HORTON, KAN. -- A little bank on the Kansas prairie made hundreds of millions of dollars in bad loans during the past few years and big profits for itself while playing a key role in pushing the United States's student loan system to the brink of a crisis.

Operating in a converted grocery store, the tiny Bank of Horton came to rival Citibank as a student lender -- admittedly exploiting a federal program for needy students. Horton has issued nearly $1 billion in loans during the past five years even as its loan default rate grew to 40 percent, according to interviews and documents obtained by Newsday.

Despite that rate of default -- almost four times the national average -- the bank made big money from loans it made to trade school students. There were virtually no risks to the bank, but there were consequences for the federal government, which picks up the tab for almost all defaulted loans.

Located in a region of rolling prairie that produces corn, sorghum and soybeans, the bank dominates this town of 2,000, where the only other big building is the Bureau of Indian Affairs, where residents flock to the Kickapoo Indian reservation to buy cheap gas and no liquor is sold by the glass.

At its peak, the Bank of Horton processed about 2,000 loans a day from as far away as New York and Florida, employees said, and sold them quickly for a fast profit. The bank used high-rate certificates of deposit to lure money so it could make the loans. It hired local women to handle the paperwork and paid wages so low that many of them were eligible for welfare.

All along the way, federal regulations allowed the bank to operate and even prosper without the kind of control that could ensure that the system would not be exploited. Even when a regional Department of Education auditor found that the bank did almost all of its business in student loans -- contrary to federal regulations -- the bank got the regulator's bosses back in Washington to bend the rules.

While officials in the General Accounting Office have long warned of student loan problems, it was only in May that the Bank of Horton was reined in -- the Federal Deposit Insurance Corp. told the bank to change its practices. Horton, which posted losses this year after a tide of defaults nationwide dried up the resale market for its loans, has even had to lay off a couple of dozen workers.

Most of Horton's loans were insured by the Higher Education Assistance Foundation (HEAF), which in July told the Department of Education that it did not have enough funds to cover its obligations for more than $1 billion in bad loans, triggering a scramble to rescue it.

The troubles of HEAF, which was the largest guarantor of the student loans, shook the financial markets and the student loan industry. Never before had a guarantor said that it could not meet its obligations to holders of the loans.

Federal education officials say that another half dozen of the more than 50 guaranteeing agencies are in a fiscal danger zone. And if they follow HEAF's pattern, students could find it much harder to get loans for school.

While the Bank of Horton is not the only cause of the troubles in the student loan business, it provides an unusual look at how lenders have contributed to the growing student loan debacle, a small-scale version of the savings and loan crisis. The cost of defaults to taxpayers has been rising and this year will exceed $2 billion.

"The Bank of Horton is a spectacular example of the whole student loan problem -- it made a lot of risky loans," said Gary Beanblossom, an analyst in the Department of Education's student loan division. "I always associated Horton with HEAF."

Horton officials see themselves as simply carrying out a government mandate. In their view, Washington said to make educational financing available to everyone and absorb much of the risk, and the bank merely obliged.

"If you see a niche in a government program run out of Washington, D.C., and you exploit that niche in an honest way, you're doing what Congress intended you to do," said Craig MacPherson, a director of Horton. "The fact that the Bank of Horton exploited that niche is partly to Horton's credit."

Horton's chairman, majority shareholder and, until July, its president, Vance B. Norris, said that the bank served as a key player in an effort to educate the underprivileged.

"Everyone can't go to Harvard," Norris said, noting that "three kids out of five can pay back the loans" made by Horton. The two others represent what he called "the social trade-off."

"If the public doesn't want to bear the cost {of the loan program} ... they'll pay the costs with more people on the welfare rolls," Norris said.

Student loans are intended to help people who would not ordinarily be considered good credit risks by offering guarantees, subsidies and various payments to lenders and insurers. Banks make the loans, which are administered and insured by agencies such as HEAF. The government subsidizes the interest and makes interest payments while the students are in college. Everything works well as long as students make their loan payments, which start soon after graduation. But if the student defaults, the federal government is ultimately liable.

In recent hearings before a Senate subcommittee, Secretary of Education Lauro Cavazos said that the loan problem is attributable to poor oversight by agencies that accredit trade schools. "We're going to have to work a lot harder to see that this problem doesn't happen again," Cavazos said.

Trade schools that are operated for profit, where students learn to cut hair, tend bar or fix appliances, have long drawn the scrutiny of government regulators because of high student default rates and questionable recruiting practices. In 1987, the last year for which figures were available, the Department of Education said that the default rate at profit-making trade schools was 33 percent, while it was only 7 percent for public four-year colleges.

Trade School Defaults High

Sherwood Johnson, director of student financial aid at the State University of New York at Stony Brook on Long Island, said that even after they finish and get jobs, trade school students often cannot afford to repay the loans.

HEAF Chairman Richard Hawk acknowledges that the risky trade school loans in which HEAF specialized were the cause of his company's problems. While declining to discuss details of HEAF's relationship with Horton, Hawk said, "I'm not trying to suggest that the Bank of Horton or any other lender to vocational schools was not a problem. It was. But if you only have one, it wouldn't be a problem."

While neither HEAF nor Horton will divulge the extent of their business dealings, bank officials said that HEAF used to be the guarantor for all Horton's loans, at least until the late 1980s, when the relationship began to sour. Based on the bank's default rate on its almost $1 billion in loans issued, Horton's bad loans could have totaled up to $400 million, much of which would have ended up with HEAF.

Trade school loans were a new line of business for the Bank of Horton, which was founded in 1887 and specialized for much of its history in the agriculture loans that fueled the commerce of northeast Kansas.

The Norris family had long owned the bank when Vance Norris took control in 1977. But it was not until 1985 that the bank began going after student loans in a big way. It was then that his wife's brother, Tony Pizzuti, a former insurance salesman from Philadelphia who became a high-ranking bank official, said that he noticed the profits possible in student loans. The bank started a huge growth spurt that saw its assets go from $20 million in 1987 to $275 million at the end of last year.

The student loan business quickly made Horton one of the most profitable banks in the United States in its rate of return.

It was all made possible by mastering the details of the Great Society program begun under President Lyndon Johnson in 1965. Because the program was too cumbersome to run from Washington, Congress authorized "middlemen" agencies, such as HEAF, to administer the program and guarantee the loans to the banks.

The Bank of Horton's move into student loans coincided with the growth of HEAF, headquartered two hours away in Overland Park, Kan. The relationship between the two became close because HEAF is the designated guarantee agency in Kansas, which means it had to accept loans made by Horton.

Loan Revolution

In the early 1980s, HEAF was revolutionizing the student loan business by reducing the turnaround time on loan approvals from two months to two weeks. HEAF eventually would become the nation's largest guarantor, concentrating its business in high-risk trade school loans. In June 1988, such loans accounted for 59 percent of its business, according to Hawk.

In 1988 alone, the Bank of Horton originated a phenomenal $398 million in all categories of guaranteed student loans, second only to Citibank with $571 million, according to the Department of Education's Beanblossom. Last year, after the balloon had started to deflate, Horton slipped to fourth place, with $263 million, behind Citibank and Bank of America and in a virtual tie with Chase Manhattan.

Horton's default rate was staggering, however; it led the nation in 1987-89 with $66.8 million in defaults in the one category of student loans -- supplemental loans for students -- studied by the GAO.

The only risk for lenders involves collection procedures. The Department of Education can refuse to cover a bad loan if the lender does not follow a series of steps to try to collect on loans that go bad. Because of high defaults on trade school loans, the steps can cost the lender time and money. Horton sidestepped this risk by selling the loans as soon as it made them.

"Many banks did not want to get involved with trade schools," said John J. Conard, a former HEAF official who left four years ago. "But the Bank of Horton didn't really care if it was a trade school. They would take all comers."

Horton Chairman Norris said that it was not his job to pass judgment on the creditworthiness of borrowers. He said that the Department of Education makes the lending choices by deciding which schools can participate in the student loan program.

Despite the problems, the Bank of Horton did well for itself financially. Records show that Horton Bancshares, the holding company that owned the bank and nothing else, paid $423,000 in dividends between 1987 and 1989.

HEAF, however, is not so fortunate. The Education Department said Friday it plans to turn over the $9 billion portfolio of the agency to Sallie Mae, the Student Loan Marketing Association, and set into motion a three-year wind-down of HEAF's existing portfolio.

So how could all this have happened?

"The oversight obviously hasn't been as good as it could have been," said Jay Eglin of the GAO, who has studied the student loan program and warned of its shortcomings for years. "It works fine until the fox gets into the coop. You keep warning and the hens keep pecking away and all of a sudden he's in there."

Because of the government guarantees, Norris said, there's no reason to get out of the business.