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The Wacky World of Student Loans
How Government Created an 'Industry'

By Michael Kinsley
Saturday, September 15, 2007

If you know anything at all about the federal student loan program, you will not have been surprised by the scandal of recent months. The only amazing thing is that it has taken so long to arrive.

Here's how the program works: Banks and other private companies lend money to students. The federal government pays part or all of the interest -- currently 7 or 8 percent. The government also guarantees the loans.

What is wrong with this picture? Well, the government itself borrows the odd nickel to finance the national debt. This borrowing, obviously, is also guaranteed by the government. For that reason, it carries an interest rate of only 3 or 4 percent. If the government can borrow money at 3 or 4 percent, why should it pay 7 or 8 percent for the privilege of guaranteeing loans to someone else? Wouldn't it make more sense for the government to lend the money itself?

That is the $4 billion question (the approximate annual cost of the interest subsidy). And the answer is: Of course that would make more sense. It is what any level-headed businessperson would do. So, what is stopping the government from behaving like a level-headed businessperson? Not those head-in-the-clouds Democrats. It's Republicans, who adopted the student loan "industry" in its infancy, like a stray cat, and have nurtured and protected it ever since. There actually is a parallel student loan program that uses government funds. It was started in the early days of the Clinton administration. It costs less to operate, and it has not been tainted by scandal. But when the Republicans regained control of Congress in 1994, they pushed through a law forbidding the Education Department to encourage use of this program. As a result, direct federal loans account for only 25 percent of all student loans.

There is plenty of other encouragement going on. New York Attorney General Andrew Cuomo has extracted fines of more than $1 million each from prestigious institutions such as Columbia and Johns Hopkins universities -- and, for that matter, from such nearly-as-prestigious institutions as Citibank, JP Morgan Chase and Bank of America. It seems that kickbacks were being paid to university financial aid officers who delivered customers. Some of them even got stock in some of the more specialized, and dubious, student loan companies. When the government is giving away free money -- which is what the program amounts to (and I mean giving it away to the banks, not to the students) -- it's worth a good deal to get cut in on such a good deal.

When the student loan abuse story broke, fingers were pointed at the Education Department, which is supposed to supervise the program. The Government Accountability Office minced no words. It called on the department to "develop a protocol to determine the appropriate level of response for cases of non-compliance and assess the effectiveness of these actions to inform and improve this protocol." Wow. While the Education Department quaked in its boots over that one, Congress more usefully passed a bill substantially reforming the student loan program and cutting the subsidy to banks and other loan providers by 80 percent. President Bush, to his credit, will sign these reforms into law. In fact, he proposed some of them in his budget in February. But this puts him at odds with his party.

The student loan "industry," as it is comically referred to by newspapers, is an interesting case study in politics and business. To start, it is hardly an industry. There are no factories. The only things it "makes" are loans. Furthermore, it exists only because of a government program. Yet in the four decades since the federal government started it, the student loan business has evolved into a pretty good imitation of an industry, with trade associations, lobbyists and support from politicians, mostly Republican. This "industry" is so dependent on the goodwill of politicians, in fact, that the reform bill alone may be enough to queer the deal in which its biggest player, Sallie Mae, is supposed to be bought by a private equity firm for $25 billion. Even before taking over, the private equity firm booted Sallie Mae's chief executive on the explicit grounds that he did not have good relations with Democrats. To run this so-called company, in other words, you don't need to know how to make widgets, or even how to make loans. You just need to know how to make nice. But don't feel too bad for this CEO who suddenly found his Rolodex obsolete: He made $40 million last year and will get millions more if the deal does go through.

But why do Republicans love student loans? Oh, there are the usual reasons: lobbyist and campaign contributions. There is almost sure to be at least one of these firms -- the local bank, if no one else -- in their district. But there is more. Student loans are the clearest example of the common Republican confusion between free-market capitalism and business. Capitalism is an economic system that is held, with some justification, to be the best guarantor of prosperity. Business can be capitalism in action, or it can be something entirely different. There is very little about the student loan program that has anything to do with free-market capitalism. Yet whenever the student loan system comes under criticism, lobbyists, "industry" leaders and supportive politicians haul out the same old cliches, as if they were defending Adam Smith's famous pin factory itself.

During the recent reform bill debate in the House, for example, a Republican from Texas, Jeb Hensarling, declared that the very notion of reducing the subsidy to private companies was "all part of a Democrat tax-and-spend program." Rep. Virginia Foxx, Republican of North Carolina, declared that "we should call this the new Democratic welfare bill," because it was "taking away personal responsibility from people and giving them out-and-out payments for loans that they take out." This may be referring to a part of the bill that would forgive loans after many years for people who devote their lives to public service. Or it may just be nuts.

An "analysis" by an industry expert, which ( according to The Post) circulated on Capitol Hill during the debate, worried that the big boys would survive but that the subsidy reductions "may leave smaller lenders unprofitable." Concern for "small lenders" was a common theme, as if a loan from a ma-and-pa bank, if such an institution exists, would be warmer and more cuddly than a loan from Citibank. Another common theme was that the subsidy cut was part of a covert Democratic effort to drive people into the federal direct loan program -- or, as one lender CEO described it, the "one-size-fits-all direct loan program." This would be no bad thing, but it doesn't seem to have been the case. I'm not sure what "one size fits all" means here, but if it refers to the interest rate that students and their families have to pay, it's true that there is only one rate in the government program, compared with many in the private one -- all of them higher, but maybe there are people for whom the variety is worth it.

Michael Kinsley is a columnist for Time magazine and an occasional contributor to The Post.

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