition to higher overall interest rates, one way lenders mitigate their risk is “by placing higher interest rates on loan products for students exhibiting low credit ratings and requiring student borrowers, particularly first-year students, to have cosigners for their loans.”8 This means that different students may pay very different interest rates, with different repayment burdens, based on their assessed risk of default. Federal insurance, on the other hand, insulates lenders from risk of default and students from repayment options in certain cases of death or disability. Federal subsidization also means that the government pays the interest for some loans (such as Perkins and Subsidized Stafford Loans) while students are enrolled in school at least half-time, for the first six months after they leave school, and during a qualified period of deferment— a postponement of loan payments. Unsubsidized private loans require students or families to pay interest from the time the loan is disbursed until it is paid in full. A second difference is that private loans provide greater flexibility to borrowers. Unlike federal Stafford loans that have annual and overall loan limits, private loans can be used to supplement student need, up to the full

PRIVATE LENDING AND STUDENT BORROWING 77 cost of college attendance. They are also available throughout the year as opposed to once annually. This is helpful, as student and family finances change over the course of the school year. Applications for private loans are shorter, easier to understand, and require less personal information than the Free Application for Federal Student Aid (FAFSA) form. Finally, private lenders provide some services to borrowers the federal government does not. These include interest-rate reductions for borrowers who provide lenders certain demographic and educational information, make all payments on time for a set amount of time, have repayments automatically debited from their bank accounts, and pay both interest and principal while in school, among other conditions. Since the private loan industry is quite varied, it is difficult to generalize about the types of loan products available to students. Nonetheless, a review conducted for this chapter of publicly available materials from seven of the largest private lenders found a few key commonalities.9 First, all seven of these lenders market their products to undergraduates as a supplement to federal student loans and, perhaps surprisingly, provide both private and federal loan products. Private loans are designed to cover expenses beyond what a student can obtain via grants or through the federal Stafford Loan Program. In particular, lenders feel their private loan products are highly competitive with unsubsidized federal loans—such as the Parent Loans for Undergraduate Students (PLUS) and the Unsubsidized Stafford Loan.10 Available data, however, suggest a more complex interaction. Since the 1996–97 academic year, the growth of private loan volume as a share of overall volume has come almost exclusively at the expense of Subsidized Stafford lending. In 2004–5, Subsidized Stafford Loan volume was only 36 percent of the overall volume, down from 54 percent in 1996–97.11 Nearly all of this reduction went into private loans, which increased to 18 percent of overall loans (up from 6 percent in 1996–97) in 2004–5.12 Such data suggest that broader changes in higher education finance have reduced the purchasing power of federal loans, contributing in part to the rise of private lending and borrowing. Interest rates for federal loans have changed significantly in recent years. Beginning in 1992, the federal loan program was shifted from a fixed interest rate (8 percent in the first four years of repayment, 10 percent for

78 FOOTING THE TUITION BILL the remainder of the loan) to a variable rate, tied to the Treasury bill rate. As interest rates overall dropped in the last decade, so, too, did student loan rates, reaching below 5 percent for Subsidized Stafford Loans in recent years. This situation, however, changed again in July of 2006, when the variable rate for Stafford was replaced with a fixed rate of 6.8 percent, as part of the Deficit Reduction Act of 2005. PLUS loans, which had also been at variable rates since 1986, now carry a fixed rate of 8.5 percent. Loan limits for Stafford loans have been increased from $2,625 to $3,500 for the first year and $3,500 to $4,500 for the second. Stafford borrowing limits for dependent undergraduates, however, remain capped at $23,000.13 It is unclear what, if any, impact the 2006 changes will have on student borrowing behavior. Rising interest rates in capital markets may make federal loans look more attractive to students and families than in recent years. In any event, changes in interest rates and other incremental shifts in the federal student loan program over the last decade have been dwarfed in significance by a set of larger structural changes in higher education finance. College costs have risen dramatically, even as the demand for postsecondary education has grown rapidly. State subsidies in higher education have also declined significantly as states have had to manage growing budgetary demands in politically compelling areas, such as Medicaid and K–12 education. The result of these shifting forces has been an enormous rise in tuition and fees, particularly at publicly supported institutions. According to the College Board, tuition and fees at public universities have gone up by 40 percent in constant dollars in just the last five years.14 When combined with stable loan limits, this is surely one reason demand for private loans has risen in recent years. A 2003 report estimated that private loan volume grew 355 percent between 1995–96 and 2001–2, increasing from $1.1 billion to $5.0 billion during this period.15 A more recent analysis using the same data found that student private borrowing grew by about 30 percent from 2004 to 2005.16 An analysis of available student-level data conducted for this chapter (see table 3-4 for detailed breakdowns) strongly confirms this growing demand for private loans. According to the 2003–4 NPSAS, 6.1 percent of undergraduates took out at least one private loan in that academic year. This was a significant increase from 1999–2000—the prior NPSAS survey year—when fewer than 4 percent of students obtained private loans.

PRIVATE LENDING AND STUDENT BORROWING 79 Profiling the Private Loan Industry The private student loan industry emerged in the United States in the context of a broader shift in the way students and families finance higher education. Through the first half of the twentieth century loans played only a small part in student aid. Tuition at public colleges and universities was kept low through generous state subsidies, and private colleges maintained their own grant scholarship funds. After World War II, the federal government sought to promote access—specifically for returning military servicemen— through the creation of the GI Bill and the National Defense Student Loan Program. Yet demand for higher education was growing in many other quarters and, along with it, demand for access to loan capital. Between 1950 and 1965, sixteen states created insured loan programs for state residents, a number of which are still in existence.17 While some of these were directloan programs, most were guarantee programs lending through private banks and other providers. Thus, as state lending for higher education grew, so did an industry of private capital providers. The student loan industry grew exponentially after the creation of the Guaranteed Student Loan Program in 1965. Federal funding was originally designed to provide startup capital and insurance for states and nonprofit lenders to develop or expand their own loan programs, but, over time, a federal entitlement program emerged that provided guaranteed, insured loans through either private banks or state agencies.18 Through the 1960s and 1970s more and more students and families came to depend on these federal loans to finance higher education. Efforts by Congress to contain costs led to a number of measures, such as origination fees, needs tests, and loan limits, that produced unmet demand for loans. In this context, the private loan industry emerged fully in the 1980s and 1990s. Private lending was further spurred by shifts in the financial markets that enabled nonbank lenders to raise capital in private markets by selling financial interest in their loans to investors. This innovation in the financial markets—called securitization—allowed a lender to pool a large number of its loans and sell interests in the pool to investors. For the lender, securitization provided a double benefit: raising capital and removing existing loans off its balance sheet, so it could issue new loans. Originally developed in the home mortgage industry, securitization spread to consumer-debt-based

80 FOOTING THE TUITION BILL securities (such as auto and student loans and credit debt) in the late 1980s and early 1990s. So-called asset-backed securities (ABSs) in the student loan market have grown greatly in recent years and opened the market to numerous nonbank lenders who, through securitization, can gain access to capital markets equal to that of their bank competitors. Securitization brought many new entrants into the student loan market, increasing competition and providing a greater array of choices for students. Still, as noted earlier, “private” loans were developed as a supplemental product by banks and nonbank lenders who conducted the majority of their business in the federal guaranteed market. As with the federal program, lenders have, over time, developed a set of comprehensive criteria for determining loan eligibility. These usually include some combination of • institutional eligibility for lending, based usually on default rates and determined via lender due-diligence; • borrower eligibility, based on family/student ability to pay and creditworthiness; and • residency requirements under certain state programs. Within these eligibility parameters, the industry has developed a wide variety of loan products. In the undergraduate market, many position their products to compete directly with PLUS loans. Private loans are more attractive to parents than PLUS, lenders believe, because they are made in the student’s name, allowing parents to shift part of the cost of education to their children. Lenders also theorize that their repayment options are much more attractive since principal and interest on private loans are in “forbearance”—essentially, a temporary delay in payment and interest capitalization—until six months after the education is completed, while PLUS loans accrue interest immediately and require monthly payments sixty days after disbursement.19 As noted earlier, one of the primary ways private loans differ from federal loans is in the calculation of interest rates. Because private loan repayments are not guaranteed from default by the federal government, most lenders use consumer credit models to determine rates, meaning that students will often

PRIVATE LENDING AND STUDENT BORROWING 81 pay widely different interest rates, based on their credit scores or other measures of individual or family creditworthiness or default risk. These rate differences can be substantial; one typical lender creates a loan package for students based on whether their credit risk is deemed excellent, good, or fair. Students or cosigning parents with excellent credit borrow at the prime rate; those with fair credit pay a minimum of 1.5 percentage points above prime, along with additional fees at origination and final repayment.20 Further evidence of rate differences based on credit can be seen in a review of loan products offered by Sallie Mae, which, with around one-third of the overall market, is the largest private-label lender. Sallie Mae markets its private loans as supplemental loans for students with unmet need who have exhausted other forms of financial aid. It offers five different private loan products to students. The most popular of these, the Signature Student Loan, has a structure that mirrors the Stafford (half-time attendance at an approved institution), with eligibility based on the creditworthiness of the student or a parent cosigner. Loan limits are set at $100,000, which is inclusive of all other loans, federal and private. Repayment is expected to begin once the student is no longer in school, with a six-month grace period.21 According to information available on the Sallie Mae website, interest rates for Signature Student Loans vary widely based on applicants’ credit scores. Rates that can go higher than guaranteed federal loans help make this market segment among the company’s most profitable. Initial rates are set at the prime (8 percent in June of 2006) for a borrower with exceptional credit; the rate can go as low as prime minus .25 percent (APR of 7.35 percent), which is competitive with rates for both the new Stafford and PLUS loans. Rates can rise precipitously, however, based on credit score, going at least as high as prime plus 6 percent (APR of 13.05 percent). The difference in monthly payments for those with poor credit is substantial: $92 a month on a loan of $10,000.22 Other private loan products offered by Sallie Mae have similar rate spreads. The company offers, for example, a set of private loans targeted to community college students and adults returning to school or entering vocational career training—students who are often higher-risk borrowers. For this group of loans Sallie Mae charges borrowers an origination fee ($130–$585) and benchmarks rates at prime plus 1 percent for borrowers with “excellent” credit. Rates on these loans, however, can often be much

82 FOOTING THE TUITION BILL higher in practice. For borrowers with “poor” credit, for example, rates are set at prime plus 9 percent.23 Some anecdotal reports suggest that interest rates can even go higher than what is reported on the Sallie Mae website, reaching 10–20 percent or more above prime, though we found no independent confirmation of these reports.24 Others have accused Sallie Mae of predatory practices in the private loan segment. In one reported case from Pennsylvania in 2005, Sallie Mae made private loans to students attending Lehigh Valley College (LVC), a private for-profit institution, at an average interest rate of 13 percent. Tuition debt for some students, as high as $100,000 for an occupational certificate, was more than twice what students paid in tuition. A lawsuit filed by former students at LVC against the school charges that these loans were marketed as federal loans, when they clearly were nonguaranteed private loans.25 Not all private lenders use traditional consumer credit assumptions in making loans and determining interest rates. One company with a different approach is the New York City–based MyRichUncle (MRU), part of MRU Holdings Inc., founded in 2004.26 Unlike the majority of providers, MRU assesses its potential loans on a customized basis to seek out those students with the lowest likelihood of default. It makes these calculations through a combination of traditional credit-scoring and “preprime,” its proprietary underwriting model.27 Preprime is designed creatively to assess risk for students without credit histories. The model is driven by an algorithm that MRU believes is more relevant to characteristics of student borrowers than most loans currently available to them, which are based on consumer credit models and assumptions. The preprime methodology instead seeks to account for the borrower’s future income potential as well as default risk by assessing statistics relating to the school attended, field of study pursued, grades earned, and financial soundness of the coborrowers. The goal is to build a loan-underwriting business more explicitly contingent on future earnings. As a result, MRU believes it can select borrowers based on ability to repay and customize loans for qualifying students while keeping its overall risk profile low.28 MRU reduces its risk position in a number of ways. The company only offers its products to colleges and universities with a 6 percent or less default rate. This adds up to around 4.8 million students at 1,500 colleges and universities (as opposed to the 6,000 approved by the U.S. Department

PRIVATE LENDING AND STUDENT BORROWING 83 of Education) and includes no two-year colleges or private for-profit schools. MRU sets its interest rates for these students based on the current London Interbank Offered Rate (LIBOR)—the interest rate banks charge each other for loans—plus a margin that is determined via the preprime process. Though the company does not report its interest-rate ranges on the web, the sample rate listed for a borrower with good credit has an APR of 7.21 percent, which is based on a LIBOR rate of 4.21 percent and a margin of 3 percent. Assuming this is on the low-to-average side of what a typical student might obtain, MRU’s rates are comparable with those of other private lenders, and competitive with the rates available on federal PLUS loans. Unlike Sallie Mae, MRU does charge origination fees of around 6.25 percent to most borrowers.29 While these capsule descriptions are suggestive of the differences between private loans and those offered through the federal student loan program, researchers and policymakers still know very little about the industry and its role in the financing of higher education. Understandably, concerns about growing student debt and the extremely high interest rates on some private loans have led to calls for greater regulation of the industry. To assess any potential regulatory actions, however, policymakers will need significantly better data on private lending and borrowing. Currently, there are no fully reliable data sources on private loan volume, or on the lending practices of leading industry players. Nor do we have a full understanding of who takes out private loans, and why the industry has grown rapidly in just a decade. The next section uses the available data to get a better handle on this latter set of questions.

Understanding the Growth of Private Loans The growth of private loans has led to a number of analyses of student borrowing behavior, using various publicly available data sources. Much of this work has been descriptive in nature and is particularly useful in understanding the demographic characteristics of this population of borrowers. According to a 2003 report from the Institute for Higher Education Policy (IHEP),30 the students most likely to borrow private loans include the following three groups:

84 FOOTING THE TUITION BILL • Undergraduates at relatively high-priced, private four-year institutions • Undergraduates with very high nontuition costs, such as room and board and living expenses • Professional students who face high tuition costs and high financial need IHEP’s data come from the 1999–2000 NPSAS, as does a recent analysis conducted by the Higher Education Project of the state Public Interest Research Group (PIRG). Our recent analysis of the 2003–4 NPSAS confirms most of the findings of these two studies in terms of the student characteristics of private borrowers. The major difference we find is a spike in the prevalence of private borrowing among undergraduates—both IHEP and PIRG report fewer than 4 percent of undergraduates with private loans in 1999–2000, while our analysis of the 2003–4 data shows this proportion now at 6.1 percent. While the NPSAS database has its limitations, it provides the most comprehensive source of student-level data on private borrowing. As such, NPSAS data are helpful for teasing out why private-label loans have grown so rapidly in the last decade. Conventional wisdom suggests that a handful of factors—including federal loan limits, rising tuition, and student college choice—account for much of the rise. Using available data from both the 1999–2000 and 2003–4 NPSAS, along with other sources, we examine the strengths and limits of each of these explanations. Loan Limits and Rising Tuition. As noted earlier, students can take out federal loans up to an institution’s cost of attendance, including living expenses, and minus a family or individual contribution based on income and asset data provided to the federal government. The aggregate Stafford loan amount a dependent student can borrow during his or her undergraduate studies has been capped at $23,000. Since 1992, even as tuition has risen greatly, efforts to raise loan limits have been regularly defeated, likely due to a combination of legitimate concern over rising student debt and a vocal private loan industry in Washington that wants to increase market share of these loans.

PRIVATE LENDING AND STUDENT BORROWING 85 For logical reasons, a number of observers suggest that this combination of stagnant loan limits and rising costs has forced many students to turn to private loans. This argument rests on two key assumptions: first, that students have significant unmet need even after federal loans, and second, that these same students and/or their families are taking out private loans to supplement their federal loans. On this first assumption, the available data are highly persuasive. According to a 1999–2000 survey of college financial aid administrators, three-quarters of undergraduate students at private four-year colleges and two-thirds of students at public four-year institutions cited unmet need beyond federal financial aid as the primary reason they took out private loans.31 IHEP’s analysis of the 1999–2000 NPSAS found that over 50 percent of undergraduates who borrowed private loans had also borrowed the maximum Stafford loan amount for which they were eligible; our recent analysis of the 2003–4 NPSAS found a slightly smaller percentage (42.53 percent) of private borrowers who maxed out their Stafford loans. Unmet need is clearly a problem for a significant portion of students. Yet, despite this, nearly half fail to max out their federal loans prior to taking out private loans, suggesting the lack of a pure substitution effect. The survey of aid administrators cited above found that 21 percent of respondents from private four-year institutions reported parents’ inability or unwillingness to borrow through the PLUS Program as the most common reason for taking out private loans. This suggests that many students with unmet need beyond their Stafford loans are choosing to replace PLUS loans with private loans, a finding consistent with the historic evidence. According to PIRG, “The average borrower with Stafford loans below the maximum level could have borrowed about 40 percent more in the Stafford Loan Program, or $6,623 over the course of a four-year undergraduate education.”32 Our analysis of the 2003–4 NPSAS confirmed this general trend: Over 36 percent of students with private loans debt did not take out any Stafford loans, and 21 percent borrowed less than the available maximum Stafford loan (see table 3-1 for detailed breakdowns). In short, loan limits and rising costs, while important factors, cannot fully account for student borrowing behavior and the expansion in demand for private loans.

86 FOOTING THE TUITION BILL TABLE 3-1 DISTRIBUTION OF PRIVATE LOANS BY STAFFORD BORROWING % of private borrowers

% of overall student population

No Stafford loans

36.29

73.34

Stafford loans below maximum threshold

21.18

10.54

Stafford loans at maximum threshold

42.53

16.12

SOURCE: Calculations by the author using U.S. Department of Education, National Center for Education Statistics, 2003–04 National Postsecondary Student Aid Survey, February 11, 2005, http://nces.ed.gov/ pubsearch/pubsinfo.asp?pubid=2005164 (accessed February 23, 2007). NOTE: Stafford loan limits for 2003–4: first year $2,625; second year $3,500; third to fifth year $5,500.

College Choice. A second explanation for the rise in private borrowing has less to do with need than with choice. According to this line of analysis, “Private loans help students attend the schools that they want to attend, rather than schools that they might have to attend because of inadequate financial resources.”33 As tuitions rise, students and families are using private loans in a variety of ways to shape the kinds of campus experiences students will have. There is some evidence to support this explanation, though the data most often reported are not causal, and thus cannot directly show the impact of loans on student and family choices.34 NPSAS, for example, consistently shows that the percentage of students who borrowed privately, as well as the average private loan amount, were highest at four-year private institutions and lowest at two-year public schools. Table 3-2 shows that over 34 percent of private borrowers attended private fouryear institutions, while roughly 14 percent attended public two-year schools. This suggests that some families use private loans to choose more elite institutions, particularly those selective private institutions that are not able to guarantee full financial aid to all admitted students. Private borrowing also appears to allow students and families to make other choices while students are in school. Private loan recipients, for example, are significantly more likely not to work while in school and to attend college full-time. Table 3-2 also shows that students with private loans are more than five times as likely to attend school full-time.

PRIVATE LENDING AND STUDENT BORROWING 87 A strength of the focus on college choice is that it seems to account for those cases in which private loans are taken when students have little or no unmet need. The NPSAS data show this occurs most frequently in moderate- and high-income families. PIRG’s 2003 analysis shows that nearly three-quarters of those students who took out private loans had no unmet need at all, based on the federal formula.35 Moderate- and highincome students and their families appear to be using private loans to cover living expenses beyond what the federal formula allows, or as an alternative means to cover the Expected Family Contribution (EFC) that is part of the federal financial aid calculation for dependent students. As noted above, other data suggest that private lending is increasingly used by moderateand high-income parents as an alternative to expenses not covered by the Unsubsidized Stafford, which has greatly lost its purchasing power in recent years.36 Some student aid experts believe that private loans are especially attractive to parents as an alternative to PLUS loans, since the former are made in the student’s rather than the parent’s name, and payment of principal and interest in most cases does not start until six months after the student finishes school.37 This set of factors—decreased purchasing power of the Stafford and the unattractiveness of PLUS loans—may explain why private loan volume has grown in the last decade at the expense of both Stafford and PLUS borrowing. While a choice-based explanation is helpful in understanding the motivations of moderate- and high-income families, it is less helpful in understanding the motivations of other students taking out private loans, particularly independent students and those from low-income families. Why, for example, do more than 50 percent of the small numbers of private borrowers at two-year colleges take out no Stafford loans at all? These students are not taking these loans to attend more elite institutions. Why, as table 3-2 shows, do 39 percent of private borrowers still work more than twenty hours a week? Again, forces beyond college choice and lifestyle are potentially at play here. In sum, the conventional wisdom explains some, but not all, of the rise of private borrowing. In particular, a focus on loan limits, tuition, and college choice has trouble accounting for the motivations of a significant portion (around 57 percent; see table 3-1 for the detailed breakdown) of private borrowers who either fail to take federal student loans at all, or fail

88 FOOTING THE TUITION BILL TABLE 3-2 DISTRIBUTION OF PRIVATE LOAN BORROWERS % of all private borrowers Institutional type Public two-year Public four-year Private two-year Private four-year For-profit institutions

13.89 34.56 .66 34.32 16.57

Age Under 24 24–29 30 and over

71.70 15.07 13.23

Dependent students Independent students

66.89 33.11

Income Lowest quartile1 ($0–$20,534) Second quartile ($20,535–$43,602) Third quartile ($43,603–$75,261) Highest quartile ($75,262–$537,000)

22.99 22.42 26.86 27.73

Attendance pattern Full-time/full-year students Part-time/full-year students Part-year students

64.03 12.84 23.13

Work intensity Nonworking students Students working 20 hours

29.15 31.96 38.89

Stafford loan status No Stafford loans Some Stafford loans (not maximum) Maximum Stafford loans

36.29 21.18 42.53

SOURCE: Calculations by the author using U.S. Department of Education, National Center for Education Statistics, 2003–04 National Postsecondary Student Aid Survey, February 11, 2005, http://nces.ed.gov/ pubsearch/pubsinfo.asp?pubid=2005164 (accessed February 23, 2007). NOTES: Undergraduate students at accredited U.S. institutions (due to sampling constraints, restricted to students who attended only one institution during 2003–4). 1) Parental income for dependent students, student income for independent students.

PRIVATE LENDING AND STUDENT BORROWING 89 to reach Stafford loan limits. This population is of more than small interest to policymakers—the behavior is most pronounced among low-income and independent students. Among private borrowers with incomes under $10,000, barely more than 20 percent borrow the maximum Stafford loan available to them.38 Who Are Private Borrowers? The data reported in tables 3-1 and 3-2 clearly show at least three distinct populations of students who take out private loans, with different demographics and motivations and different implications for policy. A first group (around 43 percent of private borrowers) consists of those hardest hit by the convergence of loan limits and rising costs—moderate- to low-income students with unmet need who have maxed out their Stafford loan limits and still need private loans to cover costs. Their reasons are likely to be varied: Some will be using loans to exercise college choice or enhance living expenses; others may have parents who do not wish to take out PLUS loans. These are students and families whose behavior is most likely to be affected by changes in federal financial aid policy, whether in the form of higher loan limits, shifting interest rates, or changes in how the estimated COA (cost of attendance) or EFC is calculated. They will also find private loans more attractive than PLUS loans, and may be further affected by the higher rates for PLUS after July 2006. Policymakers with concerns about student private-market debt should pay particular attention to this population, which may be influenced by changes in PLUS that mirror repayment plans in the private market (such as deferred interest, student loans with parent cosign options, and others). Additional research will be helpful in understanding how this group’s borrowing behavior can be influenced by changes in the federal loan program. A second group of students—roughly 21 percent in the 2003–4 NPSAS—is made up of those who have failed to max out their federal Stafford loans. The State PIRG analysis found this practice most prevalent among low-income students: “Nearly 25 percent of those with incomes under $30,000 borrowed less than the maximum Stafford, while only 12 percent of private borrowers with incomes over $100,000 borrowed less than the available maximum loan amount.”39 Our analysis of the 2003–4 NPSAS (see table 3-3 for detailed breakdowns) confirms these income differences and finds that these students were also significantly more likely to

90 FOOTING THE TUITION BILL TABLE 3-3 CHARACTERISTICS OF PRIVATE LOAN–TAKERS BY STAFFORD LOAN STATUS No Not % of Stafford maxed Maxed general (%) (%) (%) population Applied for any aid

100.00

100.00

100.00

75.70

Applied for federal aid

65.83

100.00

100.00

57.93

Percentage dependent

70.21

62.17

67.40

51.57

Immigrant status Visa Resident alien Foreign-born citizen Foreign-born parents All other citizens

6.00 5.67 3.89 11.67 72.71

0.00 4.37 4.69 11.97 78.86

0.00 5.21 4.10 13.19 77.50

0.85 5.00 5.76 11.25 77.14

Race and ethnicity White Black Hispanic Asian American American Indian Pacific Islander Other

65.98 11.51 11.51 6.16 0.49 0.00 1.30

63.11 15.05 12.94 3.88 0.00 0.65 3.24

65.49 9.86 14.31 4.58 0.83 0.42 1.46

59.09 18.15 12.78 4.59 0.81 0.39 1.45

U.S.-born

84.44

90.94

90.69

88.39

Attend school in state

73.74

81.34

75.14

86.41

Income Lowest quartile1 ($0–$20,534) Second quartile ($20,535–$43,602) Third quartile ($43,603–$75,261) Highest quartile ($75,262–$537,000)

17.31 14.42 24.92 43.35

23.46 24.68 26.62 25.24

27.06 28.10 29.12 15.72

25.00 25.00 25.00 25.00

Selectivity Most Very Moderately Minimal Open admissions

6.00 15.88 41.98 11.02 23.82

2.91 14.24 38.19 18.61 25.24

2.99 17.94 44.65 19.24 13.96

3.21 12.41 34.25 13.73 35.72

SOURCE: Calculations by the author using U.S. Department of Education, National Center for Education Statistics, 2003–04 National Postsecondary Student Aid Survey, February 11, 2005, http://nces.ed.gov/ pubsearch/pubsinfo.asp?pubid=2005164 (accessed February 23, 2007). NOTES: Stafford loan limits for 2003–4: first year $2,625; second year $3,500; third to fifth year $5,500. 1) Parental income for dependent students, student income for independent students.

PRIVATE LENDING AND STUDENT BORROWING 91 attend open-admission institutions and institutions with minimal selectivity than students who maxed out their Stafford eligibility. This is a concern, since students at less selective institutions are less likely to complete their degrees.40 Independent students were especially likely to take out private loans without maxing out the Stafford; in 1999–2000, over 50 percent of independent private borrowers with incomes under $10,000 failed to borrow the maximum Stafford available.41 Previous research on low-income students suggests that these borrowers and their families often possess incomplete or incorrect information about the federal student loan program and may not fully understand what is available to them.42 For example, independent students may not be aware of the higher lifetime loan limits available to them ($46,000) through the Unsubsidized Stafford. Other research suggests these students are particularly averse to loans and to taking on significant debt.43 Yet these students might also change their borrowing behavior with further public communication about the federal loan program, from both postsecondary institutions and such nontraditional channels as the media and the web. As it is possible that many low-income, independent students find private loan terms and features more attractive than those offered by the Unsubsidized Stafford, more research on their borrowing behavior would be helpful prior to making policy changes. A final group of private borrowers—around 36 percent—includes those who do not take out any federal loans. Though perhaps of greatest concern to policymakers, they are the least likely to be affected by incremental changes in federal financial aid policy. Who are these students? As with the previous population, they are more likely to be some combination of low-income, older, and independent. They are also more likely to be ineligible for federal financial aid, whether due to prior default, immigration status, having reached federal loan limits or other factors. Roughly 10–20 percent of private borrowers are ineligible for federal loans.44 These are usually students who have previously defaulted on a student loan, are currently incarcerated, have been convicted of buying or selling illegal drugs, are international students with visas, or are undocumented.45 Table 3-3 shows that 6 percent of individuals on student visas (and not eligible for federal loans) took out at least one private loan in the 2003–4 year. Students not eligible for federal loans may be particularly vulnerable to unscrupulous lenders and predatory practices, although our review of lender

92 FOOTING THE TUITION BILL practices found that most lenders had more stringent eligibility requirements than the federal government and often rejected students and families with, for example, poor credit. A second portion of this larger group of students— those private borrowers eligible for federal loans who fail to take them—is even more vexing for policymakers. Clearly, we can infer that many of them and their families are put off by the extensive paperwork and bureaucracy associated with the federal program and the extensive personal and financial information required. Anecdotal evidence suggests that many private lenders provide simpler and more user-friendly application processes—often online—and require less personal information from borrowers, who may find this convenience worth the extra short- and long-term costs of the loans. In any case, the calculus of students and families who take out private loans as an alternative to federal loans is an area worthy of further research. To attract these borrowers, federal policymakers likely will need to make significant changes to the financial aid process, including simplifying need calculation and making loan-amount eligibility more transparent. They may also need to examine more closely the EFC calculations, which some experts believe greatly disadvantage independent students. The history of the federal loan program offers little precedent, however, for significant procedural changes of this sort. For this reason, policymakers—whether state or federal—may have to learn to live with private loans and find ways to leverage this sector while minimizing the risk to borrowers of unsecured private loans.

Recommendations for Federal and State Policymakers Learning more about current industry practices and the characteristics of borrowers is an essential step for policymakers concerned with the recent growth of private loans. As noted above, we still have much to learn, first, about industry practices. For instance: • What are the rates of default for private loans, and how do they compare with rates for federal loans? How do default rates vary by income, ethnicity, type of institution attended, and student attainment outcomes?

PRIVATE LENDING AND STUDENT BORROWING 93 • How common are private loans at exceedingly high interest rates (10 percent or higher)? Do private lenders make these loans as a matter of course? • Which students are most likely to take high-interest loans? Are they more likely to default and/or drop out of school? We also need answers to questions about student demographics and outcomes, including: • Why do students and families with unmet need choose private loans over PLUS loans? • Why do some students take private loans before maxing out their Stafford eligibility? • Why is this practice most prevalent among independent and low-income students? • Why do some private borrowers take out no federal loans at all? Why, in particular, do students eligible for federal loans not choose them? • What impact will the decision to remove variable rates on federal student loans and replace them with a fixed rate have on private borrowing? Answers to these questions can inform potential design choices in the federal student loan program and shape deliberation on such topics as loan limits, interest rates, and repayment options for PLUS loans, and federal application and need-calculation processes. Even in the unlikely event that policy changes occur in all these areas, private borrowing will still be with us, whether among students ineligible for federal loans, or those with unmet need. Therefore, policymakers will need to find ways to harness the private sector to enhance access and minimize student debt. To move in this direction, policymakers and those concerned with higher education outcomes will need a more nuanced understanding of the impact of student borrowing. One of the most striking, and puzzling, facts about undergraduate student success is that those students who start at

94 FOOTING THE TUITION BILL two-year institutions and borrow are significantly more likely to earn degrees than those that do not borrow at all. Among first-time freshmen starting at two-year institutions, 55 percent of nonborrowers drop out, compared to only 24 percent of borrowers. Of those same borrowers, 24 percent earn their associate’s degrees, compared to 13 percent of nonborrowers, while 21 percent go on to earn bachelor’s degrees, compared to only 6 percent of nonborrowers.46 Note that these effects disappear completely when students begin college at four-year institutions. Policymakers and others should interpret these findings cautiously. One plausible interpretation—certainly not the only one—is that student borrowing promotes behaviors (such as entering college immediately after completing high school, attending college full-time, working less while in school, or starting school at a four-year institution) that research shows encourage student persistence and degree completion.47 Borrowers may also have greater motivation to earn degrees that affect earnings because of their future debt levels. In all cases, the evidence suggests that we should not see borrowing, whether federal or private, as an unqualified negative. Student loans can play a similar role as grants in helping to support college choice and reduce factors that might mitigate credential attainment. Private loans, for example, are taken out disproportionately by full-time students, suggesting that some use these loans to enable behaviors that help them attain a credential, such as working less and attending school more intensively. Students are also most likely to take out private loans later in their undergraduate education, with the highest rates of private borrowing occurring in their third year and graduating year—suggesting these loans are a valuable supplemental strategy by some to ensure degree completion. The issue, then, for state and federal policymakers is to minimize the potentially undesirable side effects of student debt and debt burden (defined as size of loan payments relative to income), while enhancing the positive benefits of borrowing. There are a number of ways policy might do this—below I highlight three. One essential strategy at both the state and federal levels is to expand the availability of grants for students with unmet need. Grants are an essential tool for policy to promote student behaviors that encourage degree completion, while reducing long-term debt burden. While across-the-board increases in need-based grants such as Pell are desirable, such expansion

PRIVATE LENDING AND STUDENT BORROWING 95 appears unlikely in the reauthorization of the Higher Education Act. Our review of private borrowing suggests that state and federal policymakers may want to target grant resources to students who both max out their Stafford loans and take out private loans. This group is a relatively small part of the overall student population—slightly more than 16 percent of borrowers and fewer than 2 percent of all students. Worryingly, this group appears to be growing and comes disproportionately from low- and moderate-income families. Our analysis of 2003–4 NPSAS data found that well over 50 percent of private borrowers who maxed out their Stafford loans were from the two lowest family-income quartiles (see table 3-3 for detailed breakdowns). Targeting need-based grant resources to these students is a sensible way to reduce the debt burden of those at the greatest risk and is a better use of scarce federal resources than incremental changes to repayment rules or to the interest rates of PLUS loans that will raise the overall costs of the federal loan program. A second strategy is to use the tax system or other means to help students reduce their overall postcollegiate debt. By applying tax credits and deductions more strategically, policymakers aid students and families in making postcollege choices less driven by debt and loan repayment considerations. One possible approach is a recent tax credit proposal developed by the Project on Student Debt. The new tax credit is designed to replace the current student loan deduction in the tax code. It would allow individuals and families to claim a credit of up to $4,000 on the loan interest they pay each year, with the size of the credit varying based on the borrower’s income, loan burden, and family size, and with eligibility phasing out at higher income levels. Both student and parent borrowers would be eligible, as would both federal and private loans. A shift to a tax credit, the designers believe, would have a greater benefit to moderate- and low-income families than the current loan deduction of $2,500 a year. Unlike the federal deduction, the tax credit specifically targets a student’s debt burden and immediately reduces taxes owed on a dollar-for-dollar basis.48 An alternative approach for state policymakers is to tie debt-reduction to postcollege behaviors that may benefit state residents, such as working in particular high-need occupations or regions.49 States that wish to pay off student debts to reduce shortages of teachers in high-need schools, for example, should include private-loan debt in any forgiveness plan.

96 FOOTING THE TUITION BILL A third, longer-term strategy for policymakers is to find better ways to support those low-income students who borrow and drop out of college. According to researchers Lawrence Gladieux and Laura Perna, around 20 percent of the borrowers they studied did not complete their degree programs and were not enrolled five years later.50 These students have a median debt burden of $7,000 and are much more likely to default on their loans than other borrowers. They also have unemployment rates twice as high. Most of them begin college at either two-year public or private forprofit schools. One way to assist these students would be to tie student completion rates more directly to state higher education appropriations, or institutional eligibility for federal loans. To do this would require significantly better institutional-level data on persistence and degree completion than currently exist—data that control for student transfer and multi-institutional attendance and include students from all private institutions. Efforts to build such data systems are still in their infancy at the state and federal levels. An interim strategy is to identify a state or a nonprofit state agency willing to conduct a demonstration that ties state appropriations, and/or federal loan eligibility, to institutional completion rates and study their impacts and unintended consequences. Such an approach might, for example, unintentionally reduce access by discouraging openaccess institutions (that is, two-year public colleges) from enrolling higherrisk students, or students who are not fully qualified for college-level classes. Though some lenders will no doubt look unfavorably at efforts to reduce the pool of eligible institutions, others, like MRU, are already doing just that, motivated by the greater likelihood of students at certain institutions to default and the much smaller likelihood of those who complete their degrees to do so.51 In addition to these strategies, policymakers should continue to find ways to help students and families better understand the potential benefits and consequences of borrowing. That so many students borrow privately when subsidized and secured federal loans are available to them should be a sobering reminder of the difficulty of communicating policy intentions to individuals. Improving public communication about loans and debt and informing student and parent choice in ways that enhance degree completion are an agenda that policymakers, the public, and the private loan industry can all share. One component of this agenda could be to radically simplify the

PRIVATE LENDING AND STUDENT BORROWING 97 FAFSA and make the federal loan process much easier to understand for students and parents alike.52 As should be clear, student loans are not going away, and private lending and borrowing are likely to be facts of higher education for years to come. Finding ways to reduce both public and private debt, and maximize its benefits when taken on, is the next frontier for researchers and policymakers concerned with the financing of higher education in the United States.

4 The Demand Side of Student Loans: The Changing Face of Borrowers Bridget Terry Long and Erin K. Riley

Today, loans play a critical and growing role in helping students pay for higher education. Even after grants and scholarships, most families struggle to meet the costs of tuition, fees, and room and board, which in 2006–7 averaged $12,796 for one year at a public four-year university and $30,367 at a private four-year university.1 Without access to student loans, many students would not have the means to attend. This chapter examines how students use loans to meet their college expenses and provides a detailed picture of the “demand side” of the student loan industry. Despite the critical role loans play in providing access as well as choice to millions, the growing debt burden shouldered by students and their families is becoming a major concern. According to the College Board, in 2003–4 a student borrowing to finance a four-year degree at a public college or university graduated with a median cumulative debt of $15,500; for those receiving four-year degrees from private institutions, the amount was $19,400. Students earning two-year degrees from for-profit institutions faced similar loan burdens, with a median cumulative debt of $16,100.2 Unlike grants and scholarships, loans can influence students’ decisions long after they are first received, and many fear their impact may be negative. Researchers suggest that debt burden may significantly affect choices of field of study, and, more narrowly, that loans may deter students from entering public service careers, such as teaching.3 Another concern is the possibility that high debt encourages a student to delay such decisions as buying a house, getting married, and having children. 99

100 FOOTING THE TUITION BILL FIGURE 4-1 LOANS USED TO FINANCE POSTSECONDARY EDUCATION, 1994–95 TO 2004–5 (BILLIONS OF DOLLARS) 70 Federal Loan Programs

60 50

Federal Grant Programs

40 30

Nonfederal Loans

20 10

04 –5 20

03 –4 20

01 –2

02 –3 20

20

00

20

00 –1

99

99 – 19

8

98 –

–9 97

19

97 19

96 – 19

95 –9 6

19

19

94

–9 5

0

SOURCE: Sandy Baum and Kathleen Payea, Trends in Student Aid: 2005, College Board, 2005, table 2, www.collegeboard.com/prod_downloads/press/cost05/trends_aid_05.pdf (accessed February 23, 2007). NOTE: 2004–5 are estimated amounts. Dollar amounts are reported in billions and are in constant 2004 dollars.

On the other hand, there are reasons to wonder whether students have access to enough student loans in the face of rising college prices.4 Some point to the growing popularity of private loans as evidence that the government is not offering enough loan support to students.5 Others still worry that increasing the federal loans students can receive will only serve to increase further their debt burden and its negative consequences.6 As a result of these competing voices, the loan limits for federal loans are a constant subject of debate. Recently, the annual limits were slightly increased under the Deficit Reduction Act of 2005 as part of the Higher Education Reconciliation Act (HERA). However, the debate continues, and this chapter will elaborate on the various arguments. While much attention focuses on the recent growth of private or alternative loans, the federal government remains the primary investor in student loans. As shown in figure 4-1, the government in 2004–5 invested $62.6 billion dollars in loan programs—nearly three and a half times more

THE DEMAND SIDE OF STUDENT LOANS 101 FIGURE 4-2 PERCENTAGES OF FULL-TIME, FULL-YEAR UNDERGRADUATE STUDENTS RECEIVING ANY GRANT OR LOAN, 1989–90 TO 2003–4 70 60 Percentage receiving grants

50 40

Percentage receiving loans

30 20 10 0 1989–90

1992–93

1995–96

1999–00

2003–4

SOURCES: All data and percentages derived from U.S. Department of Education, National Center for Education Statistics, National Postsecondary Student Aid Survey: FY 1989–90, by Andrew G. Malizio (Washington, D.C.: Government Printing Office, 1991); U.S. Department of Education, National Center for Education Statistics, National Postsecondary Student Aid Survey: 1992–93, by Andrew G. Malizio (Washington, D.C.: Government Printing Office, 1995); U.S. Department of Education, National Center for Education Statistics, “NPSAS: National Postsecondary Student Aid Study: 1995–96,” July 24, 1998, http://nces.ed.gov/pubsearch/pubsinfo.asp?pubid=98074 (accessed February 23, 2007); U.S. Department of Education, National Center for Education Statistics, National Postsecondary Student Aid Survey: Student Financial Aid Estimates for 1999–2000, July 27, 2001, http://nces.ed.gov/pubsearch/pubsinfo. asp?pubid=2001209 (accessed February 23, 2007); U.S. Department of Education, National Center for Education Statistics, 2003–04 National Postsecondary Student Aid Survey, February 11, 2005, http://nces.ed.gov/pubsearch/pubsinfo.asp?pubid=2005164 (accessed February 23, 2007).

than it gave in grant aid that year. In comparison, nonfederal sources, such as the private market and state and institutional loan programs, loaned $13.8 billion, representing 18 percent of the total in 2004–5, compared to only 6 percent in 1996–97.7 The funding of postsecondary education with borrowed money has become especially prevalent from 1989–2004, as shown in figure 4-2. While a larger percentage of students still receives grant aid, the growth in the use of loans has been significant, especially for full-time, full-year students. In 1989–90, 36 percent of these students took out loans; but by 2003–4, the proportion had increased to 50 percent. Moreover, the average loan amount has also increased rapidly in recent years. As shown in

102 FOOTING THE TUITION BILL FIGURE 4-3 AVERAGE ANNUAL GRANT AND LOAN AMOUNTS RECEIVED BY FULL-TIME, FULL-YEAR UNDERGRADUATE STUDENTS, 1989–90 TO 2003–4 (CONSTANT 2003 DOLLARS) 8,000 $6,893

7,000

$6,200

$6,085 6,000

$5,423 $5,012

$4,486

5,000 $4,375

$5,600 Mean grant received

$4,790

$4,467

4,000

Mean loan received

3,000 2,000 1,000 0 1989–90

1992–93

1995–96

1999–00

2003–4

SOURCES: All data and percentages derived from U.S. Department of Education, National Center for Education Statistics, National Postsecondary Student Aid Survey: FY 1989–90, by Andrew G. Malizio (Washington, D.C.: Government Printing Office, 1991); U.S. Department of Education, National Center for Education Statistics, National Postsecondary Student Aid Survey: 1992–93, by Andrew G. Malizio (Washington, D.C.: Government Printing Office, 1995); U.S. Department of Education, National Center for Education Statistics, NPSAS: National Postsecondary Student Aid Study: 1995–96, July 24, 1998, http://nces.ed.gov/pubsearch/pubsinfo.asp?pubid=98074 (accessed February 23, 2007); U.S. Department of Education, National Center for Education Statistics, “National Postsecondary Student Aid Survey: Student Financial Aid Estimates for 1999–2000,” July 27, 2001, http://nces.ed.gov/pubsearch/pubsinfo.asp?pubid=2001209 (accessed February 23, 2007); U.S. Department of Education, National Center for Education Statistics, 2003–04 National Postsecondary Student Aid Survey, February 11, 2005, http://nces.ed.gov/pubsearch/pubsinfo.asp?pubid=2005164 (accessed February 23, 2007). NOTE: Loan amounts may be from any source but do not include Parent Loans for Undergraduate Students (PLUS).

figure 4-3, full-time, full-year undergraduate students took out an average loan of $4,486 (in constant 2003 dollars) in 1989–90. This had grown to $6,200 in 2003–4—an increase of 38 percent in constant 2003 dollars.8

THE DEMAND SIDE OF STUDENT LOANS 103 College Loan Programs: The Supply Side The precursors to many of today’s federal financial aid programs were established as part of the Higher Education Act (HEA) of 1965, including Educational Opportunity Grants and the Guaranteed Student Loan Program, later renamed the Federal Family Education Loan Program (FFELP). While federal loan programs originally targeted low-income students, funding, regulations, and eligibility requirements have changed over the past thirty years, along with political leadership and sentiment. These changes have often had serious implications for funding and focus in terms of intended recipients.9 The Evolution of Federal Student Loan Programs. In 1992, the HEA reauthorization changed the eligibility requirements for federal student loans, expanding the use of such resources exponentially. The new policy removed home equity from the financial aid formula, thereby allowing many more upper-income families to qualify. More importantly, the act expanded the Stafford Loan Program by creating unsubsidized loans available to any student regardless of family income. From 1993 to 2003, annual loan volume for the Stafford Unsubsidized Loan Program grew to $10.4 billion.10 Much of this growth has been attributed to newly eligible upperincome borrowers. By 1995–96, three years after the change, two-thirds of borrowers in the highest income quartile had Unsubsidized Stafford Loans, compared to 13 percent in the lowest.11 Current Federal Student Loan Programs. Today, the federal government has three main loan programs for students and their families: the Stafford, Perkins, and PLUS programs.12 The Stafford Loan Program is the preeminent lender to both undergraduate and graduate students, providing 70 percent of total loans in terms of dollar volume in 2004–5.13 Stafford loans are awarded in two forms. Subsidized loans, awarded on the basis of financial need and income, do not accrue interest while students are in school. Unsubsidized loans, which are not awarded on the basis of need, accrue interest from the time they are disbursed until they are paid in full. The Federal Perkins Loan Program is campus-based, which means that postsecondary institutions distribute the federal money among their students based on financial need. Finally, the Parent Loans for Undergraduate Students

104 FOOTING THE TUITION BILL TABLE 4-1 UNDERGRADUATE BORROWING IN FEDERAL STAFFORD LOAN PROGRAMS, 1994–95 TO 2004–5 (CURRENT AND CONSTANT 2004 DOLLARS) 1994–95 1995–96 1996–97 1997–98 Subsidized Stafford Loans Number of borrowers (thousands) Total dollars (millions) Average loan (current dollars) Average loan (constant dollars)

3,515 11,240 2,888 3,681

3,609 11,614 2,928 3,633

3,841 12,531 2,957 3,567

3,933 12,864 2,965 3,515

Unsubsidized Stafford Loans Number of borrowers (thousands) Total dollars (millions) Average loan (current dollars) Average loan (constant dollars)

1,469 4,425 2,712 3,456

1,689 5,227 2,782 3,452

1,941 6,190 2,844 3,431

2,135 6,997 2,920 3,461

SOURCE: Sandy Baum and Kathleen Payea, Trends in Student Aid: 2005, College Board, 2005, table 4, www.collegeboard.com/prod_downloads/press/cost05/trends_aid_05.pdf (accessed February 23, 2007).

Program (PLUS) is available to the parents of dependent, traditional-age college students, and, since 2006, to graduate students. Students apply for financial aid by filling out the Free Application for Federal Student Aid (FAFSA). It collects information on family income and assets as well as family composition, the number attending college, and the age of the head of household. Using this information, the government determines a student’s Expected Family Contribution (EFC)— the amount the household is estimated to be able to give toward the costs of the student’s college education. The treatment of income and assets in the EFC calculation differs slightly by dependency status. Dependent students tend to be traditional-age college students who rely on their parents for support. Independent students, by contrast, tend to be older (at least age twenty-four), or they qualify as independent because they are married, have dependents of their own, or have served in the Armed Forces. Because these two types of students come from very different

THE DEMAND SIDE OF STUDENT LOANS 105

1998–99 1999–00

2000–1

2001–2

2002–3

2003–4

2004–5

3,880 12,603 2,956 3,446

3,931 12,885 3,002 3,402

3,988 13,059 2,990 3,274

4,242 13,789 2,950 3,173

4,683 15,510 3,002 3,160

5,239 17,584 3,039 3,131

5,546 18,764 3,070 3,070

2,186 7,207 2,945 3,434

2,423 8,259 3,085 3,497

2,606 9,046 3,137 3,435

2,899 10,141 3,137 3,374

3,225 11,592 3,208 3,377

3,640 13,419 3,275 3,374

3,927 14,770 3,346 3,346

NOTE: The 2004–5 figures are estimated.

circumstances, the financial aid calculation tends to be more generous toward independent students. Need is determined by comparing the EFC to the total cost of attendance at the college the student attends. This includes tuition, fees, room and board, and other costs, and it is prorated based on enrollment intensity (that is, whether the student is full- or part-time).14 It is this calculated need amount along with a family’s EFC that affects whether the student is eligible for certain grants and loans. Students who have a low EFC and financial need will be eligible for a Subsidized Stafford Loan as well as perhaps a Perkins loan. Families with higher EFCs will instead be eligible for an Unsubsidized Stafford Loan. Students may take out a combination of both subsidized and unsubsidized federal loans up to the federally established limits. As shown in table 4-1, Subsidized Stafford Loans provided $18.8 billion in aid in 2004–5, with individual loans averaging $3,070. The unsubsidized program provided $14.8 billion, with an average loan amount of

106 FOOTING THE TUITION BILL $3,346.15 In total, the federal government gave 36 percent of its loans as Subsidized and 34 percent as Unsubsidized Stafford Loans during the 2004–5 school year.16 Until recently, interest rates for Stafford loans were variable, adjusted yearly with a cap of 8.25 percent. The HERA passed at the end of 2005 as part of the George W. Bush administration’s Deficit Reduction Act instituted a fixed interest rate of 6.8 percent, effective July 1, 2006. The 2005 HERA also changed annual loan limits in the Stafford Program for undergraduate and graduate students. Beginning July 1, 2007, undergraduates dependent on their parents are eligible to borrow up to $3,500 in Stafford loans their freshman year, up 33 percent from the current limit of $2,625. The annual limit for sophomores will increase as well, from $3,500 to $4,500. The maximum Stafford loan in any remaining year will be $5,500. Independent undergraduate students may borrow an additional $4,000 in Unsubsidized Stafford Loans their first two years and $5,000 the remaining years.17 Borrowers face cumulative as well as annual limits in the Stafford Program. Dependent undergraduates are limited to $23,000 in loans from the program. Independent undergraduate students and students whose parents have been denied PLUS loans due to adverse credit history face a cumulative limit of $46,000 for undergraduate education and a Stafford limit of $138,500 for combined undergraduate and graduate education.18 The Federal Perkins Loan Program is much smaller than the Stafford Loan Program, with just $1.6 billion awarded to campuses in 2003.19 It began in 1958 as the National Defense Student Loan Program and was part of the first federal student aid program for low-income students. Despite proposals by the Bush administration to eliminate it in 2005, the final budget resolution kept the program intact.20 Perkins loans are low-interest (5 percent) loans for both undergraduate and graduate students with financial need, and are subsidized while recipients are in school, as well as for a nine-month grace period. Unlike Stafford loans, the Perkins loans are campus-based, meaning federal funding is distributed to campuses, which then allocate the loans to students.21 Loans are repaid to the school rather than the federal government. Annual limits are set at $4,000 for undergraduates and $6,000 for graduates. Cumulative maximums are $20,000 and $40,000, respectively.22

THE DEMAND SIDE OF STUDENT LOANS 107 State and Institutional Loan Programs. Some states offer loans to students. For example, Michigan provided 3,617 loans to students attending postsecondary, degree-granting institutions in the state through a program called MI-LOAN in 2003–4.23 The Massachusetts Educational Financing Authority offers loans to students attending institutions in Massachusetts, as well as to Massachusetts residents attending colleges out of state. State loan programs, however, tend to be small in terms of the number of borrowers. Some colleges and universities also provide loan programs for their students which are often funded by the institution or in conjunction with an outside lender. Eligibility is often based on need, and borrowing is generally limited to the cost of attendance, minus any other aid the student receives. Private Loan Options for Students. Besides the federal government, the other major source of loans is the private market. Private loans are on the rise, with a rate of growth in 2004–5 higher than that of any other type of student aid.24 While this growth may in part be attributed to more borrowers or larger loans, some of it is due to increased options in the private loan market. In a 2003 study, researchers at the Institute for Higher Education Policy (IHEP) found that the number of private loan products, or private loans with different types of terms and conditions, grew 244 percent from 1997 to 2003, increasing from 79 products to 272.25 Unfortunately, it is difficult to get good information on private loans, so these numbers likely underestimate the students taking on private or alternative debt. While usage is growing, the percentage of students with private loans remains small compared to that of students in federal loan programs. Only 5 percent of undergraduate and 7 percent of graduate students borrowed from private sources in 2003–4. According to our calculations using data from the National Postsecondary Student Aid Survey (NPSAS; see below), undergraduates borrowed an average amount of $5,911 from private lenders in 2003–4, while the average graduate student loan was $9,264. Why is the use of private loans increasing? Some research suggests that many students use private debt to bridge the gap between the cost of attendance and financial aid packages due to insufficient federal loan limits. According to Kate Rube of IHEP, the average undergraduate dependent student with a family income under $30,000 borrowed $3,200 in private

108 FOOTING THE TUITION BILL loans, close to the average of low-income students’ unmet need of $3,800 cited by the Advisory Committee on Student Financial Assistance.26 Credit cards are yet another source of finance for many of today’s college students. Based on their review of several studies, Robert Manning and Ray Kirshak estimate that 75–85 percent of undergraduates at four-year institutions hold universal bank credit cards.27 Furthermore, they find the highest proportion of credit card holders at private universities. A study by Nellie Mae in 2005 found almost 24 percent of undergraduates use credit cards for tuition expenses, while 71 percent report using them to pay for textbooks.28 Unfortunately, there is little information on the widespread use of credit card debt to fund college expenses. College Loans for Parents and Other Loan Options. Students are not the only borrowers in the college loan market. In reaction to growing concern that the burden of paying for college was shifting from parents to their children, the federal government created the PLUS Program in the HEA reauthorization of 1980.29 The program provides access to capital for many parents unable to secure loans from other sources.30 These loans have no annual or aggregate limits except that parents may not borrow more than what is needed to cover the cost of attendance, net other financial aid.31 In 1981, the Omnibus Reconciliation extended the terms of the PLUS Program to independent students under Auxiliary Loans to Assist Students (ALAS). Most recently, the program was extended to graduate and professional students as part of the 2005 HERA. As of July 2006, students are also eligible to take out PLUS loans. Like Stafford loans, interest rates for PLUS loans in the past varied from year to year. However, a provision of the 2005 HERA fixed the interest rate at 6.8 and 8.5 percent. Over the last decade, loan volume in the PLUS Program increased steadily, going from 8 percent of Stafford borrowing in 1994–95 to 16 percent in 2004–5.32 The expansion is due in large part to the growing number of parents trying to secure loans to help pay for college. Between 1994–95 and 2004–5, the number of borrowers has more than doubled, from 3.27 million to 8.10 million. Moreover, between 2003–4 and 2004–5, both the number of borrowers and the number of loans grew more rapidly in PLUS than in the Subsidized or Unsubsidized Stafford Program. Annual loan averages in the program amounted to $9,416 in 2004–5.33

THE DEMAND SIDE OF STUDENT LOANS 109 Like students, parents are also increasingly turning to alternative or private options for college loans. One emerging alternative is the home equity loan. While little research is available regarding their usage, a review of college financial aid websites suggests that home equity loans are being marketed to families as yet another option for funding postsecondary education.34 If this practice becomes more prevalent, differences in home ownership rates for lower-income and minority families will likely affect the distribution of the loans.

The Characteristics of Borrowers The following section examines the nature of student demand for college loans. The analysis highlights how borrowing patterns differ by enrollment status and the type of institution attended, as well as by student characteristics such as race and income. Our research on participation in the various loan programs is based on new analysis of data from the 2003–4 National Postsecondary Student Aid Survey. The NPSAS is a comprehensive, nationally representative survey of college students, sponsored by the National Center for Education Statistics (NCES). It is designed to determine how students and families pay for postsecondary education and to describe some demographic and other characteristics of those enrolled.35 In this analysis, the term “borrower” refers to a student who applied for, qualified for, and received a loan. Unfortunately, there is not an equivalent data source for loan applicants that would provide information on all students trying to obtain loans, nor is there a way to distinguish those who qualified for a loan but chose not to receive it. Our discussion of the data focuses largely on federal programs such as Stafford, Perkins, and PLUS, as well as private loans. While less attention is paid to state or institutional loans due to the low percentage of students with these types of debt, data on these loans are available in the tables. Unfortunately, we do not have information on home equity loans or credit card debt used for higher education expenses. There are several factors to consider when assessing the characteristics of borrowers. First, one must distinguish between the percentage of students who take out a particular type of loan and the average amount of those

110 FOOTING THE TUITION BILL TABLE 4-2 UNDERGRADUATE STUDENTS WHO RECEIVED LOANS BY ATTENDANCE PATTERNS, 2003–4 Total loans (excl. PLUS)

Federal Stafford loans

Federal Perkins loans

Percentage who received within the group Mostly full-time

46.6

44.2

5.5

Mostly part-time

17.6

16.6

0.8

Full-time and parttime equally

32.6

30.9

2.0

19,054

19,054

19,054

5,960

4,894

1,957

(61)

(27)

(42)

5,238

4,961)

1,832

(82)

(82)

(107)

5,817 (186)

5,051 (154)

2,060 (166)

6,670

6,323

683

Total observations

Average loan amounts within group (dollars) Mostly full-time Mostly part-time Full-time and parttime equally Total observations

SOURCE: Calculations by the authors using U.S. Department of Education, National Center for Education Statistics, 2003–04 National Postsecondary Student Aid Survey, February 11, 2005, http://nces.ed.gov/pubsearch/pubsinfo.asp?pubid=2005164 (accessed February 23, 2007).

loans. In some cases we find that a particular group of students is very likely to utilize a certain program, but that the average amount borrowed is relatively small. It is also important to make a distinction between annual and cumulative loan amounts, which are discussed in a later section. Borrowers by Attendance Pattern. Enrollment intensity, or whether a student is enrolled full-time or part-time, is one factor that influences the amount of aid a student is eligible to receive, since costs will be less for those attending less than full-time. Additionally, the demand for loans may be affected by enrollment intensity, since part-time students may have a

THE DEMAND SIDE OF STUDENT LOANS 111

State loans

Institutional loans

Private (alternative) loans

PLUS loans (parents)

0.5

1.0

7.4

5.3

0.1

0.2

1.8

0.5

0.1

0.5

4.4

1.6

19,054

19,054

19,054

19,054

4,358

2,830

6,160

9,102

(237)

(228)

(199)

(160)

$2,451

$4,318

7,585

(410)

(174)

(379)

low n

low n

6,201 (782)

9,333 (1,734)

55

126

978

634

low n

NOTES: Stafford loans include both subsidized and unsubsidized loans. Students may have multiple types of loans and so may be counted in more than one column. “Low n” appears where the number of valid cases is too small to produce a reliable estimate. Standard errors are presented in parentheses.

greater ability to pay for college expenses with concurrent employment. As table 4-2 shows, the percentage of students borrowing is greatly affected by enrollment. Of full-time students, 47 percent borrowed, versus 18 percent of part-time students. This is almost identical to the 44.2 percent and 16.6 percent, respectively, of full-time and part-time students participating in the Stafford Program. Despite large disparities in participation rates, little difference is observed in the average loan amounts by enrollment intensity ($5,960 versus $5,238). This may reflect the facts that both full-time and part-time students will borrow up to their limits, and that a large portion of borrowing occurs in the federal programs.

112 FOOTING THE TUITION BILL TABLE 4-3 UNDERGRADUATE STUDENTS WHO RECEIVED LOANS BY INSTITUTION, 2003–4 Total loans (excl. PLUS)

Federal Stafford loans

Federal Perkins loans

Percentage who received within the group Four-year

50.2

47.7

6.7

Two-year

18.0

16.9

0.5

Less than two-year

49.9

47.4

0.3

Public four-year

44.5

42.1

5.8

Private four-year (not-for-profit)

56.3

53.4

9.9

Public two-year

12.1

11.1

0.4

Private for-profit (proprietary)

73.4

71.7

1.4

19,054

19,054

19,054

Total observations

Average loan amount within group (dollars) Four-year

6,279 (62)

5,199 (36)

1,949 (40)

Two-year

4,597 (121)

4,141 (60)

1,919 (116)

Less than two-year

5,059 (68)

4,458 (37)

low n

Public four-year

5,593 (46)

4,902 (42)

1,885 (43)

Private four-year (not-for-profit)

6,943 (139)

5,058 (65)

2,033 (69)

Public two-year

3,638 (87)

3,402 (83)

2,023 (167)

Private for-profit (proprietary)

6,759 (176)

5,840 (65)

2,165 (250)

Total observations

6,670

6,323

683

SOURCE: Calculations by the authors using U.S. Department of Education, National Center for Education Statistics, 2003–04 National Postsecondary Student Aid Survey, February 11, 2005, http://nces. ed.gov/pubsearch/pubsinfo.asp?pubid=2005164 (accessed February 23, 2007).

THE DEMAND SIDE OF STUDENT LOANS 113

State loans

Institutional loans

Private (alternative) loans

PLUS loans (parents)

0.5

1.1

7.5

5.7

0.1

0.1

2.5

0.8

0.02

1.8

7.4

5.0

0.6

0.6

5.1

4.9

0.5

2.4

11.5

7.8

0.1

0.1

1.4

0.2

0.1

1.0

12.7

4.9

19,054

19,054

19,054

19,054

4,448 (241)

2,922 (268)

6,435 (156)

9,319 (169)

$3,147 (234)

2,635 (516)

4,451 (588)

7,788 (616)

low n

2,136 (124)

4,890 (125)

6,576 (305)

4,570 (332)

2,684 (221)

5,392 (163)

7,765 (179)

$4,026 (211)

3,096 (474)

7,863 (262)

11,392 (293)

$3,249 (259)

low n

3,378 (212)

5,642 (632)

low n

2,342 (336)

5,648 (642)

8,833 (457)

55

126

978

634

NOTES: Standard errors are presented in parentheses. Stafford loans include both subsidized and unsubsidized loans. Students may have multiple types of loans and so may be counted in more than one column. “Low n” appears where the number of valid cases is too small to produce a reliable estimate.

114 FOOTING THE TUITION BILL TABLE 4-4 PERCENTAGES OF UNDERGRADUATE STUDENTS RECEIVING LOANS BY INCOME, 2003–4 Total loans (excl. PLUS)

Stafford loans

Perkins loans

All students

35.0

33.2

3.6

Dependent students All dependent students Lowest income quartile Lower middle income quartile Upper middle income quartile Highest income quartile

38.1 39.2 41.6 39.8 31.6

35.7 36.8 39.3 37.3 29.6

5.2 8.2 7.1 3.7 1.8

Independent students All independent students Lowest income quartile Lower middle income quartile Upper middle income quartile Highest income quartile

32.0 37.8 40.5 31.2 18.0

30.7 35.9 39.2 30.0 17.1

2.0 3.5 2.4 1.7 0.3

19,054

19,054

19,054

Total observations

SOURCe: Calculations by the authors using U.S. Department of Education, National Center for Education Statistics, 2003–04 National Postsecondary Student Aid Survey, February 11, 2005, http://nces.ed.gov/ pubsearch/pubsinfo.asp?pubid=2005164 (accessed February 23, 2007).

Full-time students are also more likely to participate in the private loan market, with 7.4 percent borrowing privately, compared to 1.8 percent of part-time students. Although differences in the average loan amount were not observed either overall or for the Stafford Loan Program, full-time students borrowed 43 percent more on average in private loans ($6,160 versus $4,318). Since the private loan market does not set annual limits like federal programs do, it is unsurprising that full-time students, who likely face higher costs than those attending only part-time, would obtain more debt from these sources. Loan Demand by Type of Institution. The type of institution attended heavily influences student reliance on loans and the size of the loans. Table 4-3

THE DEMAND SIDE OF STUDENT LOANS 115

Private (alternative) loans

State loans

Institutional loans

PLUS loans

5.1

0.3

0.7

3.3

6.9 5.6 7.2 8.1 6.6

0.5 0.3 0.6 0.5 0.4

0.9 1.1 1.0 1.0 0.6

6.7 3.6 6.2 8.7 8.4

3.4 4.1 3.8 3.5 2.3

0.1 0.1 0.1 0.2 0.1

0.4 0.6 0.6 0.3 0.1

– – – – –

19,054

19,054

19,054

19,054

NOTES: Stafford loans include both subsidized and unsubsidized loans. Students may have multiple types of loans and so may be counted in more than one column.

shows many differences according to the level of the institution (four-year, two-year, or less than two-year) and the sector (public, private, or for-profit). At the four-year institutions, 50 percent of students borrowed, compared to only 18 percent at two-year institutions. This disparity might be influenced by the likelihood that more part-time students are found at twoyear institutions, affecting the cost of attendance and the resulting demand for loans, as discussed earlier. Stafford borrowing trends were similar to overall borrowing, with 48 percent of students attending four-year institutions and 16.9 percent from two-year institutions participating in the program. Students who enrolled in less-than-two-year programs, such as certificate programs, borrowed at the same rate as those attending four-year institutions (49.9 percent), but they borrowed less on average ($5,059

116 FOOTING THE TUITION BILL TABLE 4-5 AVERAGE UNDERGRADUATE LOAN AMOUNTS BY INCOME AND DEPENDENCY STATUS, 2003–4 (DOLLARS) Total loans (excl. PLUS)

Stafford loans

Perkins loans

5,816 (52)

4,912 (28)

1,948 (38)

All dependent students

5,282 (63)

3,982 (27)

1,932 (43)

Lowest income quartile

5,041 (98)

4,026 (52)

1,984 (46)

Lower middle income quartile

5,172 (80)

3,946 (40)

1,888 (58)

Upper middle income quartile

5,363 (94)

3,947 (45)

1,829 (65)

Highest income quartile

5,634 (106)

4,018 (44)

2,080 (104)

All independent students

6,447 (69)

5,984 (48)

1,990 (68)

Lowest income quartile

6,203 (91)

5,693 (69)

2,054 (91)

Lower middle income quartile

6,289 (97)

5,826 (72)

1,932 (86)

Upper middle income quartile

6,553 (122)

6,072 (100)

2,058 (125)

Highest income quartile

7,151 (145)

6,829 (118)

low n

Total observations

6,670

6,323

683

All students Dependent students

Independent students

SOURCE: Calculations by the authors using U.S. Department of Education, National Center for Education Statistics, 2003–04 National Postsecondary Student Aid Survey, February 11, 2005, http://nces. ed.gov/pubsearch/pubsinfo.asp?pubid=2005164 (accessed February 23, 2007).

THE DEMAND SIDE OF STUDENT LOANS 117

Private (alternative) loans

State loans

Institutional loans

PLUS loans

5,911 (175)

4,263 (221)

2,825 (231)

9,019 (160)

6,349 (165)

4,440 (272)

3,059 (256)

9,019 (160)

5,245 (274)

3,098 (349)

2,716 (432)

6,906 (344)

5,743 (235)

4,051 (322)

3,033 (439)

7,799 (282)

6,579 (225)

4,840 (409)

3,083 (412)

8,848 (239)

7,698 (302)

5,585 (549)

3,701 (769)

11,075 (271)

5,040 (275)

3,608 (365)

2,302 (273)

–

5,093 (386)

low n

1,903 (377)

low n

5,200 (358)

low n

2,348 (484)

low n

5,047 (384)

low n

2,433 (423)

low n

4,670 (380)

low n

3,515 (702)

low n

978

55

126

634

NOTES: Standard errors are presented in parentheses. Stafford loans include both subsidized and unsubsidized loans. Students may have multiple types of loans and so may be counted in more than one column. “Low n” appears where the number of valid cases is too small to produce a reliable estimate.

118 FOOTING THE TUITION BILL versus $6,279). The percentage of students turning to the private loan market reflects a similar pattern of demand by institutional level. Seven and one-half percent of four-year students, 2.5 percent of two-year students, and 7.4 percent of less-than-two-year students took out private loans. Even more disparities appear among public, private, and for-profit institutions. The higher cost of private institutions and the resulting increased demand for loans is evident for those attending private four-year compared to public four-year institutions. At private four-year schools, 56 percent of students borrowed, compared to 45 percent at public four-year schools. These numbers closely reflect differences in Stafford borrowing rates, with 53 percent and 42 percent, respectively, participating in the program from private nonprofit and public four-year institutions. Moreover, almost 12 percent of students at private colleges borrowed from private lenders, compared to only 5 percent at public institutions. A startling 73 percent of students who attended for-profit, proprietary colleges borrowed, with 71.7 percent borrowing from the Stafford Loan Program. Finally, parents of students at private colleges seem to have demonstrated either an increased willingness or a greater need to borrow to finance the higher costs associated with these schools. Participation in the PLUS Program among parents of students at private, nonprofit, four-year colleges was 7.8 percent, almost 60 percent higher than the 4.9 percent participation rate of parents of students at public four-year institutions. Private-school parents, in addition to having higher participation levels, took out much larger PLUS loans than parents of public four-year students ($11,392 versus $7,765). Virtually no parents (less than a quarter of a percent) whose children enrolled in public two-year programs took out PLUS loans. However, the borrowing rate for parents with children at for-profit, proprietary schools, which tend to be two-year or less, matched that of parents of children in public four-year programs (4.9 percent). Cost differentials and differences in attitudes toward borrowing for education likely influenced these disparities. Additionally, some of the observed differences by institutional sector may have resulted from differences in the ways financial aid offices market loan options. Borrowers by Income and Dependency. Tables 4-4 and 4-5 compare student loan demand by income level. These are shown separately for dependent and independent students for two reasons. As discussed above, the

THE DEMAND SIDE OF STUDENT LOANS 119 income distributions and attendance patterns tend to be vastly different for these two types of students. In addition, financial aid is awarded differently by dependency status, as illustrated by the different loan limits for each group. As shown in tables 4-4 and 4-5, in 2003–4 a higher percentage overall of dependent students took out loans than independent students (38.1 percent versus 32.0 percent). However, independent students borrowed, on average, over $1,100 more than dependent students. In terms of specific loan programs, the percentage of students participating in the Stafford Program differed little by dependency status; approximately one-third of both dependent and independent students took out Stafford loans. Average loans in the program were 50 percent higher for independent students—$5,984, compared to $3,982 in 2003–4. While less than 1.0 percent of students in each category borrowed through state or institutional loan programs, dependent students received, on average, larger loans from these nonfederal sources. They and their families turned to PLUS and private loans at nearly equivalent rates, with 6.7 percent and 6.9 percent, respectively, carrying these loans. There are several possible explanations for the lower percentage of independent students participating in loan programs. One is that they received more grant aid because financial aid calculations are more generous for them. Alternatively, since independent students tend to select lowercost institutions, they were more likely to attend less than full time and therefore required fewer loans. Among dependent students, demand for loans was not limited to lowincome students and families. Both dependent and independent students in the top income quartile, however, were the least likely to have any loans. Of dependent students in the lowest income quartile, 37 percent borrowed in the Stafford Program, while in comparison only 30 percent of students in the highest income quartile did so. These two groups borrowed average amounts of $4,026 and $4,018, respectively, suggesting income is not a strong indicator of demand in the Stafford Program. Participation in the PLUS Program paints a very different picture. A lower percentage of parents of students in the lowest income quartile took out PLUS loans than of those in the highest income quartile, and, on average, the lowerincome families borrowed a smaller amount. PLUS borrowers from the lowest income quartile borrowed an average of $6,906, while those from the

120 FOOTING THE TUITION BILL TABLE 4-6 STUDENTS WHO RECEIVED LOANS BY INCOME, ACCOUNTING FOR ATTENDANCE PATTERN OR INSTITUTION TYPE, 2003-4 Attended mostly full-time Percent Average loan (dollars) Lowest income quartile Lower middle income quartile Upper middle income quartile Highest income quartile

48.6 51.2 47.5 37.3

5,777 (78) 5,901 (75) 6,048 (101) 6,238 (105)

SOURCE: Calculations by the authors using U.S. Department of Education, National Center for Education Statistics, 2003–04 National Postsecondary Student Aid Survey, February 11, 2005, http://nces.ed.gov/pubsearch/pubsinfo.asp?pubid=2005164 (accessed February 23, 2007).

TABLE 4-7 PERCENTAGE OF UNDERGRADUATE STUDENTS RECEIVING LOANS BY RACE OR ETHNICITY, 2003–4

White Black or African American Hispanic or Latino Asian American American Indian or Alaska Native Native Hawaiian / other Pac. Islander Other More than one race Observations

Total loans (excl. PLUS)

Stafford loans

Perkins loans

35.2 43.1 29.8 24.8

33.5 41.6 27.9 21.7

3.8 3.4 2.5 4.7

32.4

30.9

2.5

26.8

25.4

1.8

35.6 34.9 19,054

33.3 33.3 19,054

3.9 4.0 19,054

SOURCE: Calculations by the authors using U.S. Department of Education, National Center for Education Statistics, 2003–04 National Postsecondary Student Aid Survey, February 11, 2005, http://nces.ed.gov/pubsearch/pubsinfo.asp?pubid=2005164 (accessed February 23, 2007).

THE DEMAND SIDE OF STUDENT LOANS 121

Attended a public four-year institution Percent Average loan (dollars) 5,490 (69) 5,720 (74) 5,633 (96) 5,479 (112)

50.1 52.3 44.7 30.8

Attended a private four-year institution Percent Average loan (dollars) 60.9 64.1 59.9 44.1

Attended a public two-year institution Percent Average loan (dollars)

6,866 (238) 6,914 (241) 7,018 (195) 6,972 (216)

13.5 16.2 12.6 5.6

3,544 (142) 3,552 (95) 3,667 (115) 4,087 (239)

NOTES: Standard errors are presented in parentheses. The average loan amounts are only for those who took out a loan.

Private (alternative) loans

State loans

Institutional loans

PLUS loans

5.5 4.2 4.7 4.5

0.4 0.2 0.1 0.2

0.7 0.8 0.6 0.7

3.8 2.4 2.3 2.5

4.1

0.6

0.3

0.3

4.9

0.2

0.4

3.8

6.2 5.7 19,054

0.1 0.5 19,054

0.4 0.4 19,054

3.5 4.4 19,054

NOTES: Stafford loans include both subsidized and unsubsidized loans. Students may have multiple types of loans and so may be counted in more than one column.

122 FOOTING THE TUITION BILL TABLE 4-8 AVERAGE UNDERGRADUATE LOAN AMOUNTS BY RACE OR ETHNICITY, 2003–4 (DOLLARS) Total loans (excl. PLUS)

Stafford loans

Perkins loans

White

5,861 (71)

4,852 (41)

1,898 (45)

Black or African American

5,69 (107)

5,155 (93)

2,042 (60)

Hispanic or Latino

5,619 (120)

4,862 (91)

1,969 (113)

Asian

5,899 (204)

4,833 (124)

2,081 (108)

American Indian or Alaska Native

6,011 (357)

5,319 (242)

low n

Native Hawaiian / other Pac. Islander

6,336 (528)

5,238 (389)

low n

Other

5,949 (291)

4,907 (177)

2,278 (200)

6,099

4,825

2,050

(277)

(165)

(139)

6,670

6,323

683

More than one race Observations

SOURCE: Calculations by the authors using U.S. Department of Education, National Center for Education Statistics, 2003–04 National Postsecondary Student Aid Survey, February 11, 2005, http://nces. ed.gov/pubsearch/pubsinfo.asp?pubid=2005164 (accessed February 23, 2007).

highest borrowed $11,075 on average. This disparity may have been a result of differences in the cost of attendance at their children’s schools, or perhaps a reflection of attitudes toward borrowing to pay for college. Perkins loans, which are need-based, are largely awarded to low-income students. About 8.0 percent in the lowest income quartile took out a loan, compared to 1.8 percent in the highest quartile. While it might seem strange for any students in the highest quartile to qualify for a need-based loan, it is important to remember that need is not only a function of income, but also the cost of attendance, as well as other factors—such as how many siblings are in college at the same time—that affect a family’s EFC.

THE DEMAND SIDE OF STUDENT LOANS 123

Private (alternative) loans

State loans

Institutional loans

PLUS loans

6,124 (177)

4,033 (177)

2,945 (336)

9,138 (182)

4,793 (232)

low n

3,388 (668)

8,612 (504)

5,429 (293)

low n

1,628 (195)

8,582 (459)

6,294 (684)

low n

2,633 (524)

9,341 (659)

5,122 (1,038)

low n

low n

low n

low n

low n

low n

low n

6,027 (1,072)

low n

low n

7,382 (825)

low n

low n

55

126

7,019 (737) 978

9,311 (915) 634

NOTES: Standard errors are presented in parentheses. Stafford loans include both subsidized and unsubsidized loans. Students may have multiple types of loans and so may be counted in more than one column. “Low n” appears where the number of valid cases is too small to produce a reliable estimate.

In absolute terms, demand for private loans varied only slightly between income groups, but the differences were significant considering the small percentage of students borrowing from these sources. The highest level of participation was by students in the third income quartile, with a little more than 8.0 percent holding private loans. In the lowest income quartile, 5.6 percent of students borrowed, or 45 percent fewer than in the third quartile. Roughly 7.0 percent of students in the second quartile and 6.6 percent in the highest quartile took out private loans. Although the highest-income students did not participate at the greatest rate in the private market, they borrowed significantly more on average

124 FOOTING THE TUITION BILL TABLE 4-9 STUDENTS WHO RECEIVED LOANS BY RACE OR ETHNICITY, ACCOUNTING FOR ATTENDANCE PATTERN OR INSTITUTION TYPE, 2003–4 Attended mostly full-time Percent Average loan (dollars) White

46.6

5,971 (79)

Black or African American

56.0

5,906 (125)

Hispanic or Latino

42.1

5,870 (136)

Asian

32.9

5,937 (252)

SOURCe: Calculations by the authors using U.S. Department of Education, National Center for Education Statistics, 2003–04 National Postsecondary Student Aid Survey, February 11, 2005, http://nces. ed.gov/pubsearch/pubsinfo.asp?pubid=2005164 (accessed February 23, 2007).

than other students. Students in the highest income quartile borrowed $7,698 on average, 47 percent more than the average private loan of $5,245 for students in the lowest quartile. Not only did the highest-income, dependent students borrow more from private sources; the data suggest these students carried a larger average loan in every program except Stafford. While the data do not reveal the reasons for borrowing, explanations may include higher costs of attendance due to school choice, greater familiarity with borrowing, or less eligibility for grant aid. Furthermore, higher-income students might be willing to accept larger loans than low-income students because of differences in attitudes toward borrowing and confidence in their ability to repay the loan. Independent students exhibited somewhat reverse trends by income status in terms of the percentage participating in the different loan programs, with a higher percentage of low-income students receiving loans. Also, independent students from lower-income groups borrowed more, on average, than those in higher-income groups.

THE DEMAND SIDE OF STUDENT LOANS 125

Attended a public four-year institution Percent Average loan (dollars)

Attended a private four-year institution Percent Average loan (dollars)

Attended a public two-year institution Percent Average loan (dollars)

44.0

5,609 (58)

55.8

7,054 (147)

12.7

3,684 (103)

57.4

6,023 (135)

66.3

6,606 (251)

17.0

3,524 (130)

41.3

5,055 (132)

50.1

6,251 (387)

7.1

3,250 (211)

33.1

5,073 (205)

49.2

7,178 (456)

4.4

3,888 (452)

NOTES: Standard errors are presented in parentheses. The average loan amounts are only for those who took out loans.

The patterns observed by income level are partly due to differences in enrollment patterns. Upper-income students are more likely to attend fulltime and to choose four-year institutions. To account for this, table 4-6 explores differences in the use of loans within the group of students who attended mostly full time, and by institution type. Even accounting for enrollment intensity, students in the highest income quartile were less likely to take out loans. Those in the lower-middle-income quartile took out the highest proportion of loans. Overall, the loan rates were higher for each income group among only full-time students. Differences are also evident by income level within institution type, but they were much larger. Borrowers by Race or Ethnicity. Tables 4-7 and 4-8 display loan usage by race or ethnicity. A higher proportion—43.1 percent—of black students overall had loans (excluding PLUS), compared to white (35.2 percent), Hispanic (29.8 percent), and Asian (24.8 percent) students. In terms of the Stafford Loan Program, minority students borrowed larger amounts on average. Among minority groups, however, the percentages receiving these loans differed

126 FOOTING THE TUITION BILL greatly, with 41.6 percent of black compared to 27.9 percent of Hispanic and 21.7 percent of Asian students receiving these loans (table 4-7). Among white students, 33.5 percent borrowed from the Stafford Loan Program. White students were most likely to take out private loans, with approximately 5 percent borrowing from this source, but there was not a great deal of variation in borrowing by race. Native American and black students were least likely to carry private loans, with just over 4 percent doing so in 2003–4. Parental borrowing among racial groups followed a similar pattern to private borrowing, with 3.8 percent of white parents having PLUS loans, while 2.4 percent of black, 2.3 percent of Hispanic, and 2.5 percent of Asian parents used PLUS loans. Average loan amounts in the PLUS Program were greatest for Asian and white students at $9,341 and $9,138, respectively. Out of the groups for which race was known, Hispanic students borrowed the least, with an average loan of $8,582. Table 4-9 attempts to account for differences in enrollment patterns by race. Looking at the loan usage of full-time students only, it is clear that students of color were still more likely to take out loans. The pattern is also robust within institution type. Therefore, enrollment pattern and institution type do not appear to explain away differences in the use of loans.

Concerns about Student Loans: Too Much or Not Enough Debt? So far we have detailed annual loan amounts. To truly understand the role of debt, however, one must consider the total, or cumulative, amount students take out to cover their college expenses. Trends in Cumulative Debt. As might be expected given the growing amount of debt outlined above, it is not surprising to find that the cumulative amount of student debt has been rising steadily since 1992–93. As table 4-10 shows, the total cumulative amount of debt held by second-year undergraduates at public two-year institutions increased an average of 106 percent in 2003–4 dollars, from $3,087 in 1992–93 to $8,296 in 2003–4. Amounts over this period for fourth-year undergraduates at public and private institutions were 76 percent and 57 percent higher, respectively. The College Board calculates slightly different numbers, yet our calculations

THE DEMAND SIDE OF STUDENT LOANS 127 TABLE 4-10 CUMULATIVE AVERAGE AMOUNTS BORROWED BY FULL-YEAR UNDERGRADUATES, 1992–93 TO 2003–4 Amounts borrowed in nominal dollars 1992–93 1995–96 1999–00

2003–4

Change 1992–93 to 2003–4 Nominal 2003–4 dollars dollars

Public two-year First-year undergraduates

2,784

3,553

5,139

5,717

105%

57%

Second-year undergraduates

3,087

4,535

6,874

8,296

169%

106%

First-year undergraduates

3,780

3,813

6,111

6,158

63%

25%

Second-year undergraduates

5,378

5,958

9,929

9,505

77%

35%

Third-year undergraduates

6,591

8,506

13,880

14,083

114%

64%

Fourth-year undergraduates

7,604

11,146

16,794

17,507

130%

76%

First-year undergraduates

4,965

4,828

8,083

8,262

66%

27%

Second-year undergraduates

7,199

7,759

13,078

12,672

76%

35%

Third-year undergraduates

9,289

11,026

19,730

18,385

98%

52%

Fourth-year undergraduates

10,676

14,157

22,568

21,946

106%

57%

Public four-year

Private four-year

SOURCE: Calculations by the authors using U.S. Department of Education, National Center for Education Statistics, 2003–04 National Postsecondary Student Aid Survey, February 11, 2005, http://nces. ed.gov/pubsearch/pubsinfo.asp?pubid=2005164 (accessed February 23, 2007). NOTES: Includes all loans ever borrowed for undergraduate education. Does not include parent PLUS loans. Data were collected from the National Student Loan Data System (NSLDS). However, because students may also borrow from other sources, self-reported and institutional information were also used. Sample weights were used to reflect the total population of undergraduates.

128 FOOTING THE TUITION BILL show that, considering all sources of loans except PLUS loans, these students accumulated on average $17,507 and $21,946 in debt, respectively. Part of this increase is due to the creation of Unsubsidized Stafford Loans and relaxed eligibility for other aid. While the averages in table 4-10 take into account programs such as Subsidized and Unsubsidized Stafford Loans, as well as campus-based programs like Perkins, information is also available on cumulative federal loan amounts. Huge disparities among borrowers at different types of institutions suggest that school choice is a key determinant of cumulative debt level. Not only are there differences between two- and four-year institutions, but also between public and private as well as public and proprietary, for-profit institutions. According to the College Board, the median total amount of federal loans taken out by bachelor’s degree recipients in 2003–4 was $15,500 at public institutions. Four-year degree recipients attending private institutions faced a median debt of $19,400, almost 25 percent more. Students attending associate’s programs at for-profit institutions reached federal debt levels almost equal to bachelor’s degree recipients from public institutions, accruing a median total of $16,100.36 Parents are also borrowing increasingly more to support the college educations of dependent children. Table 4-11 presents a summary of the cumulative amounts borrowed through the PLUS Program from 1992–93 to 2003–4. It demonstrates that students are not the only ones facing larger loan debts. Growth in cumulative amounts borrowed over this period was tremendous for parents with students at private four-year colleges. In 2003–4, parents had borrowed $19,468 by a student’s fourth year, up 113 percent from $7,005 in 1992–93. Measuring the Burden of Debt. In order to understand whether the increases in student loans over time have had a significant effect, one must consider not only the cumulative amount borrowed, but also the debt burden. Debt burden, defined as the percentage of income that must be dedicated to loan payments, provides a way to measure the impact of student borrowing. In 2004, the American Council on Education (ACE) issued a report that concluded the median debt burden for students receiving their bachelor’s degrees in the 1990s was manageable, based on general debt guidelines, and stable at 7 percent.37 However, one-third of borrowers

THE DEMAND SIDE OF STUDENT LOANS 129 TABLE 4-11 CUMULATIVE AVERAGE AMOUNTS BORROWED THROUGH PLUS LOANS FOR FULL-YEAR UNDERGRADUATES, 1992–93 TO 2003–4 Amounts borrowed in nominal dollars 1992–93 1995–96 1999–00

Public four-year First-year undergraduates Second-year undergraduates Third-year undergraduates Fourth-year undergraduates

Change 1992–93 to 2003–4 2003–4

Nominal 2003–4 dollars dollars

6,303

5,853

7,704

9,260

47%

13%

6,848

7,279

8,323

11,166

63%

25%

6,482

7,712

11,074

13,518

109%

60%

5,924

6,892

10,587

12,659

114%

64%

7,853

9,987

12,887

28%

–2%

10,754

14,034

16,780

79%

37%

12,503

15,117

18,985

148%

90%

10,367

19,263

19,468

178%

113%

Private four-year First-year 10,084 undergraduates Second-year 9,361 undergraduates Third-year 7,664 undergraduates Fourth-year 7,005 undergraduates

SOURCE: Calculations by the authors using U.S. Department of Education, National Center for Education Statistics, 2003–4 National Postsecondary Student Aid Survey, February 11, 2005, http://nces. ed.gov/pubsearch/pubsinfo.asp?pubid=2005164 (accessed February 23, 2007). NOTES: Indicates the cumulative amount of PLUS loans ever borrowed by parents for the student. It is based primarily on NSLDS loan history data. Sample weights were used to reflect the total population of undergraduates.

faced debt burdens of more than 8 percent,38 the level above which financial aid researchers consider debt burden to be a concern.39 Additionally, there may be reason for concern in the future. A study by the USA Group looking at Stafford loans revealed that the share of undergraduate and graduate student borrowers who left school with cumulative debts in excess of

130 FOOTING THE TUITION BILL $25,000 increased significantly in the mid- to late nineties after the limit was increased and borrowing restrictions eased.40 Default rates are another measure of how students are coping with their loan debt. A recent report looking at 1992–93 borrowers ten years after bachelor’s degree completion finds larger loans associated with higher default. Of borrowers with $15,000 or more in Stafford loans, 20 percent entered default during this period, compared to 13 percent borrowing $10,000–$14,999, 8 percent borrowing $5,000–$9,999, and 7 percent borrowing $5,000 or less.41 Thus, there is again reason for concern as average debt amounts rise. While students can default at any time during repayment, starting salaries appear to be an important determinant of who cannot pay their loans. Borrowers with the highest starting salaries in 1994 were the least likely to default over the ten-year repayment period. Only 4 percent did so, compared to 17.4 percent of borrowers with the lowest starting salaries. Therefore, it is likely that more students will face repayment difficulties if the average starting salaries of people who attend college do not grow at a pace to keep up with rising debt levels. Too Much Debt? Concerns about the Effect of Debt Burden. As the percentage of students relying on loans rises along with the average amount of cumulative debt, concern grows regarding the impact of student loans on life after college. Beyond the burden on individuals of monthly payments, loans may have negative effects on the overall economy. Does debt accrued in school delay later decisions, such as buying a house, getting married, or even starting a family? Research on this question is mixed. Over a fifteen-year period, Nellie Mae has conducted four surveys of borrowers in repayment, finding that attitudes toward education debt have been becoming more negative over time.42 While previous analyses found no effect on the likelihood of home ownership, the 2002 survey found home ownership rates decreased by 0.2 percentage points for every $1,000 in loans. This means that for every additional $5,000 in student loans, the likelihood of owning a home decreased by 1 percent.43 This effect probably does not warrant a great deal of concern about student loans affecting homeownership, especially since age and marital status were stronger predictors of whether or not someone owned

THE DEMAND SIDE OF STUDENT LOANS 131 a home. However, as cumulative debt amounts increase, it may become a problem in the future. Other studies suggest loan debt does not affect decisions to live independently or to marry. Or, if there is an impact, it disappears over time, with no significant differences reported between borrowers and nonborrowers ten years after graduation in measures of educational, career, and family development.44 An additional concern raised in recent years is how the growing reliance on loans might influence students’ choice of college major and subsequent occupation. Particularly in public service areas, such as teaching, the need to use loans to cover costs unmet by grants or other forms of aid might deter students from entering a field. A recent report by the Higher Education Project of the State Public Interest Research Groups (PIRG) looked closely at the impact of debt on graduates entering teaching and social work by comparing average starting salaries and debt burdens. Using a benchmark developed in a 2005 report by Baum and Schwartz, the report found that 23 percent of graduates from public and 38 percent from private colleges and universities would have unmanageable debt as starting teachers.45 Students entering social work would be even worse off, with 37 percent and 54 percent, respectively, of public and private college graduates facing unmanageable debt.46 Using what we know about median debt levels and income, we can construct an example of the average debt burden starting teachers may face. In 2003–4, the average starting salary for a teacher was $31,704, according to the American Federation of Teachers.47 Given the average debt accrued by full-year undergraduates in their fourth year at a public college and assuming a standard ten-year repayment schedule with a 6.8 percent interest rate, a graduate with a cumulative debt of $17,507 would face a monthly payment of $201.47.48 This would represent 7.6 percent of his or her pretax monthly income of $2,642. A graduate from a private university with a cumulative debt of $21,946 could expect monthly payments of $252.56, or 9.6 percent of monthly pretax earnings. While the numbers are not far from the 8 percent upper limit for unmanageable debt, these scenarios may present more favorable conditions than many students face. If part of their debt is in the form of private loans, students may face interest rates greater than the government’s rate of 6.8 percent. Additionally, most

132 FOOTING THE TUITION BILL students take more than four years to graduate. Finally, it is important to note that the calculations do not reflect cost of living and are only representative of an average. While there are good reasons to believe loan debt is becoming too large for many, some argue that students may be taking on increased debt burdens as a means of facilitating choice or lifestyle. This argument finds some support in the evidence regarding private loan usage by high-income students. Researchers at the IHEP have concluded that private loans help students attend their first-choice schools, with financial need being a function of high costs of attendance rather than low ability to pay.49 In other words, private loans may not be necessary to attend college, but they may be necessary for some students to attend their dream schools. Kate Rube supports this finding, reporting that 75 percent of private loan borrowers lack demonstrated financial need in accordance with the federal government’s definition. Moreover, 92 percent of dependent students borrowing from private sources come from families with incomes over $100,000 and do not demonstrate unmet need.50 The Loan Limit Debate. Given concerns about the growing debt burden, some suggest that the government should hold fast to limiting the amount a student can borrow. Those supporting this notion include the American Association of Community Colleges (AACC), the American Association of State Colleges and Universities (AASCU), and the United States Student Association (USSA). They argue that students already have too much debt and do not always make responsible decisions about loans. Furthermore, opponents to raising the loan limits argue that doing so would relax pressure on the federal government, states, and schools to provide need-based aid or might encourage colleges to raise prices more than they otherwise would.51 On the other hand, proponents of increasing loan availability argue that loans are necessary to cover essential costs related to a college education, and that loan limits have not kept pace with increasing costs. They point to the percentage of students borrowing at or near the maximum amounts allowed in the federal loan programs as proof that they are not able to borrow enough. For example, in 2003, Jacqueline King (of ACE) reported that 69 percent of all dependent undergraduate Stafford borrowers were at or above the limit, as were 76 percent of first-year students.52 Supporters of raising

THE DEMAND SIDE OF STUDENT LOANS 133 the loan limits, such as ACE, the Association of American Universities (AAU), and the National Association of Student Financial Aid Administrators (NASFAA), have also argued that the insufficient limits have encouraged students to seek less favorable private loans. According to Kenneth Redd, 90 percent of high-cost institutions indicated that students received private loans because they had exceeded the annual loan limits allowed under federal programs.53 Perhaps in response to these arguments, under the Deficit Reduction Act of 2005 the annual limits increased. However, the role of loan limits in access and debt burden will continue to be debated, and the repercussions of the recent increase will be watched closely. Not Enough Debt? The (Un)Willingness to Take Out Loans. On the other side of the debate about loan burden, some worry that differences in willingness to borrow by race or income may affect opportunities for postsecondary education. A 2003 report by the Educational Credit Management Corporation investigating cultural barriers to incurring debt concluded that differences in willingness to borrow among ethnic groups were attributable to socioeconomic differences.54 The report used mortgage status as a proxy for a family’s general willingness to borrow and found that although students from households with mortgages are generally wealthier than students from households that rent, a greater percentage took out loans. It is not possible to say whether this is solely a reflection of attitudes toward borrowing, since, as we have mentioned, students from lower-income families (represented by renters) may self-select into lower-cost schools or attend part-time. The data presented in this chapter suggest that the percentage of minority students borrowing is just as high as, if not higher than, that of nonminorities. However, because our data only consider minority students who have already chosen to enroll, there is likely to be selection bias in the analysis. In other words, the data tell one nothing about the thousands of minority students who choose not to attend college, perhaps due to a reluctance to take out loans, the most prominent form of financial aid. Debt and College Dropouts. An often overlooked aspect of student borrowing is the effect of loans on those students who fail to complete a degree. Since many students must borrow to finance their education, persistence takes on an added importance as the costs of college increase. Unfortunately,

134 FOOTING THE TUITION BILL the national six-year graduation rate at four-year colleges is only about 57 percent, or 63 percent taking into account students who transfer to other colleges.55 While it is difficult to follow students once they drop out of school, recent work by Lawrence Gladieux and Laura Perna found that undergraduate borrowers who dropped out accumulated a median debt of $7,000.56 Students who dropped out of four-year programs accumulated a median debt of $10,000, while that for dropouts from associate’s degree programs was $6,000. More importantly, 22 percent of borrowers who dropped out defaulted on at least one loan in the six years following initial enrollment, while only 2 percent of graduates did so.57 Therefore, the issue of debt is very much tied to the goal of college degree completion. To be able to afford to repay what they borrow, students need to be able to reap fully the benefits of higher education by completing their degrees. Unfortunately, researchers suggest that persistence is related to the amount of unmet financial need—students are less likely to persist if they are unable to meet the costs of higher education. This can create a “catch-22” for students who already have significant debt but not enough resources to complete their degrees. Given the millions who incur debt but do not finish their degrees, this issue cannot be ignored.

Conclusions This chapter has attempted to provide an overview of the demand for student loans by examining the types of programs available, who uses them, and annual and cumulative loan amounts. While federal loans are the most prevalent by far, the average loan amounts from private sources are often higher than the average amounts borrowed from federal sources. Institutional choice plays a significant role in who participates in loan programs, as a higher percentage of students attending private four-year colleges borrow, and borrow larger amounts, than students at public four-year schools. Enrollment intensity also matters, as students attending college part-time are less likely to borrow. However, loans are utilized by high-income as well as low-income students. And although there are concerns about differences in the willingness to take out loans by background, minority students utilize student loans at equal if not higher rates than others, although they borrow

THE DEMAND SIDE OF STUDENT LOANS 135 smaller amounts on average. In short, reliance on student loans is not limited to any one characteristic or profile. During the next couple of years, loan debt will continue to grow as a result of the recent increases in federal loan limits, as it did after the 1992 changes. Also, in an era of declining grant aid and rising tuition and other college costs, larger loans will be necessary for some students to attend college. Others may rely on larger loans to facilitate school choice or ensure they will not have to work while in school. Aside from developing stronger entrance counseling and providing students with the information they need regarding debt repayment after college, there is little policymakers can do to limit the demand for loans, and, in some cases, restricting access to debt is not advisable. Conversely, it is important to ensure that access is not limited for those students who are averse to taking on substantial debt to pay for college. Even with the recent increase in federal loan limits, the role of private loans is likely to continue to grow. As more private options become available and private loan companies continue to mount extensive marketing campaigns, the percentage of students using these private sources will likely double in a short amount of time. One concern is the fact that private loans have less favorable terms than government loans. Higher interest rates increase the risk of having an excessive loan burden and defaulting. Therefore, as the use of private loans grows, it is likely that so will the number of students who face the negative consequences of too much debt. This experience will not likely be limited to private loans, however. While the debt burden of government loans has been deemed manageable for most students in the past, the recent increase in the interest rates on federal loans may push significant numbers into more onerous repayment schedules. What is clear is that for many students, loans have become a necessity to finance a postsecondary education. Caution must be taken to balance the benefits of loan availability with the possible, harmful side effects of debt.

5 The Supply Side of Student Loans: How Global Capital Markets Fuel the Student Loan Industry Joseph Keeney

Student loans make up a large and fast-growing asset class, with a demand fueled by student enrollment growth, college tuition costs that are rising faster than the rate of inflation, and aggressive marketing efforts by loan companies and financial aid offices. This chapter focuses on the supply of capital to fund these loans—both federal and private—and the increasingly complex financial intermediation process linking the borrower with the provider of capital. An understanding of the dynamics of this process is important from a public policy perspective for two reasons. First, the global capital markets already exercise tremendous discipline over the behavior of student loan market participants, not unlike the way the U.S. Treasury bond market “votes” on changes in monetary or fiscal policy. Second, the mechanics of both the demand for, and supply of, student loan capital affects policy prescriptions and the ability to anticipate unintended consequences. The first section of this chapter summarizes student loan volume and growth and outlines the “value chain” of activities performed by student loan industry participants. The second section focuses on key student loan metrics: loan losses and loan value. The third section provides an in-depth exposition of student loan securitization—the process by which student loans are fashioned into financial securities which, through the efficient operation of the global capital markets, find their way to the lowest-cost provider of capital. The last section looks at the potential development of the international student loan market. 136

THE SUPPLY SIDE OF STUDENT LOANS 137 Student Loan Volume and Growth Over the past five years, total federal student loan volume grew at an 11 percent compounded annual rate, to almost $62.6 billion.1 At the same time, total private student loan volume grew to over $17.3 billion, with a five-year compounded annual growth rate of 27 percent.2 This means that from 2000 to 2005, private loan volume as a proportion of total loan volume more than doubled, from 9 percent to 21 percent. If these growth rates are maintained, private student loans will account for more volume than federal student loans by the time today’s preschoolers enter college. Why has the volume of student loans grown more rapidly in the private market than in the federal sector? Primarily, the answer is that the costs of attending college have outpaced the maximum borrowing limits in the federal student loan programs.3 The approximate annual cost of attending a four-year private college, for instance, has increased at more than double the inflation rate over the past ten years and is now $30,367 per year.4 Assuming 5 percent inflation, the four-year cost would be more than $137,000. The equivalent in-state cost at a four-year public university is just over $67,000. The maximum cumulative amount of undergraduate loans from the Stafford Loan Program and the Federal Family Education Loan Program (FFELP) remains at $23,000. The large gap between actual costs and the federal loan limit—estimated to be some $100 billion—is filled by a variety of sources, including student and parent contributions, parent loans (including Parent Loans for Undergraduate Students, or PLUS, and home equity loans), scholarships, grants, other forms of aid, and, increasingly, private student loans. Other reasons for the growth of private student loans are more mundane: The application is easier to complete than that for the federal loan (the Free Application for Federal Student Aid, or FAFSA); the private loans can be obtained at any time during the year instead of annually as for federal loans; and older students who may not qualify for federal loans (but who represent a growing percentage of college enrollment) can apply for private ones. Other factors that affect the growth of the private loan market include interest rates and government regulation (for instance, further increases in loan limits for federal loan programs or changes in college savings plans,

138 FOOTING THE TUITION BILL such as 529 programs). But even if the private loan growth rate slows, such loans are likely to be the primary source of higher education funding for the next generation of college students.

The Student Loan Industry A chart (see figure 5-1) from the 2006 Annual Report of First Marblehead Corporation—a leading provider of private student loan services— illustrates how the private student loan process works. (Of course, the program design and application processes for federal student loans are regulated by the U.S. Department of Education.) Some industry participants like Sallie Mae (a subsidiary of the SLM Corporation) operate across several activities, while others, like Affiliated Computer Services (ACS), specialize in a particular activity, such as loan servicing.5 The innovation taking place at the front end of the process, in loan origination, is particularly apparent in the marketing of private student loan programs through the fast-growing direct-to-consumer (DTC) channel,6 as the Internet lowers some of the barriers to entry for loan marketers. For example, First Marblehead received approximately 64 percent of its student loan applications in 2005 online.7 Because of the way financial aid offices (the “school” channel) also serve students through their websites, the distinction between these channels is not clear-cut, and the capital markets do not seem biased against either one. While the majority of the loans securitized by First Marblehead are DTC, Sallie Mae’s securitizations are more likely to include school-channel-originated loans. The nature of competition in loan origination differs between federal and private student loans. Originators in the more mature federal student loan sector are increasingly eliminating 3 percent origination fees by promoting “zero fee” loans, but those fees can still be high for private student borrowers, where loan costs (the combination of origination, application fees, and interest rates) depend more on the borrower’s credit quality. Competition on the basis of “borrower benefits”—such as principal or interestrate reduction for thirty-six or forty-eight months of consecutive on-time payments—is also more common in the federal student loan origination market, where there is a statutory interest rate.

THE SUPPLY SIDE OF STUDENT LOANS 139 FIGURE 5-1 VALUE CHAIN FOR FIRST MARBLEHEAD CORPORATION Program Design and Marketing

Borrower Inquiry and Application

• Market research • Dissemination of and analysis loan materials and • Program design applications - Credit standards • Application - Loan terms screening - Regulatory and • Customer call cenlegal compliance ter management • Training, marketing support, and advisory

Loan Origination and Disbursement

Loan Securitization

• Application pro• Organization of cessing and credit critical resources underwriting (investment banks, • Delivery of promisfinancial guaransory note tors, rating agen• Disbursement of cies, and other funds to school or participants) borrower • Structuring of • Regulatory and securitization/asset legal compliance selection • Negotiation with transaction parties and coordination with rating agencies • Execution and reconciliation

Loan Servicing • Customer call center management • Billing and account management • Delinquency and collections management • Securitization trust administration - Calculation and distribution of funds

SOURCE: First Marblehead Corporation, “Creating Solutions for Education Finance: Annual Report 2006,” 2006, http://library.corporate-ir.net/library/14/147/147457/items/221699/2006_Annual_Report.pdf (accessed February 23, 2007).

At the other end of the value chain, loan servicing is a critical and specialized activity that is presently performed by entities like the Pennsylvania Higher Education Assistance Agency,8 Great Lakes Educational Loan Services Inc., and student loan servicers classified by the Department of Education as “exceptional performers.” Those exceptional performers receive 99 percent reimbursement on defaulted FFELP student loans (see the loan loss discussion, below), and approximately 73 percent of FFELP loans are serviced by them. Student loan servicers generally do not service other types of loans, mortgages, or consumer credit, since compliance is required at both state and federal levels. Private student loan credit is much more like consumer credit: The quality, reputation, and performance of loan servicers are very important to student loan security investors. As the industry continues to grow, it is likely that some of the larger loan servicers that now focus on credit card and other forms of debt will enter the student loan market—a source of disruption if they err, and efficiency if they lower overall costs of servicing.

140 FOOTING THE TUITION BILL Key Metrics: The Art and Science of Loan Losses One of the key drivers of profitability in the student loan industry is the rate of loan loss. Losses occur when borrowers (in this case, students) default on their loans. But a simple definition of default masks a broad range of loan conditions (in ascending order of severity): • Deferment. Payments are not being made, although interest is accruing, while the borrower is enrolled in school. • Forbearance. The borrower’s repayment has been temporarily suspended by the lender. Loans in deferment and forbearance are considered performing, and not in default, under the Education Department’s definition. • Delinquent. The borrower is late on making a scheduled payment. • Default. Notice of default has been made by the lender because of nonpayment, and delinquency has persisted for more than 270 days. • Charge-off. Lender estimates loan loss from the defaulting borrower, less the expected recovery on the loan. • Loan loss. Actual loss after recovery from collections.

The Education Department publishes cohort default rates—the rate at which federal loan program borrowers who enter repayment in a given year default before the end of the following fiscal year. One of the most publicized graphs in the student loan industry shows the cohort default rate decreasing fairly steadily, from a high of 22.4 percent for cohort year 1990 to 5.1 percent for cohort year 2004.9 The average cohort default rate of 5.1 percent includes rates of 4.7 percent for public institutions, 3.0 percent for private institutions, and 8.6 percent for proprietary institutions. The percentage of B.A. degree recipients who graduate from these types of institutions with debt is 62 percent, 73 percent, and 88 percent, respectively.10 There are some caveats for using the cohort default rates as a measure of student loan performance over time. First, the definition of “default”

THE SUPPLY SIDE OF STUDENT LOANS 141 matters—in the early years of the 1990–2004 timeframe, default was measured as 120 days delinquent; later it was 270 days. Weaker schools (those with high default rates) were removed from the data after Congress added regulations that threatened their expulsion from the program; in fact, many schools were kicked out in the early 1990s.11 (Maintaining a cohort default rate below 25 percent is now a requirement for a school’s continued participation in the FFELP. Thus, institutions have an incentive to keep their default rates low.) But cohort default rate by definition is a short-term measure of default during the first two years of loan repayment; it is not an estimate of cumulative losses across the life of the loans. Many explanations are offered for the reduction in default rates over time. The elimination of schools that were suspended from the program is perhaps the most significant. Other explanations include improved debt management and default-aversion techniques by lenders and servicers, better guidance from financial aid offices, the threat of aggressive collection techniques, and increasing awareness that student loan debt is not discharged in personal bankruptcy. Loan consolidation—either for rate reduction, term extension, or repayment simplification—establishes a connection between the lender and borrower that reaffirms the borrower’s intent to repay and probably reduces the default rate. Normal business cycles are surely another factor—the high 1990 cohort default rate was measured in 1992, a year which registered the highest U.S. unemployment rate since 1984.12 Default rates on private student loans are typically lower than on federal student loans, for two reasons: First, private student loans are creditunderwritten (that is, the borrowers must meet private-sector underwriting standards); and second, private student loans often have cosigners, typically parents and grandparents, and are therefore less likely to default.13 Fewer data are available on default rates of private student loans, however, because they are a relatively new phenomenon and have been through fewer economic cycles. Indeed, because of the relative newness of this sector of the industry, having data is in itself a competitive advantage. First Marblehead’s trove of student loan performance data, acquired in 2001 from The Education Resources Institute Inc. (TERI), a leading nonprofit private student loan guarantor, is acknowledged as a barrier to entry for other potential competitors because these data capture a long history of student loan repayment performance behavior.14

142 FOOTING THE TUITION BILL TABLE 5-1 TERI NET DEFAULTS PAID BY COHORT YEAR

Cohort year

Total loans guaranteed (thousands of dollars)

Total net defaults paid for loans guaranteed (thousands of dollars)

Net cohort default rate (%)

2001

97,120

3,857

3.97

2002 2003 2004 2005

623,496 965,416 1,704,139 2,556,750

13,230 12,365 10,246 1,598

2.12 1.28 0.60 0.06

SOURCE: First Marblehead Corporation, The National Collegiate Student Loan Trust 2006-1: Prospectus Supplement, March 7, 2006, S-35, http://library.corporate-ir.net/library/14/147/147457/items/217793/ NCSLT2006-1ProspectusSupplement3-07-06.pdf (accessed February 23, 2007).

The expected loss on private student loans can be put into context by looking at TERI’s net cohort default rate and Sallie Mae’s loan loss reserves. In TERI’s case, the net cohort default rate reflects the total of defaults paid, net of recoveries, on the aggregate principal amount of loans it guarantees. Table 5-1 highlights the relatively young vintage of the majority of these loans. Student loans are typically pooled and sold to a trust as part of the securitization process.15 Cumulative default rates—defined as 180-day delinquent loans purchased by a servicer—on Sallie Mae’s 2002 and 2003 student loan trusts are tracking to about 2.5 percent through their first fourteen quarterly reporting periods. An excerpt from Moody’s January 2006 analysis of Sallie Mae’s parent, SLM, underscores the analytical complexity in the evolving art and science of loan loss allowances: Based on development of additional data to better estimate the amount of recoveries on defaulted private education loans, during the third quarter of 2005 SLM changed its methodology for estimating the amount of recoveries on defaulted private education loans that will ultimately be recovered; on a managed basis this resulted in a $65 million reduction in the private education

THE SUPPLY SIDE OF STUDENT LOANS 143 loan allowance for loan losses to recognize the effect of the change. Additionally, during the second quarter of 2005 SLM changed its estimate of the allowance for loan losses and the estimate of uncollectible accrued interest for the managed private education loan portfolio using a migration analysis of current and delinquent accounts. Migration analysis—a widely used reserving methodology in the consumer finance industry—is a process used to estimate the likelihood that a loan receivable may progress through the various delinquency stages and ultimately be charged off. Previously, SLM calculated the private education loan allowance for losses by estimating the probability of losses in the portfolio based mainly on the loan characteristics and where pools of loans were in their life, with less emphasis on the current delinquency status of the loan. Also, in the prior methodology for calculating the allowance, some loss rates were based on proxies and extrapolations of FFELP loan loss data.16

Key Metrics: Loan Value The basic characteristics of a debt instrument are principal (amount borrowed), interest rate, and repayment period. A student who borrows $10,000 at an 8.5 percent interest rate to be repaid over ten years will typically make monthly repayments of principal and interest of $123.99, or $1,488 per year. The cash flows look like this: Month 1

$123.99

Month 2

$123.99

Month 3

$123.99

… … Month 120

$123.99

The cash flow on this loan is worth $10,000 to a hypothetical lender whose cost to service the loan is zero and whose cost of funds is 8.5 percent;

144 FOOTING THE TUITION BILL that is, the hypothetical lender would be indifferent about receiving $10,000 now or $123.99 per month for ten years (assuming zero credit risk). What if the lender’s cost of funds were 4.5 percent? Such a lender might be a large international bank able to borrow at or below the benchmark London Interbank Offered Rate (LIBOR) interest rate. This lender would be indifferent about receiving $10,000 now or $103.64 per month, but would obviously be paying a premium for the higher cash flows of $123.99 month: $11,963 over the course of the loan—a premium of nearly 20 percent on the original loan proceeds of $10,000. At an annual student loan volume of $76 billion, a 20 percent loan premium would be worth $15 billion per year! While this simplified illustration probably overstates the total increase in loan values, it clearly illustrates the substantial opportunities for intermediary lenders. That’s one reason First Marblehead can pay Chase 4.9 percent for a pool of loans, and take a 12.6 percent advisory fee right off the top.17 On a recent First Marblehead transaction, the total amount of loan principal and accrued interest of the loans in the pool was $518 million with an average interest rate of about 9.1 percent. This same loan pool was purchased by the trust for $748 million and then securitized with interest rates ranging from about 4.8 percent to 5.3 percent, for $901 million.18 Of course, the premium will decrease in proportion to the risk of loss on the loans—an inexact science (described above). There are many other factors that affect the loan premium, two of which are origination fees and prepayment. Many private student loan borrowers pay origination fees as “points,” or a percentage of the loan, to a third-party loan originator. For example, the borrower who pays a 5 percent origination fee may receive only $9,500 but still have to make monthly payments of $123.99 (as if he had borrowed $10,000). Thus, origination fees can increase a 20 percent premium to 25 percent. On the other hand, if this sample borrower prepays the loan in less than ten years, the premium decreases because the more valuable cash flows are not received for the full term. It is even possible that a loan buyer could lose more from an early prepayment of a loan than from a loan loss late in the term. As a consequence, student loan intermediaries estimate a constant prepayment rate (CPR) when evaluating loan pools.19

THE SUPPLY SIDE OF STUDENT LOANS 145

INITIAL BORROWER AND ULTIMATE LENDER A Hypothetical Case Joe College graduated from California University in May 2006. He graduated with total indebtedness of $28,000—$17,000 in Stafford/FFELP loans and $11,000 in private loans. When he enrolled in college Joe had never heard of private student loans, but he responded to a mailing he received during his sophomore year and applied for a loan through the website on the mailer. His parents had tapped their home equity line of credit to fund some of Joe’s tuition, rather than borrow under the PLUS Program. They also cosigned the private loans, which have an initial interest rate of 8.5 percent and a one-time 5.0 percent fee. The monthly bill Joe receives covers both his Stafford/FFELP loan and his private loan. (Joe’s unpaid credit card balance averaged $2,000 during his senior year, and was $3,000 at graduation.) **** Patricia Proper was a vice president in a major European bank. A sophisticated investor in asset-backed securities, she frequently attended investor presentations, or “road shows,” organized by American investment bankers. Over tea and biscuits, she scrutinized the prospectus on the First Marblehead transaction—she liked the quality of the underlying loans (which included Joe College’s 8.5 percent loan) as measured by the FICO scores and the types of institutions, the guarantee of the loans by TERI, and the substantial reserve account in the transaction—and offered to purchase three different classes of notes. The interest rates she would receive ranged from 4.71 percent to 5.26 percent.

Student Loan ABSs: A New and Rapidly Growing Asset Class “Structured finance” is a term used to encompass a range of investment products. Usually created by investment bankers, these products include collateralized debt obligations, commercial mortgage-backed securities, residential mortgage-backed securities, and asset-backed securities (ABSs).

146 FOOTING THE TUITION BILL These ABSs are typically streams of lease or loan payments that are collateralized by an underlying asset. Securitized student loans are a class of ABS that competes for investor dollars with other forms of ABS, such as securitized home equity loans, credit card debt, auto loans, and tobacco settlement payments (the result of a 1998 settlement with cigarette manufacturers that was worth over $200 billion to forty-six states). Total U.S. ABS issuance in 2006 was $935 billion, a 10 percent increase over 2005. Worldwide ABS issuance was $1.3 trillion in 2006, an increase of almost 20 percent over 2005.20 In 2005, Moody’s reported a total of $73.3 billion in student loan securitizations, including federally insured loans, consolidation loans, and private student loans. Student loan ABSs therefore accounted for about 9 percent of total U.S. ABS issuance in 2005. This value of total student loan securitizations is roughly equivalent to the $76 billion total level of student loan originations in 2005, although these are not the same loans because there is usually a lag between when loans are originated and when they finally find their way into an ABS. The securitization volume also includes securitizations of consolidation loans, which borrowers have consolidated to take advantage of lower interest rates, longer maturities, and/or reduced paperwork. Private student loan securitizations are newer, so the $9.4 billion of private student loan securitizations in 2005 represented only about 68 percent of total private student loan originations in that year.21 The securitization of private student loans happened more quickly than it might otherwise have because the market was already developed; most of the players who seek to monetize the loan premium on federal student loans also serve the private student loan market, and they have been cultivating, educating, and catering to many of the same investors. To date, only a handful of issuers have placed private student loan ABSs, including Sallie Mae, First Marblehead, Access, KeyCorp, and NorthStar. John Foxgrover of First Marblehead believes that several factors, which act as barriers to entry, support the profitability of intermediaries in this sector: • Scale. The ability to generate the critical mass to get access to the capital markets (for example, First Marblehead, working with five thousand schools to execute $3 billion of transactions in

THE SUPPLY SIDE OF STUDENT LOANS 147 2005) is important. Other advantages of scale are the ability to attract lender partners, the ability to invest in technology, and the ability to innovate with product breadth. • Expertise. In this particular form of unsecured consumer credit, important areas of expertise include data services, trustee relationships, program design and origination, and risk management. • Data. First Marblehead has a twenty-year database on loan characteristics. • Track record. A history of and reputation for completing securitization transactions are important.22

Student Loan ABS Investors Who are the student loan ABS investors buying up bundles of student loans? First Marblehead estimates it has placed securities with 115 different investors, in fourteen different countries on four continents.23 Derek Rose of RBC Capital Markets described the investor base today as “lopsided”— that is, a small number of large investors.24 The bankers and issuers are constantly seeking new potential investors as a way of increasing the bond premium by broadening their investor base and raising capital at even lower rates. Rose notes that awareness about student loan ABSs appears to be relatively low among broader ABS investors, who need to take the time to understand the unique guarantee arrangements and servicing rubrics; moreover, there are fewer performance data than in other sectors—for example, credit cards have fifty years of historical data and therefore predictable behaviors. Paul Wozniak of UBS Securities estimates that up to 60 percent of recent student loan pools have been purchased in Europe.25 Some buyers are special investment vehicles set up by hedge funds. Others are large financial institutions like Lloyds TSB Bank Plc, which has purchased some $4 billion of student loan assets.26 Lloyd’s generally only buys federal student loan pools that are rated AAA or AA. It will only consider private student loan pools that are rated AAA and from select issuers, but has not yet bought any.

148 FOOTING THE TUITION BILL HSH Nordbank is a European bank relatively new to the sector. It has a total investment portfolio of $16 billion, and has recently received credit committee approval to invest up to $1 billion in federal student loan securities (but not yet private student loans). In the United States, Wells Capital Management, a $175 billion manager of investments on behalf of pension plans, foundations, endowments, and insurers, has indicated that it plans to boost holdings of bonds backed by student loans, as has State Street Global Advisors.27 Some investors may have due-diligence teams that do much more than simply scrutinize the offering prospectus. They will ask questions about the school mix in the pool and evaluate multiple years of static loan pool performance. They have their own internal audit or surveillance teams and often visit student loan servicing operations, meeting management, looking at staff turnover and training, assessing call center performance (for example, average hold time and abandon rate), and reviewing independent audits. Overall, student loan investors are clearly attracted to the federal government guarantee on loans and the risk-adjusted yield given that guarantee. They appear to like the combination of over-collateralization of private student loans and the performance of the loans in the early securitized pools. Among their most consistent concerns are defective loan origination and issuers who might be cutting corners in the securitization process. Most student loans end up in the hands of these global asset-backed securities investors because they are the lowest-cost source of capital, and therefore create the biggest potential premium. Prior to widespread securitization of student loans, there was a “whole loan” market in which banks or other investors would trade or accumulate loans. Traditional banks continue to hold student loans, some on a “warehousing” basis, until they can be securitized. Standard & Poor’s, while predicting another record year for student loan ABS volume in 2006, noted that “one of the greatest barriers to further growth in federal student loan securitizations is their low regulatory cost of capital and how banks treat these receivables. . . . Some of the largest originators, including banks, have not seen an economic incentive to securitize their government-guaranteed student loan portfolios.”28

THE SUPPLY SIDE OF STUDENT LOANS 149 The Nuts and Bolts of Student Loan Securitization Sallie Mae is the largest issuer of student loan ABSs, accounting for 39 percent of the total volume in 2005.29 Other large issuers include Nelnet, Student Loan Corporation, First Marblehead, and Brazos Higher Education Service Corporation. Over the past fifteen years, there have been rated student loan securities from some eighty-four different issuers, including nonprofit higher education authorities (or their equivalent) in some thirty-two different states. Student loan ABSs are sold through an underwriting process by investment banks such as UBS, Bank of America, Citigroup, and JPMorgan. Some of these companies have investment banking and security sales teams that cover a wide range of ABSs, including collateralized mortgages, home equity loans, and credit card debt. However, some, like UBS, have dedicated student loan ABS teams. They may also have consumer loan divisions that originated the student loans in the first place. Since student loan securities are an “engineered product”—they can be structured in any currency and at any type of interest rate—investment banking teams are constantly seeking ways to create innovative student loan securities and match prospective investors with different types of cash flows. These investors are increasingly global, and most student-loan securitization road shows now include stops in Europe and sometimes in Asia. The yield of the securitized offerings is usually priced as LIBOR plus (or sometimes, for short-maturity tranches, LIBOR minus) a fixed number of basis points (“bps,” where 1 bps = 0.01 percent). Some offerings even use currency swaps that allow them to be priced based on the Euribor benchmark, the Euro Interbank Offered Rate. The investment bankers will typically carve up a pool of loans into different series, with each series having its own characteristics to target a particular investor need. These include underlying credit risk, weighted average life, currency, fixed or floating rates, and priority in the receipt or “waterfall” of student loan repayment flows. Most student loan ABSs include between five and ten securitized bonds within the total offering. Typically the lower-rated, subordinated bonds in the series are sold at higher interest rates, because they are paid with lower seniority; they are unpaid if there is insufficient cash-flow from the loans. Reserve accounts and “note triggers” give additional protection to the senior

150 FOOTING THE TUITION BILL note-holders, and “excess spread” (excess cash flow from the loans after credit losses and payments for servicing, hedging, and note-holder interest) provides credit enhancement for the subordinated series. Many issuers of student loan securities retain a residual interest in the securities after the investors are repaid, which can be quite profitable on successful transactions.30 Some issuers use the auction market to sell their securities instead of selling floating-rate notes. In the auction market the loan pools are effectively re-priced every twenty-eight days. Grant Carville of Nelnet estimates that 13 percent of the total 2005 securitization market was placed in the auction market, although among smaller nonprofit issuers (who might be less well-known to the investor base or have smaller issues) the percentage was 46 percent.31 Since broker dealer fees in the auction market have fallen, the auction-market vehicle is even more attractive. A good sign of stability in the market generally is low auction-rate spreads over LIBOR—if there is uncertainty or perceived risk across the student loan sector, auction rates will be bid up as investors seek alternative asset classes. Auction-rate spreads were frequently sub-LIBOR during the first half of 2006. Private student loans are not federally guaranteed, but they are typically guaranteed by a nonprofit state-chartered entity, a state agency, or TERI. These guarantors usually have their own underwriting criteria and often have separate credit ratings. Guarantee fees are often held in a pledge account for the benefit of the investors. The guarantors typically guarantee individual loans, not the entire security. With only a few exceptions to date—including a 2005 offering by Keycorp that has some cross-collateralization of private and federal loans at the bottom of the payment waterfall—securitizations of federal and private student loans have been marketed separately. Christopher Cronk of Bank of America points out that federal student loans often receive more favorable regulatory treatment in some European countries, so separate securitizations of federal and private loans are likely to continue in the medium term.32

Market Risks and Opportunities The student loan industry generally views overall market conditions to be good. Wizened industry veteran Murray Watson Jr. of Brazos Higher

THE SUPPLY SIDE OF STUDENT LOANS 151 Education Service Corporation describes the current market as “a ‘pretty smart’ market: The issuers all look pretty and the bankers all look smart!”33 Because of the strong demand for student loans by borrowers and ample supply of capital from global investors, issuers are able to place student loan debt close to LIBOR, capturing a greater premium. There is, of course, always the risk that the market could be disrupted. Consider the case of Mercury Finance, a leader in the subprime auto loan market. In 1997 Mercury generated loan activity at a rate of $110 million per month. It experienced financial difficulties related to accounting and securities fraud, lost $2.5 billion in market capitalization, and defaulted on $1.1 billion of debt. Investors across the sector ran for the exits, driving up auction rates and destabilizing the market for future issuers. A similar problem with a student loan market participant could destabilize the market and drive up interest rates for borrowers. It would not be surprising for a new entrant, with less sophisticated credit-underwriting standards than Sallie Mae or First Marblehead—or even one that explicitly marketed “downcredit”—to become a Mercury Financial in the student loan sector. Or underwriting could remain sound, but a loan servicer could have an operational problem that reverberated through the entire industry. Other possible sources of destabilization in the student loan market are lender noncompliance with consumer credit laws and new legislation. Unlike federal student loans, which are regulated by the Department of Education, private student loans are subject to varying federal and state consumer credit laws. Some lenders may even be tempted to outsource their private student lending simply for compliance reasons.34 Legislative changes, in reaction to the “Generation Debt” sentiment, could also destabilize the market; students have too much debt, and somehow it’s not their fault or responsibility. While normal market forces should provide sufficient disincentive for lenders to relax credit standards for people who are unlikely to pay them back, those forces were not mentioned when the popular television magazine show 60 Minutes aired a segment on Sallie Mae in May 2006.35 Nor are they mentioned on websites like www. studentloanjustice.org, which calls student loans “the most profitable, uncompetitive, oppressive, and predatory type of debt of any in the nation.” Any form of “income-contingent repayment” policy—in which borrowers would not be obligated to repay their loans unless their income

152 FOOTING THE TUITION BILL was at certain minimum levels—could have a highly disruptive effect on the flow of low-cost capital to the industry. If such a policy were also applied to private student loans, it could ultimately result in responsible borrowers subsidizing irresponsible ones through higher interest rates. Another threatened policy option is a 100 percent direct-loan policy, in which institutions are the only lenders. Not only would such a policy ignore the legitimate debate about which lending practices cost taxpayers less,36 it could possibly reduce the supply of low-cost capital to the student loan industry by restricting innovation and limiting the number and type of intermediaries seeking to match capital supply and demand. How might the market get better for its participants? First, it is already getting more efficient of its own accord. Hantz Serrao of Morgan Stanley has studied the pricing trends in the spreads on Sallie Mae student loan trusts. Over the past seven years, the average basis point-spreads on securitized FFELP loans over three-month LIBOR have dropped from the mid-teens (that is, less than 0.20 percent) to single digits, while the spreads on Sallie Mae’s private student loan trusts have dropped from fifty-plus basis points to the mid- to high teens.37 This trend underscores both the growing comfort level of the global capital markets with student loan securities and the accelerated pace at which these markets are getting comfortable with private student loan securitizations. Most buyers of student loan securities are “buy and hold” investors. There does not appear to be extensive secondary-market trading of student loan securities—unlike, for example, corporate bonds—perhaps because there is still some mystery surrounding the underlying credit quality; and there is comparatively less standardization in deal structure and disclosure. Information on student loan securities is generally not published on Bloomberg or Intex, two popular industry sources of realtime information about fixed-income securities, partially because of varying prepayment rate estimates. To the extent that a secondary market develops and information on the performance of these loan pools can be shared more easily, there will be greater liquidity for investors, more capital will be attracted to the sector, student loan ABSs will be placed at lower interest-rate spreads, and rates and loan terms for private student borrowers will improve.

THE SUPPLY SIDE OF STUDENT LOANS 153 Disclosure and Compliance Disclosure is one key to developing the market to broaden the investor pool. Recent changes in disclosure have been driven on one side by regulators and on the other side by investors. Security and Exchange Commission Regulation AB (that is, “Asset-Backed”) was published on December 22, 2004—with a transition period to become effective with issues after December 31, 2005—to codify what had been an evolving industry practice. “Reg AB” specifies certain disclosure and reporting requirements for all types of SEC-registered ABSs. For example, private student loan issues must include information on distribution of loans by originator, FICO (credit score from Fair Isaac Corporation), payment status, and school type. Periodic disclosures must include information on loans in deferment, delinquency, forbearance, prepayment, and claims paid. Reg AB also requires disclosure about the private guarantor, and covers communication during the securities offering process. Given the newness of the Reg AB implementation, it is conceivable that a material noncompliance event could occur in the near future. Sophisticated ABS investors were already demanding much of this information. FICO scores of borrowers—and cosigners, since many undergraduate students are “thin file” borrowers with no credit history—are particularly important, but only one of many credit factors. A weakness of FICO scores is that they are short-term indicators that may only be relevant for a year or two. And the average FICO isn’t enough—a high average FICO with broad distribution could be a worse credit risk than a pool with a lower FICO score but a narrower distribution, because of the higher probability of default among borrowers who scored at the bottom. The loan pools in securitized trusts are extensively audited both internally and externally. According to Michael Nie of PricewaterhouseCoopers LLP, auditors typically sample student loan data to match the borrower name, maturity date, FICO score, loan balance, loan status, interest rate, delinquency information, and loan documentation. In his review of thirty ABS issues from nine issuers and four servicers, the exception rate for incorrect data ranged from 0.4 percent to 4.4 percent. The average was 2.5 percent, which Nie says compares favorably to exception rates among mortgage-loan servicers.38

154 FOOTING THE TUITION BILL Rating agencies—Moody’s, Standard & Poor’s, Fitch, and Dominion— provide an extra level of due diligence in reviewing student loan ABS offerings. When rating a student loan issue, rating agencies typically “stress-test” the loan pools at two to five times the historical default rate to determine the effect on the cash-flows to the security-holder. Rating agencies also perform evaluations and rankings of student loan servicers, based on criteria such as management and organization, internal controls, historical portfolio performance, cash management, financial performance and organizational efficiency, loan administration, and compliance.

International Student Loan Market The U.S. student loan industry is the world’s most highly developed. In many other industrialized countries, the price of postsecondary education is significantly lower (or free), and publicly funded universities account for a higher percentage of enrollment. Some of the Commonwealth countries tend to have a form of government-sponsored loan assistance program. The United Kingdom’s program has a needs-based component, while Australia’s has a merit-based component. The repayment terms of these programs typically are income-based—in Australia, there is a sliding scale of 4–8 percent of income based on income level; in New Zealand, a 10 percent tax surcharge; in the United Kingdom, a 9 percent pay-as-you-earn scheme above a minimum annual income level of £15,000. Commercial banks tend to offer private student loans. The Bank of Ireland’s standard student loan rate is 9.2 percent, but it offers 0 percent loans to undergraduates in medicine, dentistry, pharmacology, and veterinary medicine. The bank makes such loans because, a spokesperson explains, “There is an extremely competitive market out there. . . . Studies show that 80 percent of people are unlikely to change banks. Students who become veterinarians or pharmacologists are strong business customers for us.”39 There is a lot more action in developing countries. First, enrollment growth rates are much higher because of higher population growth and higher rates of growth in participation. The information in table 5-2, drawn from an investor presentation by Laureate Education Inc., illustrates the scale of the opportunity.40

THE SUPPLY SIDE OF STUDENT LOANS 155 TABLE 5-2 GLOBAL POSTSECONDARY EDUCATION MARKET United States

Western Europe

Latin America

Population age 18–24

32 million

49 million

Participation rate (% 18–24 enrolled)

47%

23%

15%

8%

Enrollment 1990 (millions)

13.5

11.6

7.3

13.8

Enrollment 2005 (millions)

16.1

13.6

12.0

27.8

Enrollment growth rate (CAGRa 1990–2005)

1.1%

1.2%

3.6%

5.3%

Asia

78 million 411 million

SOURCE: Douglas Becker, presentation for Laureate Education Investor Day, Laureate, Inc., 2005, 7–8, http://library.corporate-ir.net/library/91/918/91846/items/144009/Becker.pdf (accessed February 23, 2007). NOTE: a) Compounded annual growth rate.

Governments in many developing countries are encouraging the creation and growth of private postsecondary institutions as a way to add capacity (classroom seats or online) without using public funds. Laureate projects the private-sector market share of postsecondary enrollment in Mexico, for example, to increase from 18 percent in 1990 to 40 percent in 2010. Chile’s university population has expanded by 6 percent annually over recent years, and 60 percent of enrollment is in private universities.41 The Chilean congress recently proposed creating a fund to guarantee loans to students at private universities. The program is modeled on the Sallie Mae loan program in the United States and on programs in Europe and Australia, according to the Ministry of Education. The Russian Federation is reportedly also seeking to introduce a government loan program, with income-contingent repayment terms.42 One important lever for governments to increase postsecondary enrollment growth in developing countries is to create a student loan program funded by private capital. For example, Hungary has formed the Student Loan Centre as a state-owned, nonprofit company to manage loan accounts, disburse student loans, and collect repayments. Since its founding in 2001, its annual loan volume has quintupled. Repayment rates are based on 6 percent

156 FOOTING THE TUITION BILL of the minimum wage for the first two years and 6 percent of actual income thereafter. Forbearance is granted for childbearing or military service. The Student Loan Centre initially raised capital from the state bank, but in 2003 tendered for commercial bank credit. In September 2003, it started a program to issue bonds that trade on the Budapest Stock Exchange.43 Given these powerful trends, it is likely that the future of the student loan industry will feature not just a global supply of capital from investors, but increasing global demand for capital driven by rapid enrollment growth in developing countries.

Summary The majority of student loans made today are likely to be securitized and sold to sophisticated global investors. This chapter focused on how the securitization of both federal and private student loans has tapped the global market for capital to fund the strong demand for student borrowing. It described why and how loans that are made to individual students at interest rates of 8–9 percent can be structured and sold to ABS investors who might receive interest rates as low as 4–5 percent through a complex intermediation process. Funds from the global capital markets are likely to continue to flow to the sector—making it more efficient and potentially reducing costs to student borrowers—as regulation remains supportive, intermediaries continue to innovate in both the marketing of loans to students and the structuring of loans for resale to investors, private student loan performance becomes better understood, and investors become more comfortable with the asset class. In the long term, the flow of private capital through student loans could accelerate the evolution of higher education institutions and systems outside the United States to an extent that could ultimately dwarf the U.S. market.

6 Marketing Opportunity: Challenges and Dilemmas Richard Lee Colvin

If you Google “private student loans,” you will come up with, literally, more than twenty million entries, page after page of companies offering tens or even hundreds of thousands of dollars in loans to pay for college and graduate school. Loan to Learn, the top sponsored link on Google in October 2006, promised “No Hassle” loans and “pre-approvals” in minutes, a pledge also touted in ads placed in magazines such as U.S. News & World Report and on television by the company’s nonprofit parent. The second link, from a startup company called Education Finance Partners, drew attention with “$1k–$200k Instant Decision for Tuition, Rent, etc. Pay after Grad.” Another link, once again from a startup company—this one with the intriguing moniker of “MyRichUncle”—lured customers with a promise of up to $70,000 per year and a lower interest rate for borrowers with good credit. Big national banks such as Chase, Bank of America, and Wells Fargo, as well as regional operations such as National City, KeyBank, and Citizens Bank, were prominent among the advertisers, highlighting high loan amounts, fast approvals, or easy applications. An assortment of loan websites, such as www.estudentloan.com, referred potential borrowers to “recommended” lenders, for a referral fee that went unmentioned. In the mix, too, were state student loan agencies from Iowa and Kentucky, among other states, as well as a plethora of sites with such innocuous names as NextStudent, StudentLoanXpress, and The Student Loan Company, the last of which is actually a subsidiary of banking giant CitiBank. Sallie Mae, perhaps the best-known name in student lending, also appeared in the search, advertising its Tuition Answer loans. 157

158 FOOTING THE TUITION BILL The results of the Google search illustrate two relatively recent and dramatic changes in how American students put together the financing for college and how companies reach them. One is the use of the Internet—and other means of reaching students directly—to make loan offers, in much the same way that lenders target customers for mortgages and credit cards. The other is the shift toward private debt and away from government loan programs under the Federal Family Education Loan Program (FFELP) or the Parent Loans for Undergraduate Students Program (PLUS) for parents who qualify. Student loans once were almost exclusively associated with government programs, with 70 percent of the borrowing occurring at government-subsidized rates. But starting in the late 1990s, private loans, also known as alternative loans, exploded in importance and became a crucial element of many students’ financial plans. This dramatic growth occurred at the same time consumers were becoming more and more comfortable shopping on the Internet for more than just books, music, and Christmas gifts. Student loan companies saw the Internet as a way not just to advertise their products, but also to lower their costs of doing business. Lenders competed to make their websites easier to use. Private loans have become more important not just because of the Internet and marketing, however. The more important explanation lies in demographic, economic, and educational trends. More students are enrolling in college, but the days when scholarships, grants, work-study, summer jobs, and government-subsidized loans covered most of the cost of a college education at all but elite private schools have passed. Average tuition has risen by 5–7 percent annually over the previous decade, faster than inflation and almost twice as fast as average family income. Tuition has gone up even more, percentage-wise, at public universities and colleges than at private ones. In 1975, Pell Grants covered about 84 percent of the costs of tuition, books, and other fees at the average public four-year institution; by 2005–6, that percentage had fallen to 33 percent, according to the College Board.1 Meanwhile, the maximum amount an undergraduate can borrow in subsidized loans has barely budged since the Reagan administration. Students have begun using advances on credit cards and private loans to fill in the gap. Private education loans are loans for which the student borrower does not have to put up collateral, and for which eligibility is not determined by income. Unlike federal student loans, which carry the government’s

MARKETING OPPORTUNITY 159 assurance that most of the money will be repaid, private loans require the lender or the loan insurance companies they work with to bear all of the risk. That’s why private loans are generally significantly more expensive than those issued under the federal loan programs. Interest rates for a borrower considered the best credit risk—one with a job, without any defaults or late payments, a reasonable FICO score (credit score from the Fair Isaac Corporation), a coborrower with a substantial income, and attending a school where students have established a good record of repaying their loans—can be competitive with some government loans. But a student with a damaged credit record, no job, and no coborrower will pay far higher interest rates—over 18 percent in some cases—if he or she is able to obtain a loan at all. In 2006, Sallie Mae, which is the largest private lender, was charging borrowers it rated the strongest a half-point below the prime interest rate of 8.25 percent; it was charging those it judged most risky the prime rate, plus 6.5 percentage points. Starting in June 2006, the interest rate on federal loans for students whose parents qualified based on income was a maximum of 6.8 percent. The fixed rate for federal PLUS loans, which are available to anyone with reasonably good credit, was 8.5 percent. But private loans have positive features that, under certain circumstances, make them more appealing than federal loans. For example, applying for a private loan does not require filling out the Free Application for Federal Student Aid (FAFSA) form, a fact that some companies highlight in their ads. Private loans also are available to students attending only parttime, which is not true of federal student loans. While federal loans are generally easier to consolidate, so that borrowers only have to make a single monthly repayment, Sallie Mae—by far the largest issuer of federal loans as well as private loans—and some other lenders have begun allowing certain borrowers to consolidate their private loans. Private and government loans are alike in that borrowers cannot escape the fact that neither is dischargeable in a bankruptcy. Between 1995 and 2005, annual private loan volume grew from $1.3 billion to an estimated $17.3 billion, based on a survey to which lenders responded voluntarily.2 That meant that students were taking out at least $1 in private loans for every $4 they were borrowing through governmentsubsidized or guaranteed programs. But the actual amount may have been significantly higher. Some industry executives put it at over $20 billion, and

160 FOOTING THE TUITION BILL most expect it to grow by 30 percent or even 40 percent annually. Some industry analysts predict that private loans will be an $80 billion business within a decade, meaning it could eventually surpass the federal program in volume, if policies remain unchanged.3 Until the mid-1990s, most private loans were taken out by graduate students going into relatively wellcompensated fields, such as law, medicine, dentistry, or business.4 But over time, undergraduates have accounted for more and more of the private loans. The loans have become a fact of life, not just for students attending high-priced private schools, but for many attending state schools, part-time students, community college students, and students enrolled in private, forprofit trade schools. Indeed, as is explored elsewhere in this volume, trade and technical school students are more likely than those attending any other type of institution to take out private loans. Recognizing the growing demand for private loans, numerous companies have stepped up to supply them. In summer 2006, the website www.finaid.org listed no fewer than thirty-three purveyors of private loans. The industry publication Greentree Gazette in May 2005 printed the names and products of seventy-six lenders. Only eight did not offer private loans. In 1997 it was estimated that students could choose from 79 different private loan programs with varying prices and conditions; by March of 2003 it was estimated that companies were offering 272 different private loans that differed by interest rates, approval criteria, and repayment terms. As the Google search indicates, that number has surely risen since then. “This is not your father’s student loan business anymore,” says John Hupalo, executive vice president at First Marblehead Corporation, a highly profitable, publicly traded company that specializes in designing loans and in raising money for student loans from investors through a process known as “securitization.”5 The growth in the demand for loans and the proliferation of lenders translates into greater competition for business. Competition has increased the variety of options and benefits available to students—on repayment terms, upfront fees, interest rates, time to repay, forbearance policies in the event of job loss or disability, and so on. But the number of loans available and the claims made by companies on websites (or, in some cases, the lack of information about actual terms and interest rates) can make it difficult for consumers to choose the best option. The web advertisements generated by

MARKETING OPPORTUNITY 161 the search illustrate that point quite vividly. To help students, many colleges and universities have created lists of “preferred” lenders, which agree to offer favorable terms or enhanced services in hopes of gaining a steady stream of business. Indeed, some colleges make private loans offered by outside vendors part of the financial aid package they offer to accepted students. While getting on the “preferred” lists is a common marketing strategy among lenders, such arrangements also can be difficult for students to evaluate.6 They either have to trust that financial officers have weighed all available options and made the best possible choice, or shop for themselves and sort out such questions as whether it is better to get a lower interest rate or a lower upfront fee, and whether it makes sense to start paying the loan back right away, pay only the interest, or pay nothing. In answering such questions, students cannot count on equal disclosure of all the terms of all the private loans. Instead, they generally have to rely on the claims made on Internet sites by large, well-established companies, a number of banks, and various startups, all vying for their business. The largest of the private lenders by far is Sallie Mae, the former government-sponsored enterprise (GSE) that moved to become a completely private enterprise beginning in 1997. Sallie Mae was not the first lender to move into private loans, but it quickly became the largest, the result of its long relationship with thousands of schools, its 350-member sales team, and its partnerships with banks. In 2005, Sallie Mae issued $6.5 billion in private student loans, or perhaps a third of the estimated private loan volume nationally. That was a 45 percent increase in private loan volume for the company from just a year earlier.7 Another important and successful company is Boston-based First Marblehead. First Marblehead operates mostly behind the scenes, offering its loans through partner companies. As of 2006, First Marblehead had set the terms—rates, maximum amount students could borrow, borrower qualifications, and so on—for more than 680 loans sold by sixty-four nonprofits, private companies, banks, and other private lenders. As has been noted, First Marblehead also “securitizes” the loans, which means the company issues a bond or security that carries a certain rate of return to investors. During the fiscal year that ended in July 2006, the company facilitated 358,000 loans worth $3.36 billion for students enrolled in 5,600 schools.8 Many of those loans came from First Marblehead’s largest three partners,

162 FOOTING THE TUITION BILL JPMorgan Chase, Bank of America, and Charter One Bank. Since it was founded, First Marblehead has securitized more than $11 billion in loans.9 Just as with the federal student loan program, banks are a significant source of private loans. But most are reluctant to keep the loans on their balance sheets and so quickly sell them off—not just to First Marblehead, but also to Sallie Mae and other “secondary” markets for private loans. Some banks, such as Citibank and Wells Fargo, have their own subsidiaries that market, process, collect, and raise money for student loans through securitizations. Through its subsidiary, called, simply enough, The Student Loan Corporation, Citibank issued $1.63 billion in its private CitiAssist loan program in 2005. The company estimated in its annual report that that amount represented 12 percent of the estimated private student loan market that year, based on the College Board’s estimate.10 The Access Group, founded in 1993 to provide private loans to law students, loaned $1.8 billion to graduate students in 2006, mostly to those attending law, dental, medical, or business schools. About $800 million of that was in private loans.11 Beyond those lenders is a host of smaller companies—including Loan to Learn, Campus Door, Education Finance Partners, College Loan Corporation (CLC), and MyRichUncle—that market loans. Note that compared to the billions of larger lenders, MyRichUncle issued about $85 million in private loans during its first fifteen months in operation. Its founders said the company was “on track” to do $100 million by the end of the year. Until 2006, few people who were not financial aid officers or parents or students trying to line up money to pay for college knew much about private loans. The College Board’s 2004 report on student debt noted the rapid growth in private loans, but they all but escaped broader notice. Then Educap, which had begun marketing private loans through private companies in the early 1990s, reentered the market in 2006 under the name Loan to Learn and began airing television ads and placing print ads in magazines, reaching out directly to borrowers. On the Internet debuted a website called www.educatedborrower.com, sponsored by a company called GCO ELF, which is, in turn, a subsidiary of a company that securitizes loans. The site opens with a video of a couple appearing to be in their forties, a shimmering swimming pool and the rear of a large, suburban home over their shoulders. “It’s easy to put your kids through college these days,” the smiling

MARKETING OPPORTUNITY 163 mother says, her voice dripping with irony. “No more vacations. No more shopping.” Not to mention, the father said, “draining your 401k.”12 The couple reports that each of them has a business degree, but they couldn’t figure out the federal financial aid forms. So they turned to a private loan, which was quickly approved. “Smaller payments would be ideal,” the father says. “That we could afford,” finishes the mother. The MyRichUncle website (www.myrichuncle.com) features the company’s iconic avatar—an invisible man wearing a black suit and tie and a bowler sporting a red star—and blunt, no-spin rhetoric. (“We know your pain.” “Debt is no laughing matter.” “We’re not here to rip you off.” “Yeah, we need to be profitable, but only so we can still be here next year.”) “The information should be obvious, instant, and exciting,” Raza Khan, the former Internet marketing executive and company cofounder, says of the website. As with other companies, MyRichUncle expected the website to generate a healthy share of its business. According to Khan, “We want to make it ‘pop-digestible,’ as easy to understand as soap.” In the summer of 2006, however, MyRichUncle got more attention for ads it placed in the New York Times, Time magazine, The Wall Street Journal, and USA Today. They repeated charges that had been widely discussed in the industry and even in such publications as the Chronicle of Higher Education,13 claiming that competitors offered “kickbacks” or “payola” to get on college “preferred lender” lists. The ads, which urged students to put their financial aid officers on the spot by asking them if they had any special arrangements with lenders, were immediately denounced by financial aid officers stung by what they said was unfair criticism. David R. Gelinas, the financial aid director at the University of the South, told the Chronicle that as a result of the ad he refused to see a sales representative for MyRichUncle. Another financial aid officer predicted a “backlash” against MyRichUncle. And a comment from a financial aid officer on the weblog “Generation Debt” said that “it wouldn’t be a huge surprise to hear that a few MRU applications accidentally got put to the side or in the recycling bin instead of the filing cabinet this year.”14 Competitors of MyRichUncle, concerned about their reputations and protective of the financial aid officers with whom they did business, were critical of the startup as well. The claims made in the MyRichUncle ads also merited coverage on the higher education news website InsideHigherEd.org and in the New York

164 FOOTING THE TUITION BILL Times. MyRichUncle, Loan to Learn, Education Finance Partners, and Sallie Mae were among the private lenders featured in a front-page Times article exploring techniques lenders employ to build close relationships with colleges. USA Today published a long piece on private loans that opened with a lawyer saying he had no idea he was taking out private loans that carried an adjustable interest rate. Editorial writers at various publications piled on, decrying the fact that lenders were profiting from lending money to college students. Airing complaints about private student loans by the United States Student Association, the USA Today article quoted a student who said, “There has been a lot of confusion, and I feel students have been deceived in many ways.”15 The attention demonstrates that, with little notice, a shift has occurred in how many students pay for college. The phenomenon is so new and unfamiliar that, when it came to light, concern spread as to who was looking out for the interests of borrowers. Are the lenders adequately disclosing interest rates and other terms of loans? Are financial aid officers being sidelined, leaving students to their own devices? Or does the direct marketing of loans give consumers more choices and empower them to decide for themselves which loans are best for them? A question raised by the Internet ads promising an instant decision is whether it has become too easy for students to take out loans. As has been noted, understanding the terms of loans and sorting through repayment options and other features can be difficult. Loan counseling helps, of course. But how do students get that counseling ahead of time when their application can be approved in minutes? Are companies doing enough to make sure students are borrowing as much as they can from government loan programs before they turn to private loans? Christopher Mazzeo’s analysis of student borrowers suggests they are not, as data show that as many as half of the students who take out private loans don’t even apply for federal loans.16 Are some companies, and perhaps some colleges, encouraging students to take out more expensive private loans before they tap the federal loans? Are offers of $50,000 or more per year causing students to overborrow? Representatives of First Marblehead and Loan to Learn have said that private loans are most suited to more financially secure borrowers, while lower-cost government loans are often a better fit for the poor. That, of course, means that low-income students have fewer choices of schools,

MARKETING OPPORTUNITY 165 unless colleges themselves choose to make up the difference. In addition, some in the industry say, students planning to go into relatively low-paid fields such as teaching or social work or journalism should not take out private loans because they will likely be unable to make the payments. Others contend that students of great talent and ambition but few means may be able, with a good education, to achieve great success even in those fields, making it easy for them to repay their loans. In such a case, of course, a private loan, to the extent it is necessary, would, indeed, be a good investment. But how good are lenders, using traditional means of estimating risk such as income and credit scores, at sorting out that particular risk-reward proposition? And is potential being squelched as a result? This chapter will not attempt to answer these questions nor reach conclusions about whether private loans are good or bad. That, of course, depends on the student and his or her circumstances. It also depends on one’s sense of the degree to which individuals, who benefit most directly from a college education, should bear the cost. Rather, the purpose here is to raise some of these questions and fill in some of the void in knowledge about the private loan business, and to profile some of the major companies and the place they hold in the industry. Suffice it to say, these are questions that lenders have had to answer for themselves. Also concerned are investors who agree to put up their cash based on assurances from the lender that the loans will be repaid, and policymakers trying to get a handle on this rapidly changing marketplace and the ways in which various companies respond to them. As one Sallie Mae executive said in an interview, “It’s in our interest to make sure students succeed.”

Sallie Mae: “We’re Big and We’re Competitive” In 1965 when the federal student loan program came about, there was little interest in it at first because, even with government backing, banks did not want to tie up their funds in the relatively low-yield loans. So, to establish what was called a “secondary market” for student loans, the government created Sallie Mae. Sallie Mae is the nickname of the student lending subsidiary of SLM Corporation. In 1972, when Congress authorized its creation, SLMA stood for the Student Loan Marketing Association, and its

166 FOOTING THE TUITION BILL purpose was specific and narrow: to “buy” the government-subsidized loans initiated by banks. The quasi-public company operated nicely within that narrow charter. In the early 1990s, the guaranteed yield on government-subsidized loans— which is different from profit because a lender’s costs have to be paid out of it—began falling. Loan defaults, meanwhile, soared to above 20 percent. In an effort to reduce defaults, students were allowed to “consolidate” their loans at a lower interest rate. Sallie Mae was slow to see the potential loss of business represented by the consolidation boom, and hundreds of millions of dollars worth of loans were “consolidated” away from them, denying the income stream from those loans to the company and the investors in its bonds. In the mid-1990s, the bottom began to fall out. The Clinton administration created the direct-loan program, under which colleges and universities loaned federal money directly to students, eliminating profits to be paid to investors and fees to be paid to middlemen, including Sallie Mae. Sallie Mae and other lenders lobbied furiously against the direct-loan program, which cut deeply into Sallie Mae’s main business. The company, according to one executive, was “not going to survive” without drastic action. But, because of the terms of its charter, Sallie Mae was unable to issue loans itself, and so its potential revenue was limited.17 In 1997, Albert L. Lord, who had previously worked for Sallie Mae, retook power on the company’s board to become chairman and CEO. From that position he persuaded Congress to let the company transform itself from a purchaser of government-backed student loans into a wholly private, forprofit enterprise. With its new status, Sallie Mae would be able not only to purchase loans from banks and other lenders, but also to make loans on its own. Rather than start a marketing arm from scratch, Sallie Mae went on a shopping spree for companies and nonprofits already in the loan business. “Our goal is not to be buying loans in the marketplace,” Lord said in June 2000 when announcing the purchase of USA Group,18 for which Sallie Mae paid $400 million in cash and $370 million in stock. USA Group included the nation’s largest guarantor of federal loans, as well as several for-profit subsidiaries that marketed and purchased both public and private loans. The purchase eliminated one of Sallie Mae’s largest competitors and gave the company the ability to participate in all aspects of the loan process, from making loans to guaranteeing them to collecting on them.19 Previously,

MARKETING OPPORTUNITY 167 Sallie Mae had purchased two other nonprofit lenders, Boston-based rival Nellie Mae and a Cincinnati-based company called Student Loan Funding Resources. By 2004, the company had become completely private, having bought out the government’s interest in the loans it held. In 1997, Lord addressed the Consumer Bankers Association (CBA) and, essentially, told its members that if they didn’t work harder to serve students and colleges, they would see Sallie Mae take the business away from them. “Nobody is putting any significant money into this business to improve delivery and technology,” he told them. “You’ve got to get your tails out from between your legs and stop apologizing for making a profit.”20 The company’s declining fortunes in the early 1990s, one company executive says, had made Sallie Mae hungry. “We wanted to compete. We wanted this to be a more competitive marketplace.” One way Sallie Mae became more competitive was to get bigger. But the company also aggressively courted schools and colleges to become “preferred” lenders through FFELP. Although critics have raised objections about the propriety of such arrangements, Sallie Mae officials say they actually benefit students, because lenders have to offer better service or better terms to win the business. Lenders cannot offer inducements to colleges to get them to steer federal loans in their direction or to get on preferred lender lists. Such relationships, of course, also help in the marketing of private loans. As of fall 2006, Sallie Mae held $137 billion in student loans and had more than 10 million customers.21 It had significant, ongoing business relationships with about 3,800 colleges and held about 27 percent of the student loans in the country, the same percentage as fifteen years earlier. With its partner banks, Sallie Mae originated about 25 percent of all loans. The company’s size makes it a target of critics. Its campaign contributions to members of Congress—an industry-wide practice—have drawn fire. So, too, has the company’s decision to buy a large collection agency, which earns fees when it collects on delinquent loans. Unwelcome headlines have come about in cases in which students wound up owing far more than they borrowed, either because they did not understand the terms of loans or saw their loan balances rise dramatically due to deferred interest and fees. The compensation earned by the company’s top executives has brought attention, as well. Lord, for example, earned more than $225 million in salary and stock options over the course of nine years. A company spokesman

168 FOOTING THE TUITION BILL said most of Lord’s compensation, like that of CEO Tim Fitzpatrick, had come in the form of stock options. In a letter to U.S. News & World Report castigating the publication for its reporting on the company, Lord said, “Taxpayers, schools and students have been well-served by private sector investment and competition in this era of spiraling college costs.”22 Despite its competitive stance, Sallie Mae was slow to get into private loans. Its Signature private loan, introduced in the mid-1990s, is marketed only by its banking partners, who now number about 150, not by Sallie Mae directly. Eighty-seven percent of Sallie Mae’s business is in federal loans, and the company cannot afford to jeopardize relationships with financial aid officers—who have been wary of private loans—by pushing too hard to bypass them by marketing the loans directly to students. According to Sallie Mae officials, the company was slow to market the government-backed PLUS loans to parents for the same reason. By 2005, however, the private loan market was well enough established, and the loans were being demanded by students; so Sallie Mae introduced its Tuition Answer loan, which it does market directly to students, principally through its websites. About $850 million of the $6.5 billion in private loans awarded by the company in 2005 were Tuition Answer loans. “We were not quick to get into the direct-to-consumer loan business,” says one company official. “But we don’t want to leave money on the table, either.” The company will not loan money through its Tuition Answer program to students enrolled in schools whose financial officers are dubious, however. Instead, officials say, Sallie Mae refers “leads” for Tuition Answer loans generated by its website from students who attend those colleges to the colleges themselves, which can then advise the students on how to finance their educations. One big reason Sallie Mae has embraced private loans is the contribution they make to the company’s bottom line. The loans are more profitable than loans issued under the aegis of the government programs. Lenders do have to set aside a higher percentage of the amount of private loans in an insurance fund to cushion them and their investors against the larger losses the loans generate. The reason is that the loans are not guaranteed by the government. But those costs are more than offset by their “yield,” which can be nearly three times as great as for government loans. To illustrate, private

MARKETING OPPORTUNITY 169 loans represented about 13 percent of the company’s lending in 2005 but generated about 25 percent of its profits. The average size of the Sallie Mae private loans being repaid in 2006 was about $9,000, the company says. But the range is wide—from under $5,000 to over $100,000. The average monthly payment is under $100, but it obviously can be much, much higher. The company says it strives to be flexible. Indeed, in 2006 it introduced a private loan consolidation program that enables qualified borrowers—graduates with high loan balances and a job—to extend their payments for up to twenty-five years. That, of course, increases the total interest paid, but it can ease the burden on borrowers still early in their careers. The company will also let borrowers make interest-only payments for months to help them get settled into their jobs. According to one executive, most borrowers want to repay their loans, so the company needs to avoid alienating them with strong-arm tactics. “We have nothing to take back, there is no collateral.” Some loan companies seek to serve a niche market. But Sallie Mae officials say the company is committed to serving all types of borrowers. That is why it makes loans to community college students and students enrolled in for-profit trade schools studying to be chefs or computer technicians, as well as to medical school students and those working on their MBAs. Sallie Mae also has special loan programs aimed at students attending Historically Black Colleges and Universities and Hispanic Serving Institutions. “We want to serve the marketplace as a whole,” one top official says. “A lot of Americans go to for-profit schools, and enrollments are increasing; so it makes sense for Sallie Mae to participate in that segment, as well as in all the other markets.” Sallie Mae’s strategy seems to be working. Its net profit in 2005 topped $2 billion, and its earnings were growing by 15–20 percent per year and were predicted to continue doing so. “Our portfolio growth, combined with our fee-based businesses, continues to position us very well in a growing student loan marketplace,” CEO Tim Fitzpatrick said in October 2006.23 But the company’s long-term goal is even more ambitious. Essentially, Sallie Mae wants to help families save for college, help them and their children borrow as needed while in college, and then maintain a relationship with the graduates as they repay their loans. That is why in 2006 Sallie Mae bought UPromise, the nation’s largest company specializing in helping families save

170 FOOTING THE TUITION BILL money in so-called 529, tax-advantaged accounts. The company also, in 2007, expects to unveil an online loan counseling service that will help students calculate their needs and their repayment costs. “In the next six months, you will see all the pieces integrated together in a package, and it will reveal very clearly how we’re positioning ourselves,” the executive said.

First Marblehead: Behind-the-Scenes Giant Aside from savvy Wall Street investors and industry insiders, few know about First Marblehead, a company that was a pioneer in the private loan industry and whose success is credited with drawing many other companies into the field. First Marblehead specializes in creating loans that are marketed by banks, schools, nonprofits, and other companies—a process called “third-party branding and labeling.” It also profits by setting up trusts to issue securities that are sold to investors, many of whom are large institutional buyers in Europe and Asia. The securities are backed by a portfolio of private student loans which carry, overall, a higher interest rate than that to be paid to the investors. As operator of the trust, First Marblehead pockets a share of the difference over the life of the trust but also collects an upfront profit for setting it up. Such arrangements are lucrative. In March 2006, First Marblehead announced it was setting up a $900 million “trust” that would purchase loans and sell shares in the revenues to investors; the company expected to earn $114 million in profit.24 First Marblehead was established outside of Boston in 1991 by securities traders Stephen Anbinder and Daniel Meyers, with the goal of helping colleges figure out how to raise private capital to cover loans made directly to students. The colleges needed to be able to give potential investors a sense of the risk they were taking by providing capital to the colleges to loan. The colleges also needed to be able to figure out what interest rate to charge their student borrowers and what interest rate to pay to the investors. A few years later, First Marblehead began designing its own loans, customizing the terms for different groups. The first market it targeted was families of students enrolled in prep schools. It added loans designed for the families of college students. Then it began developing student loans for

MARKETING OPPORTUNITY 171 banks and companies to market to students directly. First Marblehead would recommend the types of borrowers who would be eligible to receive the loans (their enrollment status, academic progress, and citizenship or residency); the credit ratings required; loan limits; interest rates and how often they would change; the fees to be charged (including origination fees, guarantee fees, and late fees); repayment terms; who would service the loans; who would guarantee the loans (a kind of insurance fund); and how best to raise money to purchase the loans. Company executive vice president John Hupalo says that when he met First Marblehead founders Anbinder and Meyers in the early 1990s, they were already talking about “the big gap between the cost of going to college and federal financial aid” and the need to find a way “to get private capital as cheaply as possible to the student.” The near-failure of another Boston-based organization, a nonprofit known as The Education Resources Institute (TERI), provided a powerful example of the importance of accurately estimating risk and how much to charge to offset it. TERI was established in 1985 as a guarantor to cushion colleges and banks against losses. TERI collected small fees from lenders and colleges that were making loans and used the fees to create a reserve fund. The reserve fund, then, would be used to pay back the lender if students defaulted. But in the late 1990s, TERI stumbled. TERI was guaranteeing many loans that had been made to law students, seemingly a good investment; but when the market for high-priced legal associates went bust in the late 1990s, TERI was left holding the bag. As the default rate soared to nearly 15 percent,25 TERI’s reserve fund hemorrhaged cash and appeared to be on the verge of insolvency. But TERI did have an enormously valuable asset: its database of information about its borrowers—their records of repayments, incomes, and so on—which could be used to predict the likelihood that other borrowers would repay their loans. Soon First Marblehead came calling to purchase these repayment histories and records of student characteristics, which the company could use to fine-tune its risk estimates. According to its 2005 annual report, First Marblehead paid $9 million in 2001 for the database and its trove of information on $9.5 billion in loans. First Marblehead also took over the marketing of new TERI loans, which are still offered through third parties such

172 FOOTING THE TUITION BILL as banks and nonprofits, but TERI would continue to guarantee the loans. The guarantee is secured by a fee each borrower pays. First Marblehead would pay TERI a quarter of the revenues generated by TERI-guaranteed loans. But, demonstrating how complicated this business is, TERI also agreed to pay First Marblehead fees for processing the loans it guarantees and for issuing securities to buy the loans. So, money continues to go in both directions between TERI, which remains a nonprofit entity, and First Marblehead, which is a for-profit, publicly traded company. Two years after purchasing the TERI database, First Marblehead went public, and its founders and executives, who had been keeping the company alive through many lean years, became fabulously rich. According to publicly available data, Anbinder sold $64 million in stock between May 2004 and July 2006, and he still held shares worth, at that time, $164 million. Meyers sold $63 million in stock and still held stock worth $320 million.26 Meyers was generous with his wealth. In 2004, he made a $22 million donation to the Curry School of Education at the University of Virginia, in honor of a longtime Massachusetts teacher and coach. First Marblehead and TERI were the designers and purchasers of loans marketed by Bank of America ($632 million in loans in 2005); JPMorgan Chase ($742 million in loans in 2005); Charter One ($603 million in 2005); and nearly two dozen others. The company also designed and purchased loans offered by Stanford, University of Southern California, Yale, Wesleyan, William and Mary, the University of Virginia, Carnegie Mellon, and Oral Roberts University, and nearly fifty other colleges. Those loans often were packaged by the colleges into financial aid awards, along with government loans. In addition, the company marketed its own loans on the Internet and in television advertisements under the brand name Astrive. One of First Marblehead’s lending partners is the College Board, best known as the sponsor of the SAT college admission test and advanced placement classes and tests. Beginning in 2005, the College Board began marketing private student loans designed by First Marblehead to students and through college financial aid offices under the name “Connect Loans.” According to Cynthia Bailey, executive director of the College Board’s Education Finance Services Department, the College Board resisted getting into the private loan business for many years. But, she says, “It became clear to us in the past few years that . . . [an] alternative loan option has to be out

MARKETING OPPORTUNITY 173 there,” especially for more affluent families whose children are attending high-priced schools. “It’s just where the business is going because federal loans . . . are woefully inadequate.” The College Board is paid a fee by First Marblehead when students take out a Connect Loan. Lenders typically pay marketers of loans a finder’s or referral fee of 1–2 percent of the loan volume. Bailey says the College Board expects to sign students up for $50 million to $100 million in private loans over the next few years. That could generate a profit of $500,000 to $2 million.27 “We look at it as money we wouldn’t otherwise get,” she adds. First Marblehead’s growth was rapid. In 2003, the company processed loans worth just over $1 billion; in the year ending July 2006, that amount was nearly $4 billion. Business relationships are, of course, often based upon personal relationships. In the fall of 2005, Meyers resigned abruptly after it was learned that he had given $32,000 worth of gifts, including an expensive watch, to a student loan executive for Bank of America. The previous June, Collegiate Funding Services (CFS), a company that marketed loans from First Marblehead, had announced that it was starting its own private loan program, which some interpreted to mean that it would no longer need First Marblehead’s services. The company’s value fell by hundreds of millions of dollars. CFS was purchased by JPMorgan Chase, First Marblehead’s largest customer. That seemed to indicate that Chase no longer needed First Marblehead, either. Then, after Meyers’ resignation, Bank of America announced it wanted to renegotiate its deal with First Marblehead, rather than renew automatically. The stock hit a low point of $20.85. Despite all the negative news, First Marblehead’s profitability, revenues, and share price soared. The company announced in April 2006 that it had reached a new agreement with Bank of America that would enable First Marblehead to continue earning fees for securitizing the loans the bank marketed directly to students. By the following summer, new First Marblehead president Jack L. Kopnisky said the firm’s 2005 revenues had soared 74 percent, and that the company was making a 49 percent return on equity. According to a story in the Boston Globe, Kopnisky said the company’s success convincingly demonstrated that entrepreneurs who spot an overlooked business niche can do well.28 The company’s stock rose into the 70s, nearly triple what it was a year earlier.

174 FOOTING THE TUITION BILL Banks and Private Loans The large banks that market private loans from First Marblehead or Sallie Mae are also heavily involved in the federal student loan programs. Private loans were growing in importance before banks were comfortable enough to get involved in a big way. The first to become directly involved was Wells Fargo, which in 2000 purchased a company called Servus Financial Corporation for an undisclosed sum. Servus carried out the mundane but profitable functions of servicing loans—accounting for loan payments, billing, trying to collect on loans before they become delinquent, and so on. Servus was partly owned by Educap, one of the first companies to market private loans directly to consumers and the same nonprofit company that would later start Loan to Learn, as described above. “Servus will be a tremendous strategic fit for our business,” said Jon Veenis, Wells Fargo’s president, at the time of the purchase. “With its focus on direct-to-consumer student loans, Servus will allow us to offer a wider breadth and range of products to our customers.” As has been mentioned, Chase in 2005 announced it would pay $663 million to purchase CFS, which had originated more than $19 billion in student loans, including federal and private loans. CFS had started emphasizing private loans in 2003 and was selling them using direct mail, the Internet, and telemarketing. But the bank with the largest presence in the private loan market is the Student Loan Corporation, 80 percent of which is owned by Citibank. The Student Loan Corporation was actually founded in the 1950s as part of Citibank’s consumer lending business. The company’s CitiAssist private loans, which first appeared in the early 2000s, have become a significant part of its business. In a 2005 interview, the president of the Student Loan Corporation, Michael Reardon, explained the company’s business model and said the “competition is fierce” in the student loan market. The way for the company to grow, he said, is to get on the preferred lender lists at as many schools as possible. Getting on those lists is important because most students want to borrow their federal as well as their private loans through a single company. Colleges, too, want to deal with as few lenders as possible, to make their business operations smoother. “You have to be a preferred lender to get

MARKETING OPPORTUNITY 175 visibility with the student population,” Reardon said. “In doing so, you drive your volume . . . You have to be out in front of the financial aid advisors on a daily basis to bring solutions to the particular schools to put the students in the seats.”

Consolidators: A New Kind of Business Three companies in San Diego, all of which were started from scratch and have a connection to a single family, show how attractive student lending can be. In 1992, the chief executive of the Union Benefit Life Company, Robert deRose, and Marcus Katz formed the Education Funding Company to market PLUS loans directly to parents. In 1997, deRose sold the student loan company to American Express. Marcus Katz went on to found a company called the Education Lending Group with his son, Ryan. Cary Katz, Marcus’s son, joined his father’s company as a marketing manager.29 Cary then struck out on his own, starting CLC and taking with him ten employees of his father’s company. In 2000, deRose jumped into the business again, hiring forty people from his old company after American Express lost interest.30 That same year, Cary’s brother, Ryan, founded an education finance company called Goal Financial. After PLUS loans, the companies all moved into consolidating government-backed loans. But the boom in consolidation has eased, and many companies that started out in that business now see private loans as a new area of potential profit. The three San Diego businesses have all been very successful. The company deRose founded went public and was purchased in 2005 for $381 million by CIT Group, which saw the growth potential of student loans and wanted to get involved. At the time, the company was on the preferred lender list at eight hundred schools, had $4 billion in student loans under management, and was lending an additional $1.5 billion each year. Private loans were but a fraction of that amount, but CIT expected that figure to grow. DeRose continued as the chairman and CEO of the company, which now markets all types of loans to students and their families, including private loans and consolidation loans, under the corporate name of Student Loan Xpress. Student Loan Xpress in May 2006 announced it had tailored a private loan for a consortium of fourteen small, liberal arts colleges in the

176 FOOTING THE TUITION BILL Midwest. It also offered private loans to students attending technical schools and community colleges. By 2006, Goal Financial had 250 employees and a loan portfolio worth $6.4 billion. The seventh-largest loan company in the consolidation loan business, it markets private loans from Wells Fargo and Loan to Learn.31 CLC is even more successful, managing $9 billion in securitized loans. The company expected to lend over $3 billion more in 2006.32 Almost all of those loans, however, were to be PLUS or Stafford loans or consolidation loans. CLC issued private loans designed by First Marblehead and backed by TERI guarantees until 2005, when it launched a subsidiary called Student Capital Corporation specifically to issue private loans it called SCALE, for Student Capital Alternative Loan for Education. “We are very, very new to private loans,” says Mark Brenner, the executive officer of CLC. But he adds that the private loan business, which hardly existed a decade earlier, had matured, making it more and more attractive to new companies: “Private credit will be 40 percent or more of our business by 2010.”

MyRichUncle Raza Khan and Vishal Garg, the young, confident, ambitious founders of the student loan company with the marketing-friendly name of MyRichUncle, work out of offices in midtown Manhattan, just up from Bryant Park. As described above, the company’s provocative advertisements in 2006 drew strong reactions throughout the education loan business and on college campuses, and resulted in the airing of issues related not just to private loans but to student lending practices in general. Ironically, Khan and Garg didn’t intend to get involved in education lending when they went into business together. The young entrepreneurs grew up in Queens and met at Stuyvesant High School, the downtown Manhattan exam high school for math, science, and technology that is tougher to get into than Harvard. They were classmates in an economics class, taught by a legendary Stuyvesant teacher, that left a lasting impression. Both attended New York University on academic scholarships. Both started businesses while students. Garg traded

MARKETING OPPORTUNITY 177 equities on the Hong Kong stock exchange and then, right after college, cofounded a $125 million technology investment fund that bought stakes in call centers in India and other emerging businesses. Khan launched an Internet marketing business called Silk Road Interactive. After college, the friends would get together for dinner and talk late into the night about what they now call their “far-out economic” theories. They happened on the idea of buying equity in individuals, a notion long championed by economists at the University of Chicago, including Gary Becker, Richard Posner, and Milton Friedman. Just as stock in a company becomes more valuable if the enterprise is successful, an investor who buys an equity stake in an individual in return for a percentage of the person’s future income does better the more money the person earns. “If you found the right demographic and put small amounts of capital in lots of different people with a model of forecasting what their incomes would be and what percentage of their income to buy, you could create a new market,” Khan says.33 They assembled a team of fifteen actuaries and data researchers who mined statistics at various colleges on earnings of alumni, starting salaries in various fields, and default rates, and then added in factors such as grade point average, extracurricular activities, and even motivation and imagination.34 Khan called it a “massive research project to unearth every possible piece of data to understand income, post-education.” Once they started working on the problem, he says, “We wondered why interest rates on education loans weren’t done this way. We assumed the players out there were smarter than we were and had already done this. But they hadn’t.” Khan and Garg were able to raise an initial stake for a business to try out their idea, and they began “investing” in college students at selective schools up and down the East Coast. But as that money ran out, they had a hard time raising additional cash from investors. As they wracked their brains for ways of explaining the concept of lending to individuals based on their potential for the future, one of them suddenly flashed on the idea that “it’s like getting money from a rich uncle, not like going to a bank,” Khan recalls. The business partners bought the rights to the Internet portal name “MyRichUncle” for $18,000. “It seemed like a lot at the time,” Khan said. Now, stock analysts consider the name one of the company’s best assets. The name helped MyRichUncle secure nearly $600 million from various investment banks, and the company began making loans in the fall of

178 FOOTING THE TUITION BILL 2005. But the terms set by its backers required the company to rely mostly on traditional underwriting practices rather than the untested methods it had devised to identify potential. Khan said that, on average, the company was approving only about 20 percent of the loan applications it received in its first year in business. Like most other student loan companies, the key factor in most cases was whether the student had a well-qualified coborrower. But the founders had not given up on the idea of lending under different terms. In spring 2006, the company announced it had raised $100 million to lend based on students’ potential. The new program would allow the company to lend to “preprime” borrowers—those with potential who had not yet established a credit history and had no coborrower. The approach would allow MyRichUncle to reach out, for example, to a student who did not otherwise qualify for a private loan but who was attending MIT and studying bioengineering, and therefore could be presumed to have a good chance of earning a healthy income. In the fall of 2006, such loans carried a variable interest rate of 13.25 percent or higher—lower than credit cards, but about five points above the rate for a creditworthy student with a coborrower. The company estimated that the market for such loans was at least $35 billion, and it expected its approval rates using those criteria to double or triple. Interviewed in the fall of 2006, company officials declined to reveal how much money had been loaned, or the approval rate under the new program. According to stock analysts and industry experts who are watching it closely, the company’s experiment with “preprime” lending has great potential. One wrote that the company’s method of evaluating the creditworthiness of borrowers is “an important breakthrough in underwriting.”35 Other analysts have been more cautious. But competitors acknowledge the wisdom of what MyRichUncle is attempting. If the company is successful, it will be able to cut interest rates for students with more potential, which will give it an edge in the marketplace. Because of the potential for profit, “Everyone in the industry is in a race to collect data” on how borrowers with different majors repay their loans, John Hupalo of First Marblehead said. But it wasn’t business practices or innovation alone that made financial aid officers and student loan companies start paying attention to MyRichUncle. Rather, it was the company’s provocative ads—alleging, essentially, corruption in the student lending business that hurt the interests of students. The ads sparked widespread anger and dismay and, in the

MARKETING OPPORTUNITY 179 minds of some executives, tainted the entire industry with the practices of a few. Companies that participate in the federal student loan industry are prohibited from offering “inducements” to get schools to issue loans or give them business. The rules do not specifically apply to private loans. But because most lenders offer both government loans and private loans, they have to be careful about stepping over the line. The National Association of Student Financial Aid Administrators has adopted guidelines on such questions. The CBA, the Education Finance Council (EFC), which represents lenders, and the National Council of Higher Education Loan Programs (NCHELP) also established voluntary guidelines for adhering to federal restrictions. But MyRichUncle’s founders said they had discovered arrangements which allowed financial aid officers to exert pressure on students to use certain lenders. Industry executives counter that MyRichUncle was using the ads to gain attention for itself in a competitive market by appearing to stand up for students. But if one looked beyond the incendiary language of the company’s ads and website, MyRichUncle was raising legitimate questions. Who, for example, was looking out for the interests of students? Were Internet websites adequately disclosing the actual costs of loans? Were they adequately disclosing other terms of the loans? Such issues are regulated in other areas of banking, such as credit cards and mortgages. But they are not in student lending. MyRichUncle’s critique of the industry, and its approach to lending, also posed larger questions about private loans. Is the industry, along with the financial aid practices of colleges, providing students with the opportunity to attend the college of their choice at a price they can afford, not just while in school but once they are out and pursuing their careers? Is the interest of society in making sure as many of its citizens as possible are educated to their greatest potential being well-served? Are financial aid and lending giving students choices in their education or taking them away? According to Hupalo, government loans are more appropriate than private loans for some students. “There are large populations of borrowers who should not take out private loans either because of their socioeconomic position, or because they are in programs of study that the economics don’t work,” he said in an interview. “They’re going to divinity school or into social work, and they’re going to come out with $100,000 in debt. You don’t need to be a rocket scientist to see that that’s not going to work.”

180 FOOTING THE TUITION BILL Questions Raised Beyond the societal questions are business considerations. The success of MyRichUncle, as well as all of the other companies discussed above, depends on whether they have properly estimated the risk of the loans they are making. But it also depends on whether the demand for private loans is as big as the companies, and many stock analysts, think it is. Third, it depends on whether college graduates will be able to earn enough money to keep up with loan payments that, in some cases, could represent as much as a quarter to a third of their entry-level take-home pay. Private lenders maintain they have accurately estimated the likelihood of student borrowers being able to make their payments, and the robust market among investors for the securities backed by the loans suggests they may, indeed, be right. Default rates, while higher than for federal loans, are generally reported to be under 5 percent. But companies may not have that same degree of success. Stock analysts have been mixed in their views of the prospects of lenders placing a big bet on private loans. In May 2006, Morgan Stanley stock analyst Kenneth Posner said Sallie Mae’s growing reliance on private loans was boosting its profits. Sallie Mae “is doing better than we expected in the private loan space,” Posner wrote in a report. He said that competition among companies to grab a bigger share of federal loan business would drive down profits as companies had to offer bigger incentives, such as covering some of the upfront fees students pay for the federal loans, to keep bringing in business. He wrote that private loans, however, would remain profitable, and that investors should consider owning shares of Sallie Mae.36 But other analysts were concerned that lenders didn’t yet know how properly to analyze risk. In April 2005, Eric E. Wasserstrom of UBS Investment Research gave Sallie Mae only a neutral rating, citing the company’s “relative inexperience” at what he called “risk-based pricing.”37 Potential profit explains some of the pressure on companies to expand their offerings of private loans. But colleges also want the loans available in order to keep raising their tuition without driving potential students away. Colleges need private credit available to fill the gap left after family resources and federal loans have been tapped out. The colleges argue the investment is worth the cost, because more education will yield higher

MARKETING OPPORTUNITY 181 salaries. But is that always the case? “We as an industry have to be careful,” says Willis Huling, the president of TERI. “Everyone who goes to college presumes they’ll make money to repay the loan. But we’re very concerned about the amount of debt someone takes on. They go to school and they may not be able to buy cars, or a house, or get married.”38 Doug Dolton, an industry veteran, puts it this way: The high interest rates lenders charge “students who have marginal credit . . . will be crippling in the long run,” both to the individuals and to the nation. “The cumulative impact on this next generation, if they are financing a significant portion of their education with private loans, is not where we should be as a country. It’s bizarre to me.” On the other hand, it is important to offer opportunity and educational choice, even to students who come from lowincome backgrounds. And as tuition rises, the dilemma of how to do both will become more difficult to sort out. Meanwhile, with interest rates rising as well, companies recognize they have to act. Sallie Mae executives say rising interest rates mean they will have to cut the maximum “margin” they are able to add to the “prime” rate in determining how much interest to charge. Otherwise, the loans would become unaffordable and unattractive to borrowers. Raza Khan and Vishal Garg remain confident that they are on the right track. They say that “competition is a good thing,” and that their way of helping students attend college will serve the public good by unleashing talent. They are driven by a sense of idealism to find a way to make loans to students who were like they had been, coming out of Stuyvesant High School—students with great potential but limited resources. But they also acknowledge that they are in the business to make money. “This is going to be a huge, huge market,” Garg says. “There’s a massive amount of opportunity in this space. We’ve barely scratched the surface.”

7 The End of Autonomy: How the Role of the Financial Aid Office Is Changing Alan Greenblatt

Campus financial aid administrators have been the fulcrum on which the entire system of higher education finance rests. They serve as their colleges’ or universities’ first and often most important ambassadors to incoming students, determining what mix of loans, grants, parental help, and work those students will rely on to pay for their educations. They generally determine which lenders those students will borrow from and, to some extent, what the terms of their loans will be. While helping to juggle the finances of hundreds or thousands of individual students, campus financial aid officers are the frontline guarantors of compliance with regulations set forth by the federal Department of Education and many other policymaking bodies. By the nature of their transactions with every other player in the world of financial aid, campus administrators exert a great deal of influence over the entire process of funneling money to students. Despite their central role, however, financial aid administrators have largely been written out of the histories and scholarly studies about student aid. The prevailing assumption of academics studying higher education finance seems to be that policies are set by Congress and presidential administrations and are faithfully, and simply, carried out by officials on campus. According to Robert B. Archibald, a William and Mary economist and author of a book on financial aid that mentions financial aid officers only in passing, “Given the constraints that the federal rules put on [financial aid administrators] and the constraints of how much money that 182

THE END OF AUTONOMY 183 they’ve budgeted for you at the school and the policy guidance that you get from the general administration, I’m not sure there’s a whole lot of latitude for decision-making at that level.”1 It’s not just scholars who have ignored the financial aid office. For most of the last forty years, financial aid directors have gone about their business with relatively little interference from lenders, senior university administrators, or the federal government. Now they have been discovered by all of these parties. Lenders, who once largely left students to the care and feeding of the financial aid office while they were still in school, now take on a much more aggressive role in marketing to and informing students on a near-constant basis. Lenders also are increasingly making private loans directly to students, often bypassing the financial aid office altogether. University administrators, who once contented themselves in the knowledge that students were getting their checks on time and that the financial aid office was not getting them into trouble during federal audits, now are pushing that office to become much more engaged in recruiting and enrolling students. And the Department of Education, which endured many years of criticism for poor management within federal loan programs, has managed in recent years to weed most of the bad actors out of these programs, cracking down on schools with high default rates. All this heightened attention and increased pressure complicates the lives of financial aid administrators. In the past, they had a fairly simple professional perspective. They didn’t have to deal with much more than determining the basic types of aid that were available and ensuring that students received what they were entitled to. But financial aid offices have not proved immune to the increasing competitiveness in higher education, particularly as this pertains to funding markets. Because of recurring policy changes in their field, they are accustomed as a profession to adapting to shifting rules and regulations. Today they face what is potentially a fundamental shift in their mission and responsibilities. Campus financial aid officers have, by and large, shared an ethos that the best and highest use of the dollars they help control is to promote access among students who otherwise would not be able to afford to attend their institutions. “Our goal each year is to try to find the brightest, lowestincome group of students and make sure that they have access to as close

184 FOOTING THE TUITION BILL to a full financial package as possible,” says Natala “Tally” Hart, director of the nation’s largest financial aid office, at Ohio State University. Although perhaps admirable, that ethos is now under stress from several quarters. For one thing, the nature of financial aid is changing. Policymakers, particularly but not exclusively at the state level, have shifted a significant share of available financial aid dollars away from programs based on need in favor of allocating money based on merit. This trend has been accelerated, to some extent, by the growing inclination of senior campus administrators to use financial aid dollars for discounts and other tools designed to attract the best-performing students but not necessarily the most economically deserving. Also, the explosive growth of private lending has changed the nature of financing for many students and decreased the overall influence of campus financial aid administrators over students’ decisions. Financial aid directors have to play multiple roles in answering to each of their constituencies. To put it bluntly, there are inherent conflicts of interest built into the system, since what is best for a particular student may not always be what is best for the university or the lender. And financial aid directors have to balance their ongoing role as gatekeepers who stand between students and these other players with the students’ desire for increased access to new options being created in a rapidly evolving marketplace. This chapter will examine all of these dynamics, as well as their effects on the campus financial aid profession. Most of the research has been journalistic in approach, based primarily on nearly fifty interviews. The majority of these were conducted with financial aid directors from every region in the country, representing virtually every type of institution of higher education. No such snapshot can hope to present a definitive portrait of such a diverse profession. But there is little doubt that it is a profession undergoing great change, and one that is likely to look very different a decade from now.

An Accidental Profession The National Association of Student Financial Aid Administrators (NASFAA), the main professional organization for financial aid officers, has members at 2,800 institutions. (Members are likely also to belong to state and regional chapters of the organization, each of which hosts educational and

THE END OF AUTONOMY 185 professional meetings.) Today, there are well over 10,000 financial aid officers around the country, earning nearly $50,000 a year, on average, in salary and benefits.2 Although these are not enormous numbers, they represent the substantial growth of a profession that barely existed forty years ago. Colleges and universities have always offered some form of aid to students, but until the federal government got seriously into the game with the passage of the Higher Education Act of 1965, institutions of higher learning did not feel the need to hire or train specialists to dole out the checks. A few folks in the admissions or bursar’s office were able to handle such duties on the side. Joseph Russo, the longtime director of financial aid at Notre Dame, was working in admissions at a private college in upstate New York when the 1965 Higher Education Act opened the modern era of college financing. He took on the role of deciding who got loans and grants, while others were responsible for work-study. “You could do this out of your hip pocket,” Russo recalls. The new programs, after all, were small and fairly manageable at first. In 1965, total government loans nationwide still amounted to less than $250 million. But like so many other Great Society programs, government loans kept growing, reaching the $20 billion mark by 1993, doubling to nearly $40 billion by 1997, and more than doubling again since then.3 Perhaps because the growth was so rapid, the campus financial aid bureaucracy grew in an ad hoc fashion. As in Russo’s case, people were routinely borrowed or reassigned from other operations. “Sometimes administrators in other jobs, sometimes secretaries,” says Tom Scarlett, a former Michigan State financial aid director who now sits on the board of the Great Lakes Higher Education Corporation, a guaranty agency. To this day, it seems you’re just as likely to find someone with a liberal arts background running the show as a trained accountant or an MBA. “In our office of fifty, I would say that most of the staff have liberal arts types of degrees,” says Albert G. Hermsen, associate director for fiscal planning and scholarships at the University of Michigan, who does hold both an MBA and an accounting degree. “I think that is fairly typical. They are people who care about students and have learned how to do the business part. It works out better, we’ve found, to find people with the social science degree and train them on the accounting and finance, rather than the other way around.”

186 FOOTING THE TUITION BILL Financial aid may not be the sort of work that any child dreams of doing when he or she grows up, but it does appear a good fit for people who like helping other people. Many financial aid directors have worked in the field for decades; the average tenure of chief administrators is more than fifteen years.4 They relish not just the chance to give young people the right start in life, but also the very act of counseling itself. As Russo suggests, many view their mission as helping students attend schools they otherwise couldn’t afford. “It’s absolutely true that in any business like this where you interact with people—individual human beings—about their hopes and futures, it attracts a certain kind of person,” says Barmak Nassirian, associate executive director of the American Association of Collegiate Registrars & Admissions Officers. “But the profession is not all therapeutic. There’s money involved, and they have to enforce the rules.” While making the numbers add up, financial aid administrators also have to make certain they do not run afoul of myriad sets of complicated rules and regulations. It’s always been the case that every transaction in the financial aid process includes at least two other participants—a student and a lender. Those negotiations are complicated enough, given that, according to NASFAA, administrators on campus have to satisfy upwards of 1,600 pages of regulations under the federal loan programs.5 These cover everything from determining which groups of noncitizens are eligible for loans to the mandate that schools confirm completion of entrance counseling before delivering loan money to a student. Many are highly technical in nature. There’s a joke in the financial aid world that by the time you think you have the rules all figured out, they will have changed. “We’re constantly looking for ideas from each other,” says Marvin G. Carmichael, financial aid director at Clemson University and a former president of the national association. “It was one of the things that people took great pride in, when someone stole one of your ideas.” As enforcers of federal rules, financial aid administrators are charged with the delicate and complex business of making certain that students, lenders, and their institutions all obey limits and regulations. Their job has been made harder by the fact that the package they offer up to each student is, in an era of often-discounted tuition, highly individualized and geared to the expectation of what the student is not just able but willing to pay.

THE END OF AUTONOMY 187 Financial aid administrators also have to bear in mind different and often conflicting sets of rules under state grants and loans, NCAA athletic scholarship requirements, private scholarships, and campus-based aid and work-study programs. In each case, financial aid officers attempt to follow the golden rule: The entity that supplies the gold makes the rules. But compliance with regulations stacked on top of each other translates into a lot of headaches. “There are more sets of policies and procedures, more scrutiny of everything that passes through our office,” says Richard Eddington-Shipman, director of the office of financial aid at Michigan State. “It’s a potential nightmare, but currently it’s at the level of a really bad dream.” How do former sociology and English majors learn the complex and constantly changing rules that govern student financial aid? Brigham Young University puts its employees through a two-year program to be certified as financial planners. Other large schools also devote substantial resources toward training their financial aid staffs in managing loan volume and complying with regulations. For most, however, knowledge comes mainly through helping each other. To be a financial aid officer is to receive dozens of daily e-mail alerts regarding the latest twists in national financial aid compliance regulations, NCAA requirements, electronic signatures, and other issues. There’s a yeasty culture of conferences in the financial aid profession, with standing meetings of national, state, and regional professional associations and regular symposia on specific topics of interest. These may include technical topics, such as ways to integrate electronic financial aid systems; policy topics, such as linking financial aid and community service programs or learning how to advocate for need-based aid programs; topics that would be common at gatherings of any sort of finance officers, such as identity theft or business taxes; and topics of highly specialized interest, mainly means of complying with various new federal regulations. “The one area where the federal government has done a decent job is training financial aid organizations,” says Tim Lehmann, aid director for Capella University, an online school based in Minneapolis. Most financial aid administrators, in other words, are trained on the job by professional associations and their peers. There is a strong ethic within the profession that the only way to stay on top of the various regulations is to share knowledge. That ethic, in turn, reflects the tendency of financial aid officers to view their work in altruistic terms. Rather than consider

188 FOOTING THE TUITION BILL themselves competitors with whom sharing secrets such as determining funding methodologies and amounts is taboo, quite the reverse is the case. “If anything, I feel I’m part of a network of people who want to encourage people to go to college and provide them access because it’s good for the society, not just the individual,” says a financial aid officer with the University of California system. “If you don’t choose my institution, that’s okay, go somewhere else.” Financial aid officers from different schools are careful not to discuss specific student information. Beginning in 1958, two dozen private institutions that became known as the Overlap Group met annually to compare notes on the financial aid packages offered to students admitted to more than one of the schools. The idea was that they would smooth out the different offers to ensure that the financial aid packages were based solely on need. Eventually, the U.S. Department of Justice (DOJ) concluded that the group was violating antitrust laws and succeeded by 1991 in getting it to cancel its annual meetings and activities. DOJ pursued a case against MIT, which led to a settlement agreement “that allowed institutions to communicate with each other about financial aid policy,” writes Robert Archibald, “but explicitly excluded discussions of financial aid awards to individual students.”6

An Era of Free Agency Mitchell L. Stevens, an education economist in the sociology department of New York University, suggests that an unintended consequence of the DOJ crackdown was the creation of a sort of free-agent market for highly desirable students. It “created a market at the top,” Stevens says. “If we had a system of collusion—or call it cooperation—in which aid was standardized, it would be very different.” Instead, college presidents today are drawn to a trend called “enrollment management,” under which financial aid dollars are distributed not necessarily to the neediest applicants, but to the most desirable. Enrollment management is an attempt to rationalize aid disbursal and consider each offer in terms of its potential effect on the bottom line. If a school has $1 million or $10 million to spend on scholarships and campus-based aid, why should it not leverage its resources in a way that maximizes desired

THE END OF AUTONOMY 189 outcomes, whether that’s attracting people who can pay most of their own freight or more National Merit scholars? “More and more, schools are chasing the small number of students who have the money or the test scores that help an institution get ahead,” writes Matthew Quirk in “The Best Class Money Can Buy,” an influential Atlantic article about enrollment management. “As those students command higher and higher tuition discounts, they leave a smaller and smaller proportion of the financial-aid budget for poor students.”7 In other words, the work of financial aid has partially turned from the question of how to get dollars to those in need to how to use dollars to attract students who can often pay most of their own way. As Quirk explains, the same $20,000 of aid that might be given to one poor youngster can be more profitably split to attract four or five other, wealthier students. Drawn in by a few thousand dollars’ worth of help, they would end up paying the bulk of tuition costs, helping fill the college’s coffers. Colleges may no longer be able to swap notes directly about student files, but they spend fortunes trying to figure out which way top students are leaning in order to best position themselves. Many low-income students might be attractive academic prospects, but those who are both gifted and rich are better bets all around for the institution. At some schools, such students are sent an “admit-deny” package, meaning they’ve been accepted but are not offered financial aid. Media accounts often confuse “admit-deny” with the far more prevalent (but less catchysounding) practice of “gapping,” meaning students are let into the school, but given such poor aid packages that it’s not truly feasible for them to enroll. According to Sandy Baum of the College Board, “Admit-deny has become less prevalent as need-sensitive admissions has become more prevalent—just don’t let them in at all.” Gapping, on the other hand, “is pervasive,” she says, while noting that in many cases this may be due to a shortage of available funds rather than any attempt at manipulating enrollment. Still, the practice of admitting students but low-balling their support is sufficiently prevalent and widely enough understood to have become something on which marketers capitalize in selling advice and software packages.8 “To the extent the aid administrators are bringing in people who are needy, those aren’t the people other administrators on campus and faculty want to bring in,” says Tom Scarlett of the Great Lakes Higher

190 FOOTING THE TUITION BILL Education Corporation. “They won’t say that publicly, because it’s not politically correct.” They may not admit it, but the practice of enrollment management has become increasingly common, especially at second-tier private schools looking to move up in rankings by attracting students with superior credentials, such as National Merit scholarships, and at public institutions. And it’s reflected in policy shifts being made at the state level. The share of state-supplied financial aid devoted to awarding merit, as opposed to addressing need, has increased from about 10 percent nationwide back in 1993, before the advent of Georgia’s HOPE Scholarships program and its imitators, to roughly 25 percent today. The aim there has been to prevent “brain drain” and keep bright students within state borders. Some financial aid officials worry, though, that such giving drains dollars from the pool for those who are needy.

Losing Clout But given the competitive nature of contemporary institutional funding, such opinions count for less. Many financial aid directors are losing their policymaking prerogatives on campus. They’re increasingly likely to answer to the dean of enrollment or the vice president for finance, rather than the campus president or chief academic officer. “Going back twenty-five or thirty years, the institutions basically viewed financial aid as kind of a charitable operation that was run on the side. The finance VP would take an interest in it only to make sure they weren’t giving away the store,” says Michael S. McPherson of the Spencer Foundation, a former college president and coauthor of a book about student aid. “It became clear to people on the finance end of things that financial aid can be viewed as a revenue management strategy—the equivalent of an airline’s pricing policy or Wal-Mart’s discount policy. The financial aid office is increasingly seen, and for good reason, as an element of the admissions effort, rather than a separate operation.” Summarizing the rising attitude toward the financial aid office among campus leaders, Nassirian, associate executive director of the registrars and admissions officers association, says, “It’s your job to make the books balance the right way. The fact that right before your eyes you’re seeing

THE END OF AUTONOMY 191 needy students go deep into debt or take on unnecessary loans is none of your business.” At a time when a demographic boomlet is bringing more applications and students to many colleges, it’s no longer clear that central campus administrations are interested in allowing financial aid offices to maintain their traditional mission of extending access to needy students as their top priority. “The question becomes for more prestigious campuses whether there will still be that sort of push when they have more students than they need knocking on the door,” says Janice Doyle, who recently stepped down as assistant secretary for finance policy at the Maryland Higher Education Commission. “It’s not just a matter of having the money and giving the money to students.”

Going Private It’s clear, as Doyle suggests, that traditional sources of higher education finance are strained. The average cost of tuition, mandatory fees, and room and board at public four-year institutions has gone up by 38 percent over the last decade in constant dollars (from $9,258 in 1996–97 to $12,796 in 2005–6). The increase has been slightly steeper yet at private colleges and universities, rising by 28 percent over the same period (from $23,795 to $30,367).9 In the meantime, limits on the major government loan and grant programs—both state and federal—haven’t budged. A couple of decades ago, federal loans by themselves were sufficient to cover tuition and fees at a public institution, but today’s freshmen are lucky if these loans will satisfy much more than a quarter of their costs. “Back in 1973, the maximum Pell Grant, plus fifteen hours of work per week at minimum wage, was 120 percent of the total cost of going to the University of Nebraska,” says Craig Munier, director of the school’s office of scholarships and financial aid. “Today, the same work effort plus the maximum Pell Grant equal less than 45 percent of the total cost.” Because tuition increases continue to outpace inflation, while grants and federal loan limits have been in relative decline, more and more students are turning to alternative sources of funding—notably private loans—to finance their education. Borrowing outside federal loan programs is fast approaching

192 FOOTING THE TUITION BILL 20 percent of total higher education borrowing. It amounted to $17.3 billion in 2005–6.10 That’s an increase of 1,473 percent over the total private loan volume of a decade ago ($1.1 billion in 1995–96). The phenomenal growth in the private loan market, however, has been fueled by two factors. One is that many students find it necessary to take out such loans because they are unable to meet tuition and other expenses through traditional means. “The number one question I get is, where do I find more money to pay for my education? And that’s true all over the country,” says Rick Shipman of Michigan State. “The answer isn’t that we have a money tree in our backyard. The answer is going to be private loans. That’s the only place where a high percentage of people are going to be able to find the money they need.” The other factor is that many students and parents find the convenience of private loans more appealing than the reams of paperwork required under federal loan programs. Financial aid officers and the federal government have traditionally been more concerned about equity—making sure that an individual student receives as many dollars as he or she is entitled to—than about simplicity. For students, private lending alters that equation. It should be noted in this context that private loans are heavily marketed to students and their parents. “The student comes home [from the financial aid office] with a 107-question form, but the father just opened a letter from Citibank that says he can have a loan in fifteen minutes,” says Joseph L. McCormick, former president of the Kentucky Higher Education Assistance Authority. “The consumer is saying . . . I’ll pay a little more and I’m going to get a loan in fifteen minutes on the Internet and you’re not going to get a look at my IRS 1040 form.” Financial aid administrators say their skepticism about private loans is based on fears that they cost students more than government-backed loans, and that students attracted to them may take on excessive debt. But private loans also represent a threat to the authority of the campus financial aid office, because they give both students and lenders a means for circumventing the aid administrator’s authority. In this regard, private loans represent the culmination of a decade-long trend of moving financial decisions out from under the financial aid office. During the early 1990s, lenders began to market Parent Loans for Undergraduate Students (PLUS) directly to parents. (PLUS loans are federally

THE END OF AUTONOMY 193 backed loans that parents can take out to cover the total cost of attendance.) This was the first foray by private companies into direct-to-consumer marketing, but because the pitches were aimed at parents, not students, they didn’t represent much of a threat to the financial aid office’s authority. By the late 1990s, companies started selling debt consolidation loans directly to students. Again, such efforts did not appear particularly high on the radar of financial aid offices. While companies now were reaching students directly, most consolidation loans are taken out after a student graduates, or after he or she has taken out primary loans through the auspices of the financial aid office. But the rapid growth of private loans, which target everyone from incoming freshmen on up, represents a direct challenge to the role financial aid administrators have played in serving as the primary or even sole contact the student will have with the financial world. Some administrators do help students shop for the best private loan deal they can find. Others take an arm’s length approach to the products. There are university aid offices that don’t tell students about private loans in the hopes they and their parents will turn instead to PLUS loans or other options, while some advise openly against private loans. One financial aid administrator at a large public university in the Southwest suggests that counseling can sway students away from private loans: “If we show them their total costs and the amount of money they would have to repay after school, they sometimes cancel their private loans.”11 A generation of students has come up that is accustomed to shopping online—and Internet offers and other direct marketing tools sometimes fall well outside a financial aid administrator’s influence. “What I’ve heard from financial aid administrators is that they don’t always know about [a student’s private loans],” said Alisa F. Cunningham, managing director of research at the Institute for Higher Education Policy (IHEP). “When the loans are outside the sphere of financial aid administrators, they wouldn’t be able to know whether students are borrowing above the cost of attendance,” which is forbidden for participants in federal government loan programs. Regardless of any qualms on the part of some financial aid administrators, use of private loans is growing at double-digit rates on many campuses. At Michigan State, only 137 students took out private loans in 1996, when that business first started coming into its own. A decade later, 2,600

194 FOOTING THE TUITION BILL MSU students had taken out such loans. At rival University of Michigan, the number of students taking out private loans has more than tripled over the last six years (from 800 to more than 3,600). The aggregate amount they are borrowing has increased 700 percent, from $7.6 million to more than $61 million. According to Al Hermsen, associate director for fiscal planning and scholarships at Michigan, “The lack of growth in the federal loan programs has made them a necessity.” There are schools, such as Notre Dame, that have negotiated package deals for private loans, getting better deals through volume for their students. Others offer lenders a piece of the traditional loan market on their campuses if they give students a good deal on private loans. Still others have compiled lists of lenders for students to choose from. At Capella University, for example, the financial aid office has researched a list of lenders the school believes offer the best terms and conditions, offering that information online with directions for students on how to apply. Some financial aid offices, though, seem to wish private loans would just go away. “Some offices don’t say much about private loans to their students, hoping that this will discourage them,” says Hermsen, who has a private lending arrangement with Citibank. It would be natural for aid officers to be wary of new products that threaten to diminish their role in the financing process. “You talk to me five years from now, I’ll probably be saying that there’s a whole world of borrowing out there that has grown tenfold, over which the financial aid office has no knowledge or control,” says Eileen K. O’Leary, assistant vice president for finance and director of student aid at Stonehill College, a Catholic institution south of Boston.

What’s Best for Students Students today are bombarded with loads of financial packages and marketing materials. The question asked by campus aid administrators is whether they have the sophistication to sort through all the new choices and make good decisions. An editorial writer for The New Yorker recently complained that “whatever college you choose, figuring out how to piece together which grants, loans, and scholarships are available practically requires an advanced degree in calculus.”12

THE END OF AUTONOMY 195 College aid administrators question whether financial aid should be viewed strictly as a competitive market, like mortgages, arguing it is important that they continue to have a counseling role in helping students sort through the deluge of new loan and financing options with which they are presented, since higher education provides a public good—one that is largely underpinned by government dollars. “The federal government doesn’t help me buy a car, because it has no societal value,” says Nebraska’s Craig Munier. “The reason taxpayers are involved in financing higher education is that we do believe that society, and not just the individual, benefits from going to college.” Even as they are losing some control over the students’ ability to work through their personal calculations, campus aid administrators are attempting to provide more grounding in basic financial literacy to interested students. When it comes to providing students with money, financial aid officers strive for a Goldilocks approach. They want them to have enough money, but not too much. (The typical student who borrows to fund a fouryear public college or university degree graduates with $15,500 in debt.)13 A good financial aid administrator will always ask a student what he or she will be using the money for—whether it’s a good idea, in effect, to be borrowing money for pizzas and having to pay it back with interest. “You’re always trying to counsel students to keep them out of debt,” says Louis C. Jones, a financial aid counselor at the University of California, Riverside. “If you’re just trying to get tuition, you don’t need to borrow extra for a car.” Many also report that students and parents frequently concentrate too heavily on the cost of a single year of study, often neglecting to do the math and plan their way through the cost of a four-year degree. Here, again, their attempt to play a counseling role for the benefit of the student comes into conflict with their other responsibilities. Admissions officers and their other colleagues on campus will sometimes attempt to discourage financial aid officers from “scaring” parents and students by presenting them with a sense of the entire bill for four years’ enrollment. But presumably students and their families have some idea that a college education or a professional degree is a valuable thing worth borrowing large amounts of money for, even at market rates. The Census Bureau reports that college graduates earned, on average, $45,400 during the late 1990s, while those with high school educations averaged just $25,900. The gap grew even wider, not surprisingly, when comparing high schoolers with

196 FOOTING THE TUITION BILL those holding graduate or professional degrees.14 The tassel, in short, is worth the hassle. “Students see that college is generally a financial benefit, at least on average, and they want to pursue it and they look for whatever way they can to make it happen,” says Robert Shireman, founder and executive director of The Institute for College Access and Success (TICAS). Some financial aid officers believe that demand for private loans will slow down, at least for graduate and professional students. Provisions included in the Deficit Reduction Act (DRA) of 2005 allow them access to PLUS loans, which were formerly available only to parents, so that graduate students can borrow the total cost of their education through the federal system. But most financial aid officers have reconciled themselves to the fact that private loans are not only here to stay but are certain to grow over time. And even those who are wary about such loans, such as Tally Hart of Ohio State, concede that they can provide a beneficial bridge to families who do not want to break up an investment or take out a second mortgage in the particular year when their child is starting school. “Private loans have been filling the void,” says Anna Griswold, financial aid director at Penn State. “We have students borrowing everything they can from federal sources and then topping that off with what they can get from the private sector.” As Paul Garrard, director of education loan management for Sallie Mae, the largest higher education lending institution, suggests, the lending industry spotted an opportunity, and the growing popularity of private loans is testament enough to their value. The fact is that it doesn’t matter much whether financial aid administrators like them or not. “Financial aid officers have a limited ability to decide how people are going to live their lives,” says Michael McPherson, the Spencer Foundation president. “They have to limit their lives to what their institution can do based on what is available from the federal government and the state. If students or families want to make other arrangements, there’s nothing financial aid officers can do about it or should do about it.”

Interactions with the Loan Industry Although they have limited control over private loans, financial aid administrators still have profound influence over the government loan programs.

THE END OF AUTONOMY 197 They are central players in the ongoing lobbying effort to keep the federal direct-lending program afloat—believing it remains cheaper than the Federal Family Education Loan Program (FFELP)—as well as in determining whether individual campuses will participate in the program. Because of tuition pressures, as many as 80 percent of the students at many campuses will pass through the financial aid office, even at public universities, a service that gives financial aid administrators power over those students—as well as over lenders. The fact that many lenders approached by this author were reluctant to speak, on or off the record, about financial aid administrators is a silent tribute to their continuing power. Why risk offending a group that decides how billions of dollars are spent and distributed? Most colleges, after all, maintain “preferred lender” lists, directing students to one or two institutions that will receive virtually all of a school’s loan business. A spot on the list is highly attractive; lending volume can easily top $150 million annually at large campuses. “You should just see the bodies of lenders when they put out an RFP [request for proposal],” says Tom Joyce, vice president of corporate communications for Sallie Mae. A campus financial aid officer will indeed likely go through a formal “request for proposal” contract bidding process in selecting the lenders who end up on the preferred list, but the chief administrator will maintain broad discretion in determining who makes the final cut. “As we’ve gotten into the ’90s and early 2000s, really the student loan industry has become so gargantuan that all of a sudden we have other third parties that are paying close attention to the aid offices, because there’s quite a bit of incentive to get business through the student loans,” says Tom Scarlett of the Great Lakes Higher Education Corporation. How big an incentive? Just consider Michigan State, where Scarlett served as financial aid director. For the 2004–5 academic year, that one university alone offered three-quarters of a billion dollars in aid to students. The actual amount of aid that was handed out was quite a bit smaller, because some students who were offered money didn’t enroll, and most parents who were offered PLUS loans didn’t take them out. Still, Michigan State ended up disbursing better than $355 million that year—a sizable amount of money by any estimation. And how much of its loan business went either to Citibank or KeyBank, the two institutions on Michigan State’s “preferred lender” list? A few students

198 FOOTING THE TUITION BILL didn’t qualify for loans with either of those two banks, and a smattering took out their own loans after having been attracted by an Internet ad or direct marketing. But that left everybody but a rounding error’s worth of students to sign up with the campus’s preferred lenders. “Nearly 100 percent go with our two preferred lenders,” says Rick Shipman, MSU’s current financial aid director. There are campuses that let students choose—whatever lender they want is the preferred lender. Some are wary of recommending a financial services firm and then having a student come back and complain he could have found a better deal somewhere else. In 2007, New York State Attorney General Andrew M. Cuomo launched an investigation into the selection of preferred lenders, requesting information from six major lenders and fifty colleges and universities nationwide and raising concerns about whether lenders had offered college loan officers inducements such as free travel. Both Senator Edward M. Kennedy (D-Mass.), chairman of the Senate Education Committee, and the U.S. Department of Education are exploring ways to regulate preferred lender lists or at least require greater disclosure of transactions between colleges and lenders.15 But, in general, students are better off if they’re bundled, meaning that a college or university promises the bulk of the campus’s business to a lender or select set of lenders, according to Shipman. Students might have to pay an origination fee of 5 percent with Lender X, but they’ll pay zero to CitiAssist, because Citibank has agreed to waive the fee in exchange for the volume of business that Michigan State can send its way. “Another company said that they would save our borrowers money even over Citibank,” Shipman says. “We met with them several times, but they could not beat Citibank. We kept pointing to the spreadsheet and saying they’re not better.” Until 2003, Michigan State spent several years arranging for its students to borrow money directly from the federal government as part of the directlending program. (It was the second-largest institution in direct lending, after Ohio State.) That program, which was signed into law by President Bill Clinton in 1993, posed a direct threat to the student loan industry. The initial intention was to cut out private lenders as middlemen, with money flowing freely from the U.S. Treasury into the hands of students.16 Private lending institutions have, not surprisingly, always lobbied hard against

THE END OF AUTONOMY 199 direct lending, which has never exceeded a third of the total government student loan volume. At last count, the total college participation rate was down to 23 percent.17 One reason is that the competitive challenge posed by direct lending has led large lending institutions to invest millions of dollars in better technology and education. They have also come up with a bewildering array of loan packages, many targeted to students in particular disciplines, such as medicine. It’s the combination of improved service and enhanced borrower benefits that has led many schools either to leave direct lending for FFELP or simply to stick with their private lending partners. “I think it was a smart move for my organization not to sign up for direct lending,” says Tim Lehmann, of Capella University. “With FFELP, there are more zero-fee and no-origination-fee packages. Our learners basically get every dollar they sign up for.” Some financial aid administrators are skeptical about the great-sounding packages that private lenders offer to students. For example, some lenders will waive interest payments for the life of the loan, once a student has made thirty-six on-time payments. But most students don’t end up qualifying for such breaks, even according to lenders’ own studies.18 Many benefits are dropped once a loan is sold to another institution, which is a common practice within the industry. “When the loan is sold, the benefits that are promised upfront dissolve,” says Eileen O’Leary, past chair of the direct loan coalition. “As long as there are strings attached to the benefit, then it’s not a benefit.” Debates about the true value of borrower benefits aside, everyone seems to agree that lending companies today do a much more thorough job of providing information to both students and financial aid offices than they did prior to the competitive threat of direct lending. They also offer a multitude of practical services to financial aid staff—everything from answering the office phones to conducting exit interviews with graduating seniors. “You have partners who are interested in providing you with really good service—local folks who will come and roll up their sleeves and do work,” says Shipman, describing some of the logistical reasons Michigan State moved back into the FFELP. “With direct lending, there wasn’t an additional partner that I could get help from. There was only the federal government, and they don’t work with us.”

200 FOOTING THE TUITION BILL Lenders have revised their old attitude that students were to be handed over to aid officers for four years, and then picked up again as customers following graduation. Today they try to stay available and involved in the student’s financial education all through the process. According to a spokesman for a leading loan company, “There is at once a wealth and a dearth of information in the market for students. Often the financial aid office, while helpful, can be supplemented.” Garrard of Sallie Mae echoes that thought, saying, “If we can support financial aid professionals during the time they have contact with students, without getting in their way, then that’s a model we have to follow.” Banks and other institutions also add to the onslaught of training programs to which financial aid officers subject themselves, and help underwrite and contribute to the conferences run by NASFAA and other professional associations. And many financial aid administrators have found the simple manpower help from private lenders quite useful. Such support can be especially welcome in offices that have limited resources at community colleges and smaller schools. Peg Julius of Kirkwood Community College in Cedar Rapids, Iowa, who ultimately prefers direct lending, acknowledges the tremendous amounts of help private lenders can offer to people in her position. “Certainly the customer service aspect of FFELP was noticeably different,” she says. “They have more staff to do that. They will come to your office and do practically whatever you want them to.”

Access and Influence The fact that lenders like to help them out is the source of perhaps the greatest ethical dilemma for financial aid professionals. How much cooperation from lenders is too much? The practice of accepting gifts or favors of one kind or another is still notable. In fact, sometimes it seems like the only times financial aid offices get any kind of attention from the media are for stories about “inducements.” Perhaps the most famous example, and one still talked about in financial aid circles, is a 2003 U.S. News & World Report cover story, “Big Money on Campus,” that detailed ways in which lenders sought to woo business—everything from multimillion-dollar loans

THE END OF AUTONOMY 201 to universities to glitzy parties for financial aid administrators.19 But how big a problem are these goodies? The federal government has cracked down on inducements, so there is less overt wining and dining than there used to be. There are still plenty of examples, however, of sales and marketing reps treating financial aid officers to tickets for prime sporting events or showering them with trinkets. “It’s mostly small change—they bring in bagels,” says O’Leary. But she worries about the compounding effect of lender largesse. “I’ve heard stories of lenders providing staff, providing phone banks, providing publications and copy paper and printing supplies to schools. The law says private lenders can’t offer an inducement and in my opinion that’s an inducement.” The fear of being accused of collusion—along with the annoying persistence of the sales staffs—has led some financial aid administrators to close their doors to lenders (although they’ll let junior staff hear the sales pitch). Financial aid directors say they can keep abreast of new breakthroughs or borrower benefits by reading about new loan products and terms in trade publications such as the Greentree Gazette. “We’re all human beings; you don’t want to say no to people. They come into your office and want to get on your preferred lender list and people can get overwhelmed,” says David Rice, of the St. Louis College of Pharmacy. Nonetheless, his school stays loyal to Missouri loan companies and guaranty agencies. “We made those decisions based on them being partners in our state, not based on who bought us lunch,” he says.

Conclusion Fear of being accused of any impropriety is one of several factors that collude to keep financial aid directors, in the aggregate, conservative. One essential mission for any director, after all, is not to run afoul of the long list of regulations that guide the profession. Failing an audit, although rare, can cost an institution its ability to participate in federal loan programs that have become essential tools for students and a primary source of revenue for colleges and universities. Financial aid directors choose their preferred lenders primarily on the basis of the terms they can offer students, but they also want to avoid dealing with any fly-by-night companies that might

202 FOOTING THE TUITION BILL promise the moon but fail to deliver. “The main thing they’re trying to do is keep the college president out of trouble in terms of oversight over the money and the way the money is spent,” says Pat Smith, policy scholar in residence at the American Association of State Colleges and Universities. As with so many aspects of their job, financial aid directors have to balance competing interests in choosing their preferred lenders. It makes sense for them, from an efficiency standpoint, to have a small number of entities to deal with. But even if they have smooth working relationships with particular lenders and a sense of trust that has built over time, it behooves them to remain open to new and potentially superior offerings from competing institutions. Students, after all, are increasingly open to new lending products and do not want their choices limited out of a paternalistic sense of concern. So how much help can financial aid administrators offer students in the new environment? People in the profession contend they will be as helpful as they’ve ever been, offering solid advice to students who are faced with a bewildering array of choices and lots of fine print. But financial aid offices will not always be able to present their arguments, since lenders are increasingly circumventing them through the private loan market. And the financial aid profession has not been noted for its great flexibility. To a large extent, that is because of the many constraints under which financial aid officers must operate—the rules they have to follow to avoid running afoul of the federal government and other regulators. Such conservatism is strengthened by the fact that many members of the financial aid profession do not approve of the directions in which higher education finance is heading. Many are dubious about the benefits of private loans (if not the need). And they are nostalgic for a time when their central purpose was providing access to education. “I believe in that, that whether you get a college education shouldn’t depend on whether you can afford it or not,” says Anna Griswold, the financial aid director at Penn State. But federal and state policy changes in the loan marketplace and the recruiting desires of campus administrators are all moving in another direction. Access remains an important concern for everyone involved in higher education, particularly policymakers, but there are competing concerns as well. Financial aid offices are caught in the middle of all of these competing concerns. Navigating them will inevitably cause change in both their approach to the industry and their interactions with students.

8 Thoughts on the Industry’s Past and Present: An Insider’s Perspective Richard George

The student loan industry is at a critical juncture. One path forward will be a continuation of the current trajectory, fueled by three factors: restrictive loan limits in the federal Title IV loan programs; increased demand for, and cost of, postsecondary education; and the explosive growth of private loans to meet the mounting funding gap. The inevitable end of this path will be a gradual weakening of the traditional school-channel relationships and a shift in emphasis to direct-to-consumer marketing channels for educational loan origination. The alternative path forward lies in the recognition that the essential component of access provided by the Title IV loan programs has less to do with Congress’s history of iterative adjustment to loan rates and lender yields than with its provision of an explicit federal guarantee of principal and interest. If that recognition could be coupled to fundamental reform and subsidy cost rationalization that reallocates current Title IV loan program subsidy costs to need-based grant aid, the student loan industry could take a very different path into the future. This chapter will argue that a market-based Title IV loan program enabling reallocation of federal dollars to the original low-income access objective of the Higher Education Act (HEA) of 1965 is the path of choice. No matter which path is taken, the roles of the players will change. They will, however, change very differently, depending on which direction is ultimately followed. The thirty-five state and nonprofit, federally designated guaranty agencies (or “guarantors”) that now administer the Federal 203

204 FOOTING THE TUITION BILL Family Education Loan Program (FFELP) under agreements with the U.S. secretary of education will, in particular, face a fundamental transformation on either path; they will need to shed their current resistance to anything but incremental change or risk becoming irrelevant. Growing debt levels among student borrowers and the complexities of choice in both Title IV and private loans, as well as financial aid generally, demand rethinking and reform of repayment methodologies, as well as counseling and advocacy for borrowers. Guarantors need to understand their essential role in this effort, and Congress needs to understand and implement a new revenue model to replace the current focus on the administration of loan guarantees and postdefault collections. The new model must be attuned to outreach and access, financial literacy, delinquency avoidance, and default aversion. To ensure that guarantors are effective borrower advocates, their revenues must be tied directly to this new role. Let us begin a discussion of this future by reviewing a bit of the past, and the positioning of this insider’s viewpoint.

The Perspective The list of players in the student loan industry is long and reflects, in part, the detailed statutory and regulatory framework of the Title IV loan programs: • Lenders • Secondary markets • Bursars, registrars, and financial aid officers • Originators • Servicers • Guaranty agencies • Collection agencies • Technology providers

THOUGHTS ON THE INDUSTRY’S PAST AND PRESENT 205 • Securitization teams (issuer, bankers/underwriters, bond counsel, trustee, rating agencies, underwriter’s counsel, accountants) • U.S. Department of Education • U.S. Congress • Global investors My perspective is shaped in large part by a thirty-four-year career as a bond lawyer, public official, investment banker, consultant and student loan industry director, and executive, having at one time or another played or represented all of these roles. That career currently includes serving as chairman and chief executive officer of the Great Lakes Higher Education Corporation, a Wisconsin nonprofit, nonstock corporation and the parent company of the Great Lakes Affiliated Group (“Great Lakes”), one of the nation’s largest providers of student loan services.

A Brief Outline of Context Before reviewing important moments in the evolution of the student loan industry, it may be useful to offer briefly some context, outlined according to four key forces now driving the industry: • Concentration • Integration • Securitization • Consolidation Concentration. U.S. Department of Education data utilized in table 8-1 show that the concentration of Title IV loan volume among originators has grown significantly over the past decade; so, too, has the concentration among loan holders, consolidators, servicers, and guarantors. Department of Education data on the top FFELP loan originators also indicate a significant realignment of originating lenders: A decade ago,

206 FOOTING THE TUITION BILL TABLE 8-1 FFELP LOAN ORIGINATIONS BY TOP 100 LENDERS

Top 10 as a percent of nation Top 25 as a percent of nation Top 50 as a percent of nation Top 75 as a percent of nation Top 100 as a percent of nation

FY 92

FY 05

31.8 47.5 58.5 65.7 70.6

52.0 71.0 82.9 87.9 91.1

SOURCES: U.S. Department of Education, Financial Partners, “Top 300 Originators—FY93 and FY92,” http://www.fp.ed.gov/PORTALSWebApp/fp/pubs.jsp (accessed January 16, 2007); U.S. Department of Education, Financial Partners, “Top 100 Originators—FY05 and FY04,” www.fp.ed.gov/ PORTALSWebApp/fp/pubs.jsp (accessed January 16, 2007).

thirty-six of the top forty originating lenders were national or regional banks. By 2004–5, eighteen of the top forty were nonbank entities, including seven state agencies, five nonprofit lenders, and four for-profit, nonbank lenders (including Sallie Mae as the number one player). Integration. In the Education Department’s data on top current holders of FFELP loans for 2004 and 2005,1 two of the top three positions are held by Sallie Mae and Nelnet, companies publicly listed on the New York Stock Exchange that are leading the industry trend toward market dominance by large, functionally integrated entities offering a complete range of services, including loan origination, guaranty servicing, repayment servicing, and collections. By integrating all of the functions associated with an educational loan over its lifecycle, these entities are positioned to capture all of the revenue associated with those loans. Originally derived from governmentsponsored enterprise and state secondary-market roots—entities created by Congress and state statute to provide liquidity for the Title IV loan program by purchasing loans from originating lenders—both organizations have transformed themselves over the last several years into originating lenders and now compete directly with former customers from whom they previously purchased loans. In many instances, smaller originating lenders who

THOUGHTS ON THE INDUSTRY’S PAST AND PRESENT 207 don’t enjoy the advantages of integration or scale are forced by program economics to sell their loans to a Sallie Mae or Nelnet or enter into branding arrangements to obtain access to proprietary systems and school loan origination relationships controlled by these functionally integrated entities. Both Nelnet and Sallie Mae have also aggressively expanded into the precollege market, offering 529 college savings plans, private high school tuition payment plans, college planning, and related services intended to extend their brands and lay the groundwork early to become the postsecondary lender of choice.2 Securitization. While the role of global investors and the capital markets in the student loan space is beyond the scope of this chapter, it is important at least to touch on their transforming impact, since they play an increasingly important role in the direction of the student loan industry. The appetite of global investors for asset-backed securities (ABSs), including both federal and private student loans, and the capital markets’ ability to offer securitizations to meet that appetite have directly enabled the growth and development of nonbank players. The ability of the capital markets to securitize student loans makes the traditional bank depositary advantage (capital available from low-cost deposits by bank customers) largely irrelevant. With almost equal access to the capital markets for all major players, the cost of money has largely been neutralized as a competitive advantage. This means that new entrants into the student loan space can more readily compete. Such entrants, however, have limited access to school loan origination (“school-channel”) relationships and tend to focus initially on direct-to-consumer marketing, as discussed further below. Consolidation. The impact of securitization on student loan industry players is also evident in Education Department data showing the top consolidating lenders for 2004 and 2005.3 Four of the top ten consolidation holders (Collegiate Funding Services [CFS], College Loan Corporation [CLC], Goal Financial [GOAL], and Education Lending Group [EDLG]) began as primarily FFELP consolidation-only lenders. Their ability to grow and compete with fully integrated national players such as Sallie Mae, Nelnet, and the major national banks was enabled in part by their ability to obtain funding through securitizations.

208 FOOTING THE TUITION BILL While securitization has helped enable a new breed of consolidation lenders, the new breed’s effective exploitation of direct-to-consumer marketing was of crucial importance. Title IV nonconsolidation loans and many nonfederal private loans require a school certification as a component part of the loan origination process. The school certification—and the overall financial aid packaging process—has traditionally allowed school financial aid offices to recommend the lenders from which their students and parents borrow. It has also allowed those school aid officers to control or significantly influence the origination, guarantor, and servicing partners their lenders utilize.4 Such a counseling and processing role has led many, if not most, school aid officers to develop preferred lender lists identifying a limited set of lenders with whom the school has chosen to do business. These lists may be based on the level of benefits offered by lenders, on lenders’ willingness to use an origination platform suited to the school’s process flow and staffing capacity, on a school’s preference for a particular combination of guarantors and servicers, or all of the above. The school-channel relationships reflected in these preferred lender lists have long helped to shape market share. Title IV consolidation loans, however, don’t require any school certification and, accordingly, may be marketed directly to consumers (borrowers). This direct-to-consumer channel was exploited extremely effectively in the early years of consolidation’s explosive growth, driven in part by the historic low and declining interestrate environment of 2002–5 and the ability of borrowers to lock in fixed rates. It may be one of the most significant trends shaping the future of the student loan industry.

Private or Alternative Loans At present, the private loan segment of the student loan industry is growing significantly faster than the federal Title IV loan sector. This explosive level of private loan growth is driven by several factors. First, and perhaps most importantly, there has been a fundamental shift in the employment environment in the United States. Traditional manufacturing jobs and other semiskilled career positions are leaving the country. Higher-paid knowledge workers require some level of postsecondary education, the cost of which

THOUGHTS ON THE INDUSTRY’S PAST AND PRESENT 209 continues to escalate more rapidly than underlying inflation rates and growth rates in income.5 At the same time, the traditional sources of family and governmental funding of postsecondary education have been reduced. The resulting gap has been filled largely by borrowing and, increasingly, by private loans. This is true particularly, but by no means exclusively, at private four-year colleges and graduate and professional schools.6 The cumulative annual growth rate of private loans could result in their eclipsing federal Title IV loan volume as early as 2012. However, this projected crossover point could be influenced by a number of factors. The Higher Education Reconciliation Act of 2005 (HERA) authorization of Parent Loans for Undergraduate Students (PLUS) loans for graduate and professional students provides a new source of Title IV loans for what has been the largest segment of the private loan volume. Graduate and professional school borrowers can now borrow under PLUS up to the full cost of attendance (COA), less other aid. Whether these borrowers will elect to use this new authorization or remain private loan consumers is a wild card in the projected growth rate for private loans. PLUS loans will be at a fixed interest rate of 8.5 percent in FFELP,7 while most private loan programs are variable-rate at a tiered percentage, plus or minus to the London Interbank Offering Rate (LIBOR), a prime rate, or an alternative index rate based on individual borrower credit scores and disciplines. For any given cohort of borrowers, the comparative advantage of a fixed 8.5 percent rate or variable rate will depend on credit profile and prevailing market interest rates. PLUS loans for graduate and professional students could pose a significant competitive alternative to historic private loan growth rates, particularly if interest rates climb. Many observers believe that the impact of graduate PLUS loans will slow private loan growth rather than supplant it, and that the impact will be in the 25–40 percent range at current interest-rate levels. Other factors that will affect private loan growth include quality of customer service, and delinquency, default, and collections, as well as the related appetite of capital markets for asset-backed securitization of private loans on a stand-alone basis. A second wild card in the projected growth rates for private loans is whether the historic delinquency, default, and collections data that currently form the basis for much of the underwriting of private loans will be validated by actual portfolio performance going forward. Higher debt levels and debt-to-income ratios today may depress

210 FOOTING THE TUITION BILL performance of private loan portfolios, with resulting cost increases to borrowers and lenders that could make private loans less attractive. Finally, there are the twin wild cards of postsecondary education cost and nonPLUS loan limits in the Title IV loan programs. Unless significant structural change is embraced by, or forced upon, postsecondary education, the cost growth will continue to fuel loan demand. Technology, distance-education, legislatively mandated cost accountability, and cost transparency could all contribute to slowing the growth rates in the cost of postsecondary education, but all face enormous institutional resistance. As noted in Business Week in April 2003: Higher education is one of the few sectors of the U.S. economy that has not seriously restructured. Partly, that’s because education is essentially a social good, provided mostly by non-profit institutions in an environment in which the traditional laws of market economics have never really applied.8 Why is the growth rate of private loans important to the future of the student loan industry? Primarily because private loans lend themselves very readily to the direct-to-consumer delivery channel. While many, if not most, private loan programs today include some form of school enrollment certification, this is driven more by linkage to traditional school-channel market-share considerations than by necessity. Enrollment verification, if required, can as easily be obtained through alternatives to school certification, and the origination of private loans can and does take place completely without the involvement of school financial aid offices. The current reliance on school certification of private loans is, as noted, largely a result of continuing competition for Title IV loan market share, which today—outside of consolidation loans—is still heavily influenced by school choice as reflected in “preferred lender lists.” If private loan volumes begin to approach or eclipse Title IV loan volumes, if private loans provide higher lender returns, and if available technology, credit, and demographic data enable mass customization of a product that makes private loans more attractive to the most desired customers, the current linkage of private loan origination to traditional school channels will rapidly decrease. It is far easier for lenders with sophisticated call-center access to offer their private loan products on a direct-to-consumer basis than it is to

THOUGHTS ON THE INDUSTRY’S PAST AND PRESENT 211 field large sales staffs to call on schools continuously in support of schoolchannel relationships. This was true of the initial Union Benefit Life Insurance Company (UBLIC) PLUS calling campaign and CFS’s breakthrough consolidation sales effort. The rapid growth of private loans, if left to the current trajectory, will inevitably take the student loan industry down a new path.

An Alternative Path There is an alternative path to the current trajectory toward direct-toconsumer marketing and erosion of the control and counseling role imbedded in traditional school-channel relationships. It lies in combining the essential value of the Title IV loan programs with the innovation and differentiation the private sector can deliver. An important objective of this alternative path is to preserve the role of school financial aid offices in financial aid packaging and borrower counseling by maintaining existing schoolchannel origination as the control point for student loans. The alternative path is premised on several key bases: • A federal loan guaranty • Rationalization and redirection of federal subsidy • Market-driven price competition • Limited low-income borrowing • Expanded financial literacy training and counseling The history of the Title IV loan programs since 1965 shows a largely futile congressional quest to arrive at an appropriate borrower interest rate on the one hand and a reasonable lender yield on the other. This began as an attempt to assure sufficient lender participation to enable wide-scale loan availability. Today, the significant levels of student loan ABS issuance demonstrate widespread availability of capital to support educational loans. That liquidity ensures wide-scale loan availability and, in large part, obviates the rationale for lender subsidy, secondary-market liquidity, and other early forms of HEA support of loan availability.

212 FOOTING THE TUITION BILL Today, federally guaranteed student loans—and, to a lesser extent, private loans—are viewed as an accepted asset class in the capital markets. The federal guaranty effectively creates a homogenous asset class with only slight pricing differentiation on comparable issue composition and structure based on issuer/servicer considerations. Interest subsidies for borrowers are also largely illusory, as they must be offset by a higher borrower interest rate if a constant federal program cost equation is to be maintained. The question needs to be raised whether either lender subsidy or borrower interest subsidy is necessary. Lender subsidy in the form of special allowance payments and interest subsidies for borrowers together represent over 60 percent of the cost of the Title IV loan programs. A much more logical structure would be to retain the federal guaranty and eliminate both forms of subsidy. Default costs by contrast represent less than 10 percent of the cost. The president’s FY 2006 Budget Submission to Congress shows, on a current-cash flow basis, FFELP interest benefits and lender subsidy (special allowance) costs at 63 percent and 66 percent of total cost for FY 2004 and 2005, respectively.9 If the $6 billion-plus in interest benefits and lender subsidies estimated for FY 2006 were appropriated instead for Pell Grants, the maximum award could be raised by 50 percent, to $6,000. The “if appropriated” caveat is of critical import. Without the crosswalk of the FFELP subsidy to need-based Pell Grants, the fundamental premise of the reform is undermined. Schools have long feared that this crosswalk entails inherent political danger. This is a valid concern. The federal guaranty on a stand-alone basis would require the lender and borrower interest rates to be set by market competition. Borrowers would pay lender-determined interest rates unless Congress authorized an explicit subsidy for a particular borrower cohort. Congress could also set floor and/or ceiling rates, but this would likely be unnecessary in the context of the probable robust competition that would prevail. Lenders could capitalize in-school interest periods or require a combination of full or limited interest only, together with capitalization as part of their overall borrower-benefit/interest-rate offerings. One known benefit is that the payment of some in-school interest creates greater recognition of debt obligations— specifically, that student loans are loans and not grants—and creates a higher level of reflection on additional levels of debt as well as on a culture and habit of repayment, both of which are positive attributes. A market-based

THOUGHTS ON THE INDUSTRY’S PAST AND PRESENT 213 student loan program would also provide additional transparency on the benefits of postsecondary education. As lenders tailored their programs to specific schools, regions, and/or disciplines, significant differentiation in rates and terms would likely emerge. If income levels and employment opportunities for electrical engineers were perceived to create better-performing loans to those pursuing this discipline, then interest rates would be expected to be more attractive. Market competition could quickly offer a good deal of information on how various school types, disciplines, and related factors are viewed in real money terms. This could provide a significant additional level of guidance for students, institutions, and policymakers.10 The recently enacted HERA of 2005 may have offered a first step in the right direction.11 The creation of a new graduate PLUS loan enabling Title IV borrowing by graduate and professional students, up to their full cost of attendance less other aid, was a low-cost response to those borrowers facing increasing debt burden—a burden composed in large part of private loans. If the concept of an uncapped, unsubsidized graduate PLUS loan is a cost-effective response for this sector, why not apply the concept universally to all borrowers? If Congress did so, and also let the market determine the interest rates, a full course correction could be built off this change. Elimination of subsidies from the Title IV loan programs would save money, while shifting those savings to Pell Grants and other forms of needbased assistance would help reduce default and administrative costs. Today, there is some evidence that low-income and first-generation students are more reluctant to borrow than other demographic cohorts.12 If the level and availability of federal grant aid were increased, the access opportunities for these groups would be enhanced. This was, of course, the original objective of federal involvement—begun in 1965—in postsecondary education. Equally important, however, is the impact that reduced borrowing by low-income students could have on persistence, the major cause of default in the student loan programs. The following excerpt from Convergence is illustrative: Despite evidence that suggests that grants are better than loans at improving persistence and completion for low-income students and students of color (especially grants that are provided in the first two years of college), women, low-income students,

214 FOOTING THE TUITION BILL and minorities are more likely to borrow than are other students. Seventy-two percent of 1999–2000 dependent bachelor’s degree recipients in the lowest income quartile borrowed for their education, a higher percentage than in any of the other three income quartiles. 13 Since we know that the largest cohort of defaults arises from nonpersistence, and that these borrowers are disproportionately low-income, redirection of federal subsidies from loans to grants will also reduce default costs. Nonpersistence defaulters also tend to be the most difficult to reach— increasing collection costs for borrower-locating services, which are a highcost component—and, as a result, the most difficult to help. Deferments, forbearances, rehabilitation, and/or income-sensitive or income-contingent repayment solutions often can’t be brought to bear for this cohort of borrowers because they cannot be located. This precludes the possibility of removing adverse credit and restoring Title IV aid eligibility; and, most importantly, it decreases the likelihood of the borrowers’ returning to school to complete their credentials or degrees. The alternative path suggested may be perceived as too difficult politically. Any limitation on middle-class access to federal entitlement programs or perceived lessening of the benefits available may be too far a reach as both political parties commit to capturing middle-class voters. The alternative path can, however, be presented as an expansion of the existing Title IV programs with no change in eligibility. More importantly, it can be presented as essential to the restoration of focus on needbased aid and the underpinning of U.S. competitiveness in the emerging global economy. The current reality of differentiation in access and persistence by income levels is most disturbing. The Department of Education’s National Center for Education Statistics (NCES) reports that the 78 percent chance of the highest-achieving low-income student’s going to college is nearly identical to the 77 percent chance the lowest-achieving high-income student has. The U.S. Census Bureau’s October 2006 Current Population Survey reports that persistence rates are equally disturbing, at 34.7 percent for low-income and 86.8 percent for high-income students in the cohort of 2004 high school graduates.14

THOUGHTS ON THE INDUSTRY’S PAST AND PRESENT 215 The demographics of the United States and its student population are increasingly diverse and more heavily weighted toward lower-income students. The United States simply cannot afford to lose the maximum productivity of these populations. The society as a whole will suffer significant productivity loss on a comparative basis if the largest growth component of the population continues to lag in educational achievement levels required for the new knowledge-based economy. Allocation of educational aid on merit as opposed to need and the diversion of subsidy to the middle class may be politically expedient, but they are morally suspect and competitively unsustainable, given their negative implications for long-term productivity. While need-based aid provided through Pell Grants, Perkins loans, and Supplemental Educational Opportunity Grant (SEOG) has increased over time, aid not based on need from Unsubsidized Stafford Loans, PLUS, and tax benefits has increased more quickly. In 2003–4, 29 percent of students with Unsubsidized Stafford Loans were from families with incomes above $100,000. Even of those receiving Subsidized Stafford Loans, 56 percent were from families with incomes above $40,000.15 Aid is not being directed at, and is not reaching, the neediest students. There is little doubt that middle-income families are struggling to pay for college, but is that a sufficient reason to maintain significant access and persistence differentials for low-income students? The alternative path suggested here—redirection of federal subsidies combined with uncapped Title IV loan limits—should actually reduce the composite cost of total borrowing for the middle class. If it were possible for all loan aid needed to be borrowed at market rates, supported by an explicit federal guarantee, the total borrowing cost should be lower than a combination of Title IV loans and private loans at higher rates, where the private loans increasingly represent a larger and larger part of the whole.

A Necessary Reform A market-based reformation suggests the need for expanded financial literacy training and counseling. It is fair to assume that a market-based federal Title IV loan program will create a great deal more competitive differentiation and choice than today’s programs. In this respect, the choices facing

216 FOOTING THE TUITION BILL schools, students, and parents will look much more like those faced today on the private-loan side of the market. That level of complexity and choice compel rethinking and reform of repayment methodologies and counseling and advocacy for borrowers. And that rethinking and reform are likely necessary irrespective of whether we continue on the current path to private loan dominance or the alternative path of an expanded market-based Title IV loan program. As debt burdens grow and the complexity and consequences of available choices continue to compound, borrowers must be provided a significantly enhanced level of counseling and guidance. Traditionally, that role has been played in large part by school financial aid offices. If, however, their ability to perform it is eroded by a shift in marketing to direct-toconsumer channels, who will take it on? And even if a market-based, unsubsidized, federally guaranteed loan program were to evolve and preserve the school channel, financial aid offices would still need support to provide a higher level of assistance in the context of the market-differentiated choices to be made available. Among the current players in the student loan industry, the guaranty agencies are the most likely candidates to offer that support. They already assist and interact with school financial aid offices in a variety of ways, and they already have a direct role in assisting delinquent borrowers to avoid and resolve defaults. The 2005 HERA has also given them a specific statutory mandate to support postsecondary-access outreach and counseling.16 Great Lakes has defined that mandate as support for pursuit, persistence, and performance. This trilogy of “Ps” represents the continuum of Great Lakes’s commitment to helping borrowers and families understand how to plan to pursue postsecondary education, how to gain access to and persist in postsecondary education, and, through financial literacy, how to enhance performance in careers and contributions to communities. Importantly, HEA requires that guaranty agencies be state agencies or state-designated nonprofits. This uniquely positions them to become borrower-advocates and counselors for borrowers facing the complexities of the student loan market, and to play a key role in access outreach, financial literacy, academic preparation, and career counseling, all of which are components of that support. In many instances, they are already

THOUGHTS ON THE INDUSTRY’S PAST AND PRESENT 217 involved. Expansion of these efforts and the full realization of the borroweradvocacy role for guaranty agencies, however, require a necessary and fundamental reform. That reform comprises, in turn, a fundamental restructuring and rationalization of the current statutory compensation model for guaranty agencies. Today, guaranty agencies derive the majority of their operating revenue from postdefault collection retentions, which are derived as a percentage of total dollars collected from the defaulted loans held by a guaranty agency.17 One does not require a complex understanding of the economics of guaranty agency operations to recognize that this revenue model poses an inherent conflict to the guaranty agency’s assuming the role of “borrower-advocate.” The simple reality is that under the current statutory compensation model a “perverse incentive” exists, whereby guaranty agencies receive less compensation for preventing student loan defaults than for collecting on defaulted student loans. To illustrate, if a guarantor were substantially to expand its efforts to counsel borrowers in delinquency avoidance and default aversion, it would, if successful, “save” those loans which default for reasons other than capacity to pay.18 The result for the guaranty agency would be a corresponding reduction in its postdefault collection portfolio. In addition, the reduced portfolio composition would likely be made up of the defaulted loans that are the most difficult to collect—those that have defaulted because the borrower cannot be located in spite of diligent skip-tracing efforts, or because the borrower is not able to pay. If the postdefault collection retentions from that smaller and less collectible portfolio were to fall precipitously, a guarantor would face a very tight revenue squeeze. Its efforts to invest in sophisticated technology (such as skip-tracing, auto-dialers, voice broadcast, and scoring models) and training to avoid delinquency and avert default would be rewarded with a net increase in expense and decrease in revenue. If the guaranty agency had prevented this default with a successful default-aversion program, the current statutory compensation model provides that it would be entitled to retain a 1 percent fee (known as a “default-aversion fee”) along with a ten basis-point (.10 percent) “account maintenance fee” (the AMF). This “perverse incentive” creates a critical limitation on the potential effectiveness of guarantors. How much of a limitation is best shown by an example:

218 FOOTING THE TUITION BILL EXAMPLE OF GUARANTY AGENCY REVENUE BENEFIT ON DEFAULTED LOAN: CURRENT STATUTORY COMPENSATION MODEL Initial principal and interest (P&I) loan balance at time of default: $10,000 Defaulted borrower makes three to six low payments to qualify for consolidation of the FFELP default, and so qualifies. Guarantor adds collection costs (18.5 percent) to the default loan balance: Initial P&I balance at time of default Collection costs added New defaulted loan balance Guarantor 10% gross retention

$10,000 +$1,850 $11,850 $1,000

Guarantor pays collection agency commission, typically around 5 percent of original P&I: $500. $1,000 –$500 Guarantor net retention $500 Borrower immediately stops making payments and, 270 days later, defaults again (redefaults). P&I loan balance at time of redefault:

$12,243.00*

(*Estimate assumes a 4.5 percent interest rate, and the capitalization of $393 to prior balance of $11,850.) Guarantor adds collection costs (18.5 percent) to the redefault loan balance: P&I balance at time of redefault Collection costs added New redefaulted loan balance

$12,243 +$2,265 $14,508

Redefaulted balance has now increased 45 percent from initial default balance. Defaulted borrower pleads inability to pay or, alternatively, makes three low payments (more than $50) and is default-consolidated into FDLP in order to obtain income-contingent repayment in that program. Guarantor 10% gross retention

$1,224

Guarantor pays collection agency commission, typically around 4 percent of redefault P&I: $490

THOUGHTS ON THE INDUSTRY’S PAST AND PRESENT 219

Guarantor net retention

$1,224 –$490 $734

Summary of financial impact: • The defaulted borrower with an initial P&I balance of $10,000 now owes $14,508, an increase of 45 percent over the initial default balance. • The collection agency earned $990 to locate the defaulted borrower, set up payments, and so forth. • The guarantor “earned” $1,234 by sending the defaulted loan to a collection agency and as an administrative oversight entity, an amount that is 12 percent of the initial default balance, or 10 percent of the redefaulted balance. • The federal government, now in possession of the default-consolidated loan, shows an asset on the balance sheet worth $14,508, a net “gain” in asset value over the initial defaulted loan, even though it is likely that the asset is nonperforming. Comparatively, the private sector would have been required to write off the loan at 150 days of delinquency under Generally Accepted Accounting Principles (GAAP).

EXAMPLE OF GUARANTY AGENCY REVENUE BENEFIT ON SUCCESSFUL DEFAULT AVERSION OF LOAN: CURRENT STATUTORY COMPENSATION MODEL Guarantor successfully works with the delinquent borrower to avert default, and the loan is returned to good standing. Borrower does not default. P&I loan balance:

$10,000

Guarantor revenue benefits based on loan in good standing: Default aversion fee AMF (per year) Guarantor revenue balance

$100 +$10 $110

Summary of financial impact: •The delinquent borrower’s P&I balance of $10,000 does not increase 45 percent solely as a result of applicable collection costs.

220 FOOTING THE TUITION BILL •The guarantor earns $110 as a result of its default-aversion success. The potential net compensation loss to the guarantor is a difference of $390 if the borrower had defaulted initially, and a potential net compensation loss of an additional $624 if the borrower had defaulted a second time (redefault).

Potential compensation of $110 versus $1,234 under the current statutory compensation model simply does not provide an incentive for guaranty agencies to invest more in default-aversion efforts over default collections. Even more interesting to note is that the current Title IV regulations prohibit a guaranty agency from contracting with an outside entity to perform default aversion if that outside entity holds or services the loan or performs collection services on it.19 This prohibition eliminates any incentive an outside entity might otherwise have to encourage delinquency and default in order to obtain additional compensation for its subsequent collection activities. No similar prohibition exists for guarantors. If the policy issue of potential role conflicts is sufficient to justify regulation of outside entities, why do we allow the current statutory compensation model to create the very same conflict or “perverse incentive” for guarantors? The financial illustrations given provide some insight into how the perverse incentive works for the guaranty agency and against the basic interests of the public. The effects on the individual defaulted borrowers who are, after all, at the heart of this process also deserve to be noted. Aside from being on the receiving end of the seemingly endless racking-up of additional collection costs, borrowers find themselves caught up in a repeating cycle of default with devastating impacts: chronically low credit ratings and inability to obtain consumer credit for purchase of a home or car or other “necessities,” as well as exclusion from consideration for many types of government and private-sector employment. The cost in human terms is pretty easily seen, if not as easily quantified. Much of the negative human impact of default can be readily mitigated through use of defaulted loan rehabilitation. Thankfully, Congress, through key provisions in the 2005 HERA, is forcing guarantors to move away from consolidation and toward rehabilitation through important adjustments in the collection retention rates applicable to each. Once again, however, one must ask if this really addresses the fundamental, underlying issue—

THOUGHTS ON THE INDUSTRY’S PAST AND PRESENT 221 guarantors being paid more for collecting on defaults than for preventing them from occurring in the first place. The “perverse incentive” itself could be eliminated in many different ways, such as changing collection retentions to reduce the default-collection incentive, or requiring rehabilitation of defaulted loans prior to consolidation. However, any of these changes merely tinker with the existing compensation structure, addressing only a part of the problem—and that inadequately—without eliminating the perverse incentive altogether. More is required. If guaranty agencies are to become “borrower-advocates” and make the requisite investments supportive of that role, their commitment must be compensated by revenue streams directly connected to those efforts. School and student associations need to recognize the overall added value that can be brought to bear through neutral and experienced “borrower-advocates.” They need to work with the guarantors to convince Congress that this role is critical and must be compensated directly, in the interests of all parties. Models already exist, such as those established by guarantors participating in the Voluntary Flexible Agreements (VFAs) authorized by the HEA.20 These VFAs reflect some elements of the necessary structural reform. Essentially, they reflect the basic requirement to tie the guaranty agency revenues directly to outreach and counseling, delinquency avoidance, default aversion, and rehabilitation. Nothing in this reformation requires more money, only more rational spending. One additional issue must be considered in the context of guaranty agency restructuring to a “borrower-advocacy” role: conflict of interest. Only nine of the thirty-five federally designated guaranty agencies are not affiliated with a lender or secondary market. The borrower-advocacy role requires strict neutrality if guarantors are to be perceived by schools and students as offering unbiased advice on the complex choices that will increasingly be faced in either a direct-to-consumer environment or a restructured, market-rate Title IV loan program environment. We need to ask how guarantors affiliated with lenders can play this honest-broker role.

222 FOOTING THE TUITION BILL Conclusion A final thought on the student loan industry: Inertia is a powerful and present force. Change invariably takes longer in the student loan industry than in many other contexts. The multiplicity of parties, the regulatory framework, the interplay of politics and policy, and the substantial role of federal and state government all work against rapid or fundamental change. Change is, however, coming, and the industry is at a critical juncture. Some will argue that the growth of private loans and the direct-to-consumer channel will bring market competition, product differentiation, and all of the benefits of competition that have evolved in credit card and other consumer lending. Educational loans, however, are unlike any other consumer loan. There is no tangible asset similar to an automobile, a home, or an appliance resulting from the borrowing. Educational loans represent an investment in self that is only realizable if the pursuit, persistence, and performance trilogy is successfully achieved. Educational loans should not be allowed to be uncoupled from the school channel21 and the availability of enhanced “borrower-advocacy” to support the success of the trilogy. There are two paths before us, but only one should be followed.

9 Projections for the Student Loan Industry William D. Hansen

America’s higher education system has been cited as a leader among nations and is traditionally referred to as the “best in the world.” A fundamental component of student success and institutional recognition on the global stage has been the commitment of the United States government to promoting access, choice, and opportunity through the federal student financial aid programs. In recent years, however, the increasing cost of higher education, coupled with the inability of federal and state governments to sustain parallel increases in levels of funding for student financial aid, has raised alarm among families, institutions, and policymakers. These disturbing trends affect most students, but the greatest harm is done to academically qualified individuals from low- and middle-income families. To ensure that the dream of a higher education is available to all who desire it, and that the systems in place function efficiently, it is critical that our nation embrace a federal financial aid policy that prevents students from low-income families from taking on excessive education debt; wholly examines the federal subsidy and how it is distributed; provides an avenue for the private market to supplement federal support for middle- and upper-income families; and prioritizes family preparedness and education savings.

Federal Financial Aid Overview: Grants and Loans After twelve months of deliberations, discussions and debate, the conclusions of the secretary of education’s Commission on the Future of Higher Education mirror what higher education leaders and public policymakers have been 223

224 FOOTING THE TUITION BILL FIGURE 9-1 ESTIMATED STUDENT AID BY SOURCE, ACADEMIC YEAR 2004–5 (BILLIONS OF DOLLARS) AY 2004–5 Total Higher Education Spending Exceeded $300B Total aid was $143B, including $76B in loans

Private Employer Grants ($8.4) 6%

Federal Loans ($61.3) 43%

Educational Tax Benefits ($8.0) 6% Other Federal Programs ($4.5) 3% Federal Campus State Based ($3.2) Grants ($6.3) 2% 4%

Institutional Grants ($24.1) 17%

Federal Pell Grants ($13.1) 9%

Non-Federal Loans ($13.8) 10%

SOURCE: Sandy Baum and Kathleen Payea, Trends in Student Aid: 2005, College Board, 2005, 6, www.collegeboard.com/prod_downloads/press/cost05/trends_aid_05.pdf (February 2, 2007).

discussing for many years: inadequate information and rising costs combined with a confusing financial aid system greatly affect Americans’ pursuit of higher education.1 Where once grants, scholarships, and family savings paid most college bills, student loans are now the largest source of student financial aid. In addition, 529 savings plans are a welcome addition to the student aid menu, but are years away from having a meaningful impact. As figure 9-1 indicates, spending on loans comprised 43 percent of the total federal spending for higher education during academic year 2004–5. Students and their families employ a variety of financing mechanisms to pay for their higher education expenses, including family contributions, federal grants, government-backed loans, state assistance, and institutional aid. The impact of increasing college costs, however, has not been met with enough aid from all of these sources to fully finance higher education for the nation’s most needy students. The federal Pell Grant Program, which is

PROJECTIONS FOR THE STUDENT LOAN INDUSTRY 225 intended to function as the foundation upon which all other need-based aid to undergraduates is built, is declining in purchasing power as both costs and the enrollment of low-income students in postsecondary education rise. In academic year 2004–5, the appropriated maximum grant of $4,050 covered 64 percent of the average tuition, fees, and room and board expenses at public two-year institutions, 35 percent at public four-year institutions, and 15 percent at private four-year institutions.2 With the purchasing power of the Pell Grant having peaked relative to these charges in the 1970s, and with borrowing having skyrocketed in recent years, the resulting imbalance between grants and loans has imposed the most dramatic burden on students from low-income families. As a recent paper by the Educational Policy Institute asserts, nonrepayable grant aid is more effective than loans in getting these students to enroll in college and complete their degrees.3 To address key issues of access to higher education, then, it is critical to understand the fundamentals of the student loan programs. Currently, the largest program authorized by the Higher Education Act (HEA) is the Federal Family Education Loan Program (FFELP), which has made higher education possible for over 50 million students.4 Upon its passage in 1965, the HEA authorized federal financing to enable academic institutions to assist in solving community problems of public health, poverty, and housing by means of research, extension, or continuing education.5 By 1972, however, the HEA was providing federally funded national teaching fellowships, lowinterest loans, and grants to students, giving thousands the means necessary to pursue higher education.6 Originally, FFELP was based on the model of several preexisting state student loan programs. The federal legislation originally encouraged all states to establish student loan programs, and the federal program was originally projected to serve as a “standby.” However, state programs were eclipsed by federal activity. Today state-sponsored student loan programs constitute less than 2 percent of the federal programs.7 Today, through FFELP, loan capital is provided by private lenders, and loans are made to students based on eligibility criteria, most often without regard to creditworthiness. Loans are guaranteed against default by the federal government through guaranty agencies, which protect lenders against a percentage loss through borrower default, death, permanent disability, or, in limited instances, bankruptcy. Guaranty agencies also provide

226 FOOTING THE TUITION BILL default-aversion assistance, pay default claims, attempt to collect defaulted loans, and provide support services to lenders and schools. In 1993, a second federal student loan program, the William D. Ford Federal Direct Loan Program (FDLP), was created. In the FDLP, the federal government borrows money to supply loan capital to institutions of higher education, assumes all loan servicing costs and risks, and bears the full cost of student defaults. Students who use federal loans to finance their educations traditionally have a FFELP or FDLP loan, based on the program in which their college or university participates. Since its passage four decades ago, the HEA has been reauthorized and amended several times. The last fifteen to twenty years in particular have seen significant changes and growth in the loan programs. Congress has responded to the shifting student population, most notably with the creation of unsubsidized loans, slight increases in loan limits, and improved eligibility criteria for financial aid.8 Additionally, an unprecedented expansion of the loan consolidation program has allowed millions of borrowers to lock in historically low fixed-interest rates, while education tax credits and tuition and fee deductions have provided additional savings for students. In addition to actual reform and change having been imposed on the student loan programs through legislation and regulatory initiatives, a great deal of thought and analysis has been given to alternative models of operation and function of the programs.

Alternative Market Mechanisms In 2001, the Department of Education and the U.S. Government Accountability Office (GAO) jointly submitted a congressionally mandated study to Congress regarding alternative market mechanisms for the student loan programs.9 The report presented five different models, which used a market process either to determine the lender yield or to provide information to set the yield. The “Market Mechanism Study,” as it became known, received limited support from the loan industry and policymakers as a whole. Among other criticisms and concerns, the study specified that implementation of the models may have budgetary problems due to the way federal credit programs, such as the student loan program, are treated by the Credit Reform Act of 1990.10

PROJECTIONS FOR THE STUDENT LOAN INDUSTRY 227 Table 9-1 on the following pages offers a simple comparison of the five models presented, which included the “adjustments to the current system” model; the loan origination rights auction model; the loan sale model; the federal funding model; and the market-set rate model.11 These different models call for careful consideration, with a close eye toward how radical changes to the student loan program would affect borrowers, schools, and taxpayers. For example, a change as subtle as the service levels provided to borrowers and schools could directly affect defaults. Any erosion in service quality means less communication with borrowers and, thus, increased chance of repayment difficulty, including default. These models could also significantly increase the role of the federal government in administering, managing, and overseeing the loan program. This should be avoided, as it would, at a minimum, decrease competition among private lenders. Such competition, driven by an adequate rate of return, has lowered the cost of student loans for borrowers, improved service to both students and institutions of higher education, and led to the investment of millions of dollars in technology to support state-of-the-art loan-processing systems. In short, competition is an essential ingredient in the student loan program that results in benefits to borrowers, colleges, and universities, and to taxpayers through increased efficiencies and reduced defaults. Although the “Market Mechanism Study” was not warmly received, its release prodded higher education leaders and policymakers, in concert with the student loan industry, to evaluate the operations of the current programs. Additionally, each reauthorization of the HEA has amended or expanded the original student loan programs. Generally, there has been a noticeable shift in the focus of federal student aid programs over the last four decades, as evidenced by the declining purchasing power of the Pell Grant and the resulting increase in students who use loans to finance their education. According to the College Board, In the 1970s and the 1980s most aid programs were designed to increase access to college for students who would otherwise be unable to afford to enroll. In recent years, student aid programs have been focused increasingly on affecting students’ choice of institutions and on reducing the financial strain on middle-income families.12

228 FOOTING THE TUITION BILL TABLE 9-1 GENERAL DIFFERENCES BETWEEN THE FIVE MODELS13 Market Mechanism Model Question to differentiate the models

Adjustments to the current system

Loan origination rights auction

How does the model work?

The Congress or its designee would use market information to set lender yield

Lenders would bid for the right to make (1) a certain volume of FFELP loans or (2) loans at specific schools

What rates or costs does the market determine?

Rates or costs are determined only indirectly, based on market information

Either version above could determine (1) the lender’s yield or (2) lender’s cost to receive a given yield

Who originates loans?

Private lenders

Private lenders

Are private lenders restricted in how much, or at which schools, they originate?

No

Yes, in some cases

Is the borrower’s rate or ability to choose the lender changed?

No

Yes, for lender choice

How does the role of schools change?

No change

Schools may lose choice of lenders

SOURCE: U.S. Department of Education and U.S. General Accounting Office, Alternative Market Mechanisms for the Student Loan Program, December 18, 2001, www.gao.gov/new.items/d0284sp.pdf (accessed February 23, 2007).

From 1992–93 to 2003–4, the average proportion of federal student aid received by low-income undergraduate students in the form of loans decreased 4 percent (from 38 percent to 34 percent), while that received by high-income undergraduates in the form of loans increased 4 percent (from 88 percent to 92 percent).14 Additionally, the funding (in constant dollars)

PROJECTIONS FOR THE STUDENT LOAN INDUSTRY 229

Market Mechanism Model Loan sale

Federal funding

Market-set rate

Lenders would bid to purchase loans after the government or some designated entity originated the loans

Lenders would be allowed to borrow funds from the government to make FFELP loans

Lenders and borrowers, or schools on behalf of the borrowers, would negotiate interest rates

Lender’s cost to acquire the loan and ensure a given yield

Lender’s funding cost

Lender’s yield and borrower’s interest rate

Federal government, through contractor or other entity

Private lenders

Private lenders

Not relevant

No

Unclear

Yes, for lender choice

No

Yes, for both rates and choice of lender

Schools may serve as the originator of the loan

No change

Schools would play a stronger role in determining which lenders to use

used by students to finance their higher education increased by 120 percent in the period between 1994–95 and 2004–5.15 This statistic takes into account grants, federal work-study, loans, and tax benefits, in addition to state, institutional, and private grants. That same period saw a 96 percent increase in the amount of grant funds students received and a 130 percent increase in the amount of loans students borrowed.16 Federal loans, including Stafford, Perkins, and Parent Loans for Undergraduate Students (PLUS)

230 FOOTING THE TUITION BILL made up 47 percent of all student aid in 2004–5.17 Yet, these increases have still not kept up with annual increases in college costs!

Impact of the Deficit Reduction Act These shifts will continue to be exacerbated by recent amendments to the HEA, made through the Deficit Reduction Act (DRA) of 2005.18 This new law implemented dramatic modifications to the federal student loan programs, resulting in a reduction of roughly $12 billion in spending for the FFELP and direct lending programs. Major changes brought about by the DRA affected student aid financing, the financing mechanisms within the student loan marketplace, and the affordability of federal loans for students. Notable among the DRA changes were the following. The act • increased loan limits for first-year, second-year, and graduate students; • allowed graduate students to participate in the PLUS Program; • reduced origination fees; • eliminated the 9.5 percent minimum rate of return; • placed a moratorium on new “School as Lender” arrangements; • increased teacher-loan forgiveness; and • authorized two new grant programs for undergraduate students. Many of the DRA amendments to the student loan provisions of the HEA greatly weakened the stability of both programs. Further, other recent congressional action will have a major effect on competition in the industry in coming years. Competition by lenders in FFELP has benefited students by creating various borrower benefits, including reductions in interest rates and origination fees and flexible repayment options. While these benefits will continue to exist in some form, the capacity at which every lending partner will be able to offer them at pre-DRA levels will diminish. This shift, caused by the dramatic cut to the student loan budget, will inevitably

PROJECTIONS FOR THE STUDENT LOAN INDUSTRY 231 fuel the competition among private lenders to offer other viable loan products to students and families. In addition to the cuts made to the federal student loan programs, the increase in loan limits, which is portrayed as a benefit to students, falls short of providing the resources necessary to help low- and middle-income students afford postsecondary educations. Loan limits in the Stafford Program, both at the undergraduate and graduate levels, have not increased significantly in over a decade. While total loan volume has grown from $26.0 billion in 1994–95 to $62.6 billion in 2004–5,19 federal budget constraints and the rising number of eligible borrowers have kept average loan limits from going up more than slightly. For example, loan limits for third- and fourth-year students have remained at their statutorily set level of $5,500 since 1992. As discussed, as part of the new provisions implemented by the DRA, loan limits for first- and second-year students saw minimal increases. Currently, first-year students are able to borrow up to $3,500, up from $2,625, and second-year students are able to borrow up to $4,500, up from $3,500. Even these minor increases do not provide most borrowers with enough resources to pay for the increasing cost of a college education. Figure 9-2 demonstrates the dramatic difference between average tuition, fee, and room and board expenses at both public and private four-year institutions and the dependent first-year loan limit of $3,500. Critical to this debate is the fact that the aggregate borrowing limit, or the ceiling for borrowing, for dependent undergraduate students has remained constant at $23,000. Although the resulting policy to raise loan limits and not increase the aggregate was based upon federal budget constraints, as well as some complex public policy decisions which weighed increased borrowing in the federal program against the growing debt burden of college students, many have been left seeking additional financial assistance.

New Policies and Needed Reform When we place the current scenario for financial aid against changing trends such as expanded public-private partnerships, shifting student demographics, increasing college pricing and costs, and the realities of the alternative loan market, it becomes apparent that a drive for new policies

232 FOOTING THE TUITION BILL FIGURE 9-2 AVERAGE TUITION, FEE, AND ROOM AND BOARD EXPENSE VERSUS DEPENDENT FIRST-YEAR FEDERAL LOAN LIMIT $40,000 Average tuition, fees, room and board at private four-year institutions

$35,000

$30,384

$30,000 $25,000

Average tuition, fees, room and board at public four-year institutions

$20,000

$13,500

$15,000 $10,000

Federal loan limit for dependent first-year student

$5,000

$3,500

E

10 E 20

07 20

19

77

$0

SOURCe: Sandy Baum and Kathleen Payea, Trends in College Pricing: 2006, College Board, 2006, 11, www.collegeboard.com/prod_downloads/press/cost06/trends_college_pricing_06.pdf (accessed February 2, 2007).

and reform is imperative. These will be guided, first, by the need to revisit the evolving nature of the public-private partnership. A growing trend has been for more private entities to become partners with either the federal or state governments. This has resulted in a changing dynamic for public and private entities of all types, while having a great impact on the education marketplace. When, in the 1960s and early 1970s, the government entered the student loan business, the concept of a public-private partnership in education finance was formed, as the federal government became the guarantor for loans made by private lenders. This partnership has grown over the years to become a multibillion-dollar industry that supports the pursuit of higher education for millions of students. It will continue to evolve with the explosion of the alternative loan market. Due to increased college costs and stagnant federal support in the loan programs, alternative loans, provided by private lenders but without the federal guaranty, are becoming more of a necessity for middle-income families to supplement the federal

PROJECTIONS FOR THE STUDENT LOAN INDUSTRY 233 role of providing access to postsecondary education. The culture of competition, which has helped to make FFELP loans more attractive to borrowers, has played an integral role in the success of the alternative loan market and has kept the cost of taking out alternative loans relatively affordable. Lenders, whether participants in FFELP or in the alternative loan marketplace, are forced by competition to refine their business models and products constantly to attract borrowers and provide them with superior service and loan products. The changing demographic trends among borrowers are a second consideration for policymakers. Policymakers and higher education leaders clearly need to consider new ways for student loans to reach a population more diverse in age, race, and ethnicity. Between 1990 and 2004, the enrollment of students under the age of twenty-five in postsecondary education increased by 31 percent. However, enrollment of students ages twenty-five years and over rose by 17 percent during the same period. The National Center for Education Statistics (NCES) is projecting a further increase of 11 percent in enrollments of persons under twenty-five and 15 percent among those twenty-five and over between 2004 and 2014.20 This is significant because borrowers from older age groups tend to have different attendance patterns, enrolling in courses part-time or even less than half-time, which significantly affects the availability of federal student aid resources. Older students also tend to have children and family responsibilities, employment considerations, and other financial obligations that may influence their eligibility for federal financial aid assistance. NCES has reported that the proportion of American college students who are minorities has also been increasing. In 1976, some 15 percent of students were minorities, compared with 30 percent in 2004. Much of the change has been attributed to the rising numbers of Hispanics and Asian Americans or Pacific Islanders pursuing higher education, which rose in proportion from 4 percent to 10 percent and from 1 percent to 6 percent, respectively. The proportion of black students fluctuated during most of the early part of the period before rising slightly to 13 percent in 2004 from 9 percent in 1976.21 Many of these borrowers are from low- or middleincome families with high financial need, are first-generation college students who know little about the complexities of the federal financial aid system, or are completely averse to borrowing.

234 FOOTING THE TUITION BILL FIGURE 9-3 GROWTH IN COLLEGE COSTS COMPARED TO HOUSEHOLD INCOME, 1994–2005 59%

60

50 42% 40

30

20

10 2% 0 Growth in median household income

Growth in cost to attend a four-year public college

Growth in cost to attend a four-year private college

SOURCE: Sandy Baum and Kathleen Payea, Trends in Student Aid: 2005, College Board, 2005, 23, www. ecs.org/html/offsite.asp?document=http%3A%2F%2Fwww%2Ecollegeboard%2Ecom%2Fprod% 5Fdownloads%2Fpress%2Fcost05%2Ftrends%5Faid%5F05%2Epdf+ (accessed December 27, 2006).

A third and critical consideration for reform of the federal student loan programs is the cost of higher education. In many cases, high financial need is directly a function of the high price of attending an institution of higher education rather than a student’s low ability to pay, since the neediest students usually have the greatest access to federal, state, and institutional assistance. According to the College Board, tuition and fees at private four-year colleges have risen over the past decade at an average rate of 5.7 percent (3.2 percent per year after inflation); at public four-year colleges by 6.9 percent (4.4 percent per year after inflation); and at public two-year colleges and universities by 5.1 percent (2.7 percent per year after inflation).22 While federal loan limits have been flat in recent years, college costs have risen dramatically, with annual increases at double the rate of inflation for the past twenty years. Figure 9-3 demonstrates the growth in college costs at public and private fouryear institutions compared to household income over the last decade.

PROJECTIONS FOR THE STUDENT LOAN INDUSTRY 235 Higher education leaders argue that costs have soared in recent years due to extraordinary increases in health-care costs, increasing retirement benefits for aging faculty and staff, and necessary technology adaptations and expansions. It is also argued that a substantial and continuing decline in support from states and other public funding sources has been a significant factor. However, in many instances, the rising costs are associated with the higher education industry’s struggle to generate a more efficient means of education delivery. The decline in public support has led to what some call the “privatization of higher education” in the United States.23 While the degree to which “privatization” is actually occurring at the nation’s public colleges and universities is in dispute, the trend is startling at some institutions. For example, the University of Virginia now derives only 8 percent of its funding from public sources, the University of Michigan only 18 percent, and the University of Wisconsin only 25 percent.24 Loss of public funding is not easily returned through private fundraising or endowment funds. A large part of the difference is made up through tuition increases, which fuel the demand for student loans, most notably among middle-class families who traditionally do not qualify for federal or state grant assistance. As state support diminishes, institutional fees and tuition are raised, and the demand for student loans increases commensurately. As a member of the National Commission on the Cost of Higher Education, I was tasked to study, among other things, the relationship between federal grants, loans, and institutional aid and rising college costs. The evidence presented at that time in our report supports the notion that the availability of federal grants and loans has not directly contributed to the rising cost in tuition, although there was some evidence of the relationship between institutional aid and rising prices. Institutional aid is derived from tuition. Had institutions not been working to increase aid availability, perhaps tuition would not have risen 178 percent from 1987 to 1996.25 The report also found that the shift in the student population away from traditional, full-time students to more nontraditional, part-time students with different needs may have contributed to increased institutional costs, leading to greater numbers seeking financial aid, including federal grants, loans, and assistance through institutional aid programs. Greater

236 FOOTING THE TUITION BILL demand on the federal financial aid programs has increased the cost of these programs to the taxpayer and, in turn, resulted in stagnant funding or trivial increases in program expenditures. Some have sought to explain increasing college costs through expanded administrative need at the institutional level. However, the report found that while in the 1980s the need to employ a greater number of administrators may have driven up costs, from 1987 until 1994 those expenditures either fell or remained the same. Others may argue that faculty labor and tenure issues have led to increased institutional costs. However, the report found that institutions have required faculty to spend more hours in the classroom and hired more nontenured and part-time faculty as means to control costs.26 At the federal and state level, institutions of higher education find themselves responding to and implementing a growing number of regulatory requirements and mandates, at significant cost to campuses. The rising cost of accreditation reviews has further contributed to increased institutional costs, while high demands on and expectations of potential students, current students, faculty, and administrators have affected campuses working to maintain appearances and entice potential students and staff. The commission found that many institutions of higher education have been unwilling to review their own practices and policies to understand the effect of all these (and other) issues on their financial structures. The commission did not, however, make specific recommendations to congressional and administration leadership concerning the loan program as a way to control college costs, though it did recommend that Congress continue the existing student aid programs and simplify and improve the financial aid system.27 The congressional committees responsible for the current reauthorization of the HEA and for implementing recommendations from the secretary of education’s Commission on the Future of Higher Education have considered and provided concrete suggestions for simplifying the financial aid process. In addition, the Advisory Committee on Student Financial Assistance, an independent source of advice and counsel to the secretary and Congress on student aid policy, has commenced a one-year study of a family’s ability to pay for a college education.

PROJECTIONS FOR THE STUDENT LOAN INDUSTRY 237 Growth in Alternative Student Loans Although the three components of public-private partnerships, demographic trends, and increasing college costs have a dramatic impact on the opportunity for reform in the federal student loan program, the fastestgrowing segment of the student loan market is the market for alternative student loans. The minimal increase in loan limits and the reduction in origination fees for borrowers in the FFELP and FDLP programs are not enough to meet the increasing cost of higher education. Private student loans are often referred to as “alternative loans” because they provide students and families with an alternative to the federally guaranteed loans provided through these programs and are funded by private lenders, with no government guarantee and no public sources of capital.28 The effect of increased college costs and the inability of the aid programs to keep up with the rising price of higher education has driven our nation toward a policy that will necessitate financial aid options that include alternative student loans. In recent years, the alternative loan market has responded to the gap between rising costs and lack of student aid program growth by providing the difference that remains after students and their families have tapped the resources at the federal, state, institutional, and even family savings levels. Whatever the reasons for their “unmet financial need,” a significant number of student borrowers are relying on this form of assistance to finance their higher educations. It is important to note that high proportions of alternative loan borrowers obtain federal student loans and, in many cases, borrow up to the federal limits.29 In 1999–2000, 77 percent of professional students, half of undergraduates, and 32 percent of graduate students who took out alternative loans also borrowed the maximum total Stafford loan amount for which they were eligible.30 In comparison, among those who did not take out alternative loans, 40 percent of professional students, 13 percent of undergraduates, and 4 percent of graduate students were at the Stafford total loan limits.31 Many borrowers are faced with no option but an alternative loan when their substantial tuition burden is only minimally covered by the current Stafford limits and limited amounts of grant and institutional aid. According to the College Board, alternative loans grew from 6 percent of total student loans in 1994–95 to 18 percent in 2004–5. The loan volume

238 FOOTING THE TUITION BILL FIGURE 9-4 GROWTH IN STUDENT LOAN MARKET: ALTERNATIVE LOANS ARE THE FASTEST GROWING SEGMENT OF THE MARKET 80

CAGR*

Total Loan Volume ($B)

70

Private loans

28%

FFELP

8%

Federal direct

3%

60 50 40 30 20 10

04 –5 20

03 –4 20

02 –3 20

01 –2 20

00 –1

00 99 –

20

99 19

98 –

19

97 –9 8 19

96 –9 7 19

19

95 –

96

0

Academic Year * Compounded annual growth rate

SOURCE: Sandy Baum and Kathleen Payea, Trends in Student Aid: 2005, College Board, 2005, 4, www .ecs.org/html/offsite.asp?document=http%3A%2F%2Fwww%2Ecollegeboard%2Ecom%2Fprod%5F downloads%2Fpress%2Fcost05%2Ftrends%5Faid%5F05%2Epdf+ (accessed December 27, 2006).

grew from $13.7 billion in 2004–5 to $17.3 billion in 2005–6—a 26 percent increase in one year.32 As figure 9-4 shows, the growth in alternative student loans has far outpaced that in the FFELP or FDLP programs, and the projections shown in figure 9-5 indicate this trend will continue. It is fueled by a number of factors, but most notably by substantial college tuition increases that cannot be sustained with federal resources. The use of alternative student loans as part of a student’s financial aid package is not new. During the mid-1980s, a proposal for the Massachusetts Higher Education Assistance Corporation noted a growing gap between available government loan assistance and students’ actual financial need. The proposal included a 5 percent upfront guaranty fee to be paid to lenders in the case of default, with the assumption that the loans would only be used by borrowers from upper-income families with high creditworthiness

PROJECTIONS FOR THE STUDENT LOAN INDUSTRY 239 FIGURE 9-5 CURRENT GROWTH RATES PROJECT A $25–30 BILLION ALTERNATIVE STUDENT LOAN MARKET BY 2008 35,000

Dollars (in millions)

30,000 25,000 College Board (CB) 20,000

College Board ’99–’05 CAGR

15,000

Morgan Stanley ’05–’10 CAGR

10,000 Compounded annual growth rate

5,000 0 Act 2001

Act 2002

Act 2003

Act 2004

Act 2005

Fcst 2006

Fcst 2007

Fcst 2008

SOURCE: First Marblehead Corporation, “Board of Director’s Presentation on Market Strategies,” January 24, 2006. (This document was created and presented internally, from outside sources.)

at high-cost private institutions, such as the Ivy League schools.33 However, the proposal evolved into the basis of the alternative loan program, which has served borrowers from all income ranges, in all sectors of higher education. Judging by the success of many participants in the alternative loan marketplace, it is clear that in order for an alternative student loan program to thrive and appropriately meet the financial needs of borrowers, certain conditions should be present, including the following:34 • Societal norms that accept student debt • Available data to make credit-underwriting decisions • An active consumer loan market with a history of performing consumer loans • Laws protecting creditors in the event of default or bankruptcy • Average loan amounts large enough to justify servicing costs

240 FOOTING THE TUITION BILL • A high postgraduation employment rate • Programs to guarantee lenders in the event of default • An existing processing infrastructure • Private capital markets that can be leveraged to provide liquidity for loan-program sponsors for securitization.

Considerations for the Future The current fiscal challenges at the national level prohibit a traditional approach to infusing additional capital into the student financial aid programs, and it is unlikely that students will witness a great reduction in college and university tuition. Clearly, new approaches are needed. The following four considerations and proposals are offered based on the current state of rising college costs, stagnant federal and state investment, and increasing college enrollment projections. These alternatives for the future of student financial aid propose to utilize current resources to achieve efficiency and produce extraordinary results: expanded postsecondary access, choice, and opportunity to those who are academically qualified to pursue higher education. In the fall of 2006, the secretary of education’s Commission on the Future of Higher Education issued recommendations on how the U.S. higher education system can be improved. One proposed to replace the maze of financial aid programs, rules, and regulations with a system more in line with student needs and national priorities.35 Specifically, the commission called for a significant increase in need-based financial aid and a restructuring of the current federal financial aid system, to consolidate programs and streamline processes.36 To ensure that federal financial aid policy addresses those students who are most in need, the first proposal I offer sets the foundation for federal student aid by redistributing valuable federal resources from middleclass tax benefits to grant aid that serves low-income students. The next two proposals build upon the commitment to utilize available federal resources and programs to achieve maximum efficiency for taxpayer funds, and to ensure federal programs are managed in a way that promotes access, choice, and opportunity in higher education. With over seventeen separate federal programs providing direct financial aid or tax benefits to

PROJECTIONS FOR THE STUDENT LOAN INDUSTRY 241 individuals seeking higher education, it is clear our federal financial aid system can become more efficient.37 If current federal resources are managed more efficiently and effectively, and if subsidies are better targeted as described below, the demand for alternative loans should decline for lower- and some middle-income borrowers because they will be recipients of the majority of federal higher education spending. As a result, the alternative loan market will answer the demand for education financing options for some middle-income, but mostly for higher-income, borrowers and allow federal taxpayer dollars to be directed toward those students with the greatest need.38 The fourth proposal challenges the philanthropic community to make a serious commitment to access, choice, and opportunity in higher education. Proposal #1: Repeal Tax Benefits and Increase Support for Pell Grants. The HOPE and Lifetime Learning tax credits were created by the Taxpayer Relief Act of 1997, which also included tax benefits, such as a deduction for interest paid on student loans, penalty-free withdrawal from IRAs for education expenses, expansion of education IRAs, extension of the purposes for which state prepaid tuition plans that receive favorable tax treatment can be used, exclusion from income of employer-provided educational assistance, and exclusion from income of the loan cancellation provided by nonprofit organizations for community service.39 These programs were created at a time when need-based programs were becoming more focused on lower-income students, and Congress responded by providing some relief to middle-income students and families. Their advent occurred before that of the 529 savings plan incentives, which hold real benefit for middle-income families. They also predated the broad availability of alternative loan programs, where experience and competition now provide these families with effective financing options. The U.S. Department of Education estimated that in 2006, students and families would save nearly $3.2 billion under the HOPE tax credit, $2.1 billion under the Lifetime Learning tax credit, $1.8 billion under an abovethe-line deduction of up to $4,000 annually in higher education expenses, and $810 million in above-the-line deductions for interest paid on postsecondary student loans.40 In large part, these benefits are reductions of taxes owed and can only be applied for a certain number of years and/or

242 FOOTING THE TUITION BILL dependents or students. Therefore, these programs need to be reconsidered and a decision made as to whether these federal resources are being targeted to those students and families most in need. The HOPE tax credit is worth up to $1,500 for each eligible dependent and is available for the first two years of postsecondary education. The amount of the credit is dependent-based and contingent on income, qualified tuition and fees, and other scholarships and aid. The Lifetime Learning tax credit is worth up to $2,000 per tax year and is available for the duration of the student’s postsecondary education career. The amount of the credit is family-based and depends on income, qualified tuition and fees, and other scholarships and aid. A taxpayer cannot claim both the HOPE and Lifetime Learning tax credits for the same student. Unfortunately, the current tax benefits are not making higher education more affordable for the most disadvantaged students. The Institute for Higher Education Policy argues that, “put most simply, low-income students and students from low-income families do not qualify for the HOPE scholarship. Therefore, it makes no contribution toward paying their higher education expenses.”41 In a recent report issued by NCES, it is estimated that nearly one-half of all undergraduates or their parents had their taxes reduced by an average of $600 by claiming HOPE and Lifetime Learning tax credits or tuition deductions.42 Middle-income students and families were the most likely to receive these benefits; however, among the families of upper-middle-income students, more than two-thirds (69 percent) received an average reduction in federal taxes of $1,100.43 As figure 9-6 from the College Board indicates, a majority of the tax benefits went to students from households that earn more than $50,000. In an effort to make this money available and pass the true savings on to those students in need, the nearly $8 billion in annual savings derived from repealing the current tax benefits should be redirected to Pell Grants. Increasing Pell Grant resources will allow for greater access to higher education for those disadvantaged students already eligible for Pell Grants, while limiting their need to borrow. Larger Pell Grant awards will allow low-income students access to the cash upfront to handle immediate needs on campus, rather than waiting for possible savings seen in tax returns. Using basic math, it is estimated that every billion dollars invested in the Pell Grant Program results in about a $300 increase in the Pell Grant

PROJECTIONS FOR THE STUDENT LOAN INDUSTRY 243 FIGURE 9-6 FEDERAL EDUCATION TAX CREDITS AND TUITION DEDUCTIONS Federal education tax credits: Distribution of savings by adjusted gross income level, 2003

Federal tuition and fee deduction: Distribution of savings by adjusted gross income level, 2003

AGI