Government Extends Its Power in Student Lending

By David Cho
Washington Post Staff Writer
Wednesday, May 21, 2008

With scores of lenders unable to come up with money to provide student loans, the Department of Education is preparing to exercise broad new powers in the coming weeks that could fundamentally recast how millions of students pay for college.

This initiative could transform the federal government from a guarantor of student loans into the dominant provider, replacing the outside lenders to whom students and their families have long turned. Though the Education Department has been making a portion of these federally backed loans, it is now aiming to dramatically expand its role as a direct lender to fill the void created by an exodus of private-sector lenders, due primarily to the credit crisis.

Beyond that, the Education Department, using new authority granted by Congress this spring, is also preparing to wade for the first time into the complex world of finance in an urgent bid to keep some private lenders afloat. The profitability of the student loan industry has taken a pounding in recent years, first by cuts in subsidies from the federal government, then by turmoil in the credit markets that has raised the cost for a wide variety of lending. Now, the Education Department is hoping to offer a lifeline to troubled firms by buying their student loans and thus providing them with capital to keep on lending.

This sea change will affect the way students and their families get loans. Advocates for the lenders say that consumers will have fewer choices as many private firms drop out of the business. Students who find the federal government slow and bureaucratic will have little recourse. And those firms that survive may have less motivation to offer discounts on loan fees or improve their customer service, industry analysts said.

Many lenders remain skeptical, warning that the help proffered by the government might not be enough to restore profitability to student lending.

At a meeting yesterday with major lenders, Education Department officials said the agency might not only buy their loans but also cover some of their interest and administrative costs and pay these firms $75 for each loan they make, according to two people briefed on the department's plans. They spoke on the condition of anonymity because the plans had not been made public. The department is also planning to establish a giant pool of money that would provide funds to lenders at a rate below that available in the market, the sources said.

As it enters virgin territory, the department is borrowing staff with Wall Street experience from other federal agencies. Education officials are having to make this transition with the peak student lending season only weeks away.

"Time is of the essence here," said David Dunn, Education Department chief of staff. "It's clearly a challenge, there's no question about that. But we are confident that we have the capacity to handle the need . . . to ensure students have access to loans for the coming school year."

Yet some analysts and executives at private-sector firms worry whether the department has the expertise and capacity to operate as a financier of student loans on par with Wall Street giants such as Citigroup and J.P. Morgan Chase. Under legislation passed by Congress this spring and signed by President Bush last week, the department will have to sift through the complicated securities that fund student lenders and distinguish the good from the bad.

"It's quite clear that the Department of Education has no experience with structured finance," said Mark Kantrowitz, publisher of FinAid, a Web site that provides financial advice for students.

Traditionally, there have been two primary sources of student loans guaranteed by the federal government. About a fifth have come from the Education Department itself. Outside lenders have represented a far larger share of the market. But now, as the mortgage crisis has crippled the broader credit markets, many firms are exiting the student loan business, saying it's no longer profitable. The expanded role of the Education Department -- both as a direct lender and a source of capital to other lenders -- is just one of the fundamental changes sweeping through the student loan industry. According to FinAid, 88 lenders, including 25 of the largest firms, have announced they will no longer offer federally guaranteed loans, citing their difficulty in getting financing from the troubled credit markets.

By the fall, the department is expected to become the dominant player in the business of providing and financing federally guaranteed student loans. These initiatives, however, would not address problems in the separate market for "private" student loans, which are issued without a federal guarantee. The new duties assigned to it mark a significant departure for the Education Department, which is the smallest of the Cabinet-level departments and agencies. Two decades ago, under President Reagan, it was nearly disbanded altogether. Since then, it has assumed greater prominence and under President Bush was given the responsibility for his much-publicized No Child Left Behind program.

Now, the department is being asked to issue far more loans this year than it ever has in the past. Last year, the department provided $14 billion in federally guaranteed loans directly to students. This summer, during the peak of the student-lending season, that share is expected to more than double and possibly reach $35 billion, or about half the market, according to FinAid and other analysts.

In addition, the department will likely have to take over the market that consolidates federally guaranteed loans for post-graduates. This is a $37 billion business that allows these borrowers to combine all of their student loans into one package with a single, relatively low rate. Already, lenders representing 77 percent of the consolidation market have dropped out since the start of the credit crisis. Department officials said they are prepared to hire contractors to handle this burden.

Edward M. Kennedy (D-Mass.), who chairs the Senate Health, Education, Labor and Pensions Committee, recently sent a letter to the presidents of all the nation's universities, urging them to join the direct-lending program as soon as possible. He is concerned that a flood of requests to switch to the direct-loan program will come late in the summer and overwhelm the department, aides said. Since the beginning of March, nearly 300 universities and colleges have applied to make their students eligible for direct loans from the government.

Some leading Democrats in Congress have urged the government to take responsibility for providing all federally guaranteed loans. Sens. Hillary Rodham Clinton (D-N.Y.) and Barack Obama (D-Ill.) have both said that, as president, they would hand the entire market to the Department of Education.

At the same time that the department is expanding its direct loan program, its officials are also working with financial experts from several federal agencies, including the Treasury, the Council of Economic Advisers, and the Office of Management and Budget, to plan for purchasing loans from other lenders. Officials familiar with the plan, which is likely to involve money from the Treasury, said it may take weeks to release details.

Kennedy and Rep. George Miller (D-Calif.), who chairs the House Education and Labor Committee, are also preparing a letter that asks the Government Accountability Office to keep a close eye on how the measure is carried out because the department is required to buy student loans in a way that does not result in a loss for taxpayers.

Treasury spokeswoman Jennifer Zuccarelli said, "Recognizing that we are on a tight deadline, we're working around the clock to ensure that funds for student loans will be available this summer."

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