Budget Battle: The Latest Tussle? Student Loans

President Obama and congressional Democrats have good reasons for wanting to eliminate federal guarantees for private student loans. They should keep in mind, however, that the resulting budget savings will likely be much smaller than official estimates suggest.

Health care and defense spending have grabbed most of the budget headlines lately, but they aren’t the only budget battles in Washington.

The latest tussle? Student loans.

The federal government supports college loans in two ways: by making loans directly to students and by guaranteeing loans made by private lenders. The current budget battle has arisen because President Obama and many congressional Democrats want to kill the guarantee program in favor of the direct program. Many Republicans, on the other hand, support private lenders, and thus want the guarantee program to continue.

There are three things you should know about this debate:

1. The guarantee program has experienced two crises in recent years. In 2007, the problem was kickbacks. Private lenders were being overpaid by the program, and some of them started competing for business by giving goodies to student loan officers. President Bush and Congress put an end to that by reducing payments to private lenders. Then the financial crisis hit, and we had the reverse problem: private lenders stopped lending. So President Bush and Congress stepped in with some duct tape and paperclips to keep the guaranteed loan market working. (Actually they gave private lenders a put option — the right to sell the loans back to the government — which many lenders used; in essence, the lenders got paid for originating loans, but didn’t hold them very long.)

In short, the guarantee program has been a headache for policymakers in recent years.

2. Guaranteed loans cost the government more than direct loans. There’s no law of nature that says that has to be the case. In principle, one can imagine a guarantee program that would cost less than direct loans. That could happen, for example, if the private sector is more efficient than the government in making the loans or if the private sector is willing to use student loans as a loss leader to promote other financial products (e.g., credit cards). In practice, however, the government has never been able to calibrate guarantees to the private lenders so that (a) lenders are willing to make the loans and (b) the guarantees cost less than direct loans.

When you put points 1 and 2 together, you can understand why many budget analysts and lawmakers want to kill the guarantee program and have the government make all the loans directly. That’s certainly the way that I am leaning. (If readers have any compelling arguments in favor of the guarantee program, however, I’m all ears.)

In fairness, though, opponents of the guarantee program should acknowledge one complication to their position:

3. Congressional budget procedures are biased in favor of direct student loans over guaranteed loans. As a result, the budget case against guaranteed loans is overstated. It isn’t wrong — we are still talking tens of billions of dollars over the next ten years — but it isn’t as strong as the official numbers suggest. One implication is that eliminating the guarantee program may not save as much money as lawmakers think. That’s important, particularly if lawmakers want to spend those savings on other programs.

This third point is the key to current budget brouhaha over student loans. To understand it fully, we need to delve into a bit of budget arcana.

Last week the Congressional Budget Office released a cost estimate for H.R. 3221, the Student Aid and Fiscal Responsibility Act of 2009. Among other things, that bill would eliminate the guaranteed loan program and correspondingly expand the direct program. Following usual congressional scoring procedures, CBO estimated that this change would save $87 billion over the next decade.

On Monday, CBO released a second analysis that used a different approach to estimate the savings from eliminating the guarantee program. In a letter to Senator Judd Gregg, the top Republican on the Senate Budget Committee, CBO reported that, under that approach, the estimated savings would be $47 billion.

The $40 billion difference between the estimates results from two factors:

1. The administrative costs of the two programs show up in different budget categories. The administrative costs of the guarantee program are treated as mandatory spending, while the administrative costs of the direct loan program are treated as discretionary spending. If you look at just mandatory spending (the usual focus in many budget debates), you thus see the budget benefits of eliminating the guarantees (about $80 billion) and the benefits of not having to run the guarantee program (about $7 billion). However, you don’t see the added costs of operating a larger direct loan program (about $7 billion in discretionary spending). If you consider all the costs, the real savings from the proposal would be about $80 billion, not $87 billion.

2. The congressional scoring process does not appropriately measure the cost of bearing financial risk, such as that from extending loans or loan guarantees. The details here are arcane, so please just trust me on this or read the nice account in the second CBO letter (for a related discussion, you can also look at a chapter I have in a forthcoming book from the NBER). The key point is that this error is more pronounced for direct loans than it is for loan guarantees. If you account for the cost of financial risk, CBO estimates that the savings from eliminating the guarantee program are about $47 billion, not $80 billion.

In short, you get from $87 billion to $47 billion by (a) recognizing that $7 billion in administrative costs will still happen, just in a different budget category and (b) adjusting for $33 billion in financial costs that traditional budget scoring doesn’t usually track. (One major exception is the TARP program; its costs are calculated using methods that reflect the cost of financial risk.)

Bottom Line: Eliminating the guarantee program would reduce government spending, but not as much as traditional budget measures indicate.

Disclosure: I played a peripheral role in designing the duct tape and paper clips. I don’t have any investments in student lenders.

About Donald Marron 294 Articles

Donald Marron is an economist in the Washington, DC area. He currently speaks, writes, and consults about economic, budget, and financial issues.

From 2002 to early 2009, he served in various senior positions in the White House and Congress including: * Member of the President’s Council of Economic Advisers (CEA) * Acting Director of the Congressional Budget Office (CBO) * Executive Director of Congress’s Joint Economic Committee (JEC)

Before his government service, Donald had a varied career as a professor, consultant, and entrepreneur. In the mid-1990s, he taught economics and finance at the University of Chicago Graduate School of Business. He then spent about a year-and-a-half managing large antitrust cases (e.g., Pepsi vs. Coke) at Charles River Associates in Washington, DC. After that, he took the plunge into the world of new ventures, serving as Chief Financial Officer of a health care software start-up in Austin, TX. After that fascinating experience, he started his career in public service.

Donald received his Ph.D. in Economics from the Massachusetts Institute of Technology and his B.A. in Mathematics a couple miles down the road at Harvard.

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