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Student Loan Loophole Cost Millions
IG Urges Education Dept. to Recoup Sums From Lender

By Brian Faler
Special to The Washington Post
Tuesday, June 14, 2005

It is an obscure government report that could have big consequences for taxpayers.

The Education Department's inspector general said late last month that the agency, which subsidizes student loan lenders, overpaid one lender in New Mexico by as much as $36 million.

It said the lender, a nonprofit called the New Mexico Educational Assistance Foundation, took advantage of a loophole in federal education law to improperly inflate the amount of loans it issued that qualified for a particularly large government subsidy. The IG's report said the department ought to figure out exactly how much it overpaid, reclaim the money and demand that the lender stop claiming subsidies for those sorts of loans.

The lender is considered a small player in the multibillion-dollar world of student loan financing. But some observers said the report could have a big impact on not only the New Mexico organization but also other lenders, the government and, ultimately, the taxpayers.

Many suspect that other, much larger lenders have used similar methods to increase their own subsidies. If the department adopts the IG's recommendations, it could create a precedent that would enable the agency to recover subsidies paid to other lenders. Nobody knows how much money could be at stake, but some suspect it could run into the billions.

"These are tax dollars that would be better spent helping families be able to afford college," said Robert Shireman, head of the Institute for College Access and Success, a watchdog group.

The New Mexico organization said that it has faithfully followed the Education Department rules and that the IG's report is based on a novel reading of the law. "Our feeling is that we have followed the interpretation issued to us over the years and therefore there is no refund to be made," said its president, Elwood Farber.

His complaints were echoed by his state's congressional delegation in a recent letter to the Education Department, and by the Education Finance Council, an industry trade association. Conwey Casillas, the council's spokesman, acknowledged that the financial transactions in question amount to taking advantage of a loophole. But he said the government has allowed it for years and that it is unfair to retroactively punish a lender. "This has been the practice for more than a decade and spans multiple administrations from both political parties," he said.

Sen. Edward M. Kennedy (Mass.), the senior Democrat on the Senate Health, Education, Labor and Pensions Committee, fired off a letter last week to Education Secretary Margaret Spellings, asking her to decide the issue. He also asked the agency to audit other lenders to determine if they have used similar methods.

"The report and its recommendations have multibillion-dollar budget implications far beyond the single lender studied," he said. The agency declined to comment, other than to say it is studying the report.

The government has long subsidized lenders -- banks, state agencies, nonprofits, for-profits -- to encourage them to give low-interest loans to students. The Education Department guarantees the loans against default and, under one program, offers them a fixed 9.5 percent return. That program, created decades ago, was intended to limit government subsidies at a time when interest rates were in the double digits.

But as interest rates have dropped -- students now pay less than 4 percent -- those "9.5 loans" have become more lucrative for lenders and more expensive for the government. The less students pay in interest, the more the government has to pay to ensure lenders get a 9.5 percent return on their money.

Congress tried to end that program in 1993. But it grandfathered loans that were funded by tax-exempt bonds issued before Oct. 1, 1993. In recent years, lenders have discovered and used various financial techniques and arrangements not only to maintain but also, in many cases, dramatically increase the volume of loans eligible for the subsidy.

A Government Accountability Office report last year found that subsidy payments skyrocketed from about $209 million in 2001 to more than $600 million as of June 2004. The government said it ultimately spent about $1 billion on the payments last year.

The GAO attributed much of that increase to a drop in interest rates. But it also said the growth was tied to a number of financial maneuvers lenders used to get the 9.5 percent return -- including a method denounced by the IG. Under that arrangement, the lender issued a "refunding bond" to pay off the original, pre-1993 bond and also to finance new loans that it asserted were also eligible for the special subsidies. Because those refunding bonds mature later than the original ones, they enabled lenders to continue billing the government for the subsidies.

The GAO report, issued in September, called the subsidies "unnecessary" and said the Education Department had the authority to end them immediately. The department disagreed, saying that it could stop them only after a lengthy regulatory process and that Congress could close the loophole more quickly. Congress did just that last year, barring the technique cited by the IG. But its ban applies only to subsidies for loans issued after the measure became law.

© 2005 The Washington Post Company