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entitled 'Consolidation Loan Borrower Interest Rates' which was 
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February 25, 2005:

The Honorable John A. Boehner:
Chairman:
Committee on Education and the Workforce:
House of Representatives:

Subject: Consolidation Loan Borrower Interest Rates:

This letter responds to your question related to the recommendation we 
made in our October 31, 2003, report Student Loan Programs: As Federal 
Costs of Loan Consolidation Rise, Other Options Should Be Examined (GAO-
04-101), which we completed at your request. As you know, we reported 
that then recent trends in interest rates and consolidation loan 
volumes had affected the federal costs of consolidations in the 
Department of Education's two major student loan programs--the Federal 
Family Education Loan Program (FFELP) and the William D. Ford Federal 
Direct Loan Program (FDLP)--in different ways, but in the aggregate, 
estimated federal subsidy costs[Footnote 1] for consolidation loans had 
increased. In light of these increased costs, we recommended in our 
report that the Secretary of Education assess the advantages of 
consolidation loans for borrowers and identify options for reducing 
federal costs, taking into consideration how best to distribute program 
costs among borrowers, lenders, and the taxpayers. Among the options we 
suggested for the Secretary's consideration was changing the borrower 
interest rate on consolidation loans from a fixed to a variable 
rate.[Footnote 2] Given that some time has passed since we issued our 
report, you asked for our perspective on whether economic 
circumstances--such as current and projected interest rates--are such 
that a variable interest rate remains a viable option for reducing 
federal costs of student consolidation loans. On the basis of the 
information discussed below, we believe a variable interest rate 
remains a viable option for reducing federal costs.

VARIABLE BORROWER INTEREST RATE FOR CONSOLIDATION LOANS IS A VIABLE 
OPTION FOR REDUCING FEDERAL SUBSIDY COSTS:

Changes in market interest rates affect the costs of the FFELP and FDLP 
in different ways due to differences between how the programs operate. 
Under FFELP, private lenders make loans to students, with Education 
guaranteeing the lenders loan repayment and a rate of return on the 
loans they make. Under FDLP, the federal government makes loans to 
students using federal funds. A change in the borrower interest rate on 
consolidation loans from a fixed to a variable rate would affect 
federal subsidy costs for FFELP and FDLP consolidation loans in the 
ways discussed below.

FFELP:

As we previously reported, increased federal subsidy costs of FFELP 
consolidation loans were due in part to the fact that the government- 
guaranteed rate of return to lenders was projected to be higher than 
the fixed interest rate consolidation loan borrowers pay. When the 
interest rate paid by borrowers does not provide the full guaranteed 
rate to lenders, the federal government must pay lenders the 
difference--an interest subsidy called a special allowance payment 
(SAP).[Footnote 3] If the borrower's rate exceeds the guaranteed lender 
yield, Education does not pay a SAP, and the lender receives the 
borrower rate. As was the case when we issued our prior report, the 
Administration currently projects that interest rates and the 
guaranteed lender yield will continue to rise over the next several 
years. As a result, in future years, when the guaranteed lender yield 
is expected to increase, Education would have to make up any difference 
between the higher lender yields and the fixed rate paid by current 
consolidation loan borrowers.

Since we issued our report, Education has developed several proposals, 
presented in the President's Fiscal Year 2006 Budget, that are intended 
to reduce federal costs of consolidation loans, including the 
introduction of a variable borrower interest rate. The proposal would 
replace the current fixed rate interest formula for consolidation loans 
with the variable rate formula currently used for Stafford student 
loans--loans that underlie consolidation loans.[Footnote 4] The 
interest rates that borrowers currently pay on Stafford loans adjust 
annually, based on a statutorily established market-indexed rate 
setting formula, and may not exceed 8.25 percent.[Footnote 5] Figure 1 
shows how, when interest rates are projected to increase in the future, 
a change to a variable borrower interest rate would reduce federal SAP 
costs for FFELP consolidation loans originated in fiscal year 2006.

Figure 1: Illustration of Estimated SAP Paid to Holders of FFELP 
Consolidation Loans Originated from October to June of Fiscal Year 
2006: 

[See PDF for image]

Note: The estimated lender yield and variable borrower interest rate do 
not vary after fiscal year 2011 because the Administration's interest 
rate projections do not vary after fiscal year 2011. The estimated 
fixed borrower rate is for a consolidation loan originated from October 
to June of fiscal year 2006, whose underlying loans are Stafford loans 
disbursed after July 1, 1998, and in repayment at time of 
consolidation. Under current law, borrower rates on Stafford loans are 
scheduled to become a fixed rate of 6.8 percent on July 1, 2006.

[End of figure] 

As the figure shows, based on current interest rate projections, 
lenders would receive a SAP in fiscal year 2006 and beyond for 
consolidation loans made in fiscal year 2006. The amount of the SAP 
would be determined based on the difference between the lender's yield 
and the borrower interest rate and the amount of the consolidation 
loan. As the figure also shows, the difference, or spread, between the 
lender yield and the variable borrower interest rate proposed by 
Education is less than the spread between the lender yield and the 
fixed borrower interest rate. This is due to the fact that, as interest 
rates rise in the future, the variable borrower rate would increase 
along with the lender yield. As a result, federal SAP costs would be 
reduced. The amount by which SAP costs would be reduced would be 
determined by the difference between the fixed borrower rate and the 
variable borrower rate shown above. If market interest rates were to 
decline, rather than increase as projected, SAP cost reductions would 
be smaller because the spread between the projected variable and fixed 
borrower interest rates would decrease. Further, if market interest 
rates were to decline to the point that a variable borrower rate would 
be less than the fixed rate shown, SAP would continue to be paid on 
loans with a variable interest rate, but would not be necessary for 
loans with the fixed rate shown.

FDLP:

We also previously reported that, as a direct loan program, the FDLP 
consolidation program involves no guaranteed yields to private lenders 
and the subsidy cost of this program is determined in part by the 
relationship between the interest rate Education earns from borrowers-
-the borrower rate--and the rate Education pays Treasury to finance its 
lending. The government's cost of capital is determined by the interest 
rate Education pays Treasury to finance direct student loans, which is 
equivalent to the discount rate.[Footnote 6] When the borrower rate is 
greater than the discount rate, Education receives more interest from 
borrowers than it pays to Treasury. In calculating the subsidy costs of 
FDLP loans made in a given year, the discount rate is generally fixed 
for the life of the loans. Because current borrower interest rates on 
consolidation loans are also fixed, the subsidy costs of FDLP 
consolidation loans made in a given fiscal year do not vary in the way 
the subsidy costs for FFELP consolidation loans do. However, changing 
the borrower rate from a fixed to a variable rate would affect the 
subsidy costs of FDLP consolidation loans. Figure 2 shows the 
relationship, for a FDLP consolidation made in fiscal year 2006, 
between the discount rate, a fixed borrower interest rate, and a 
variable borrower interest rate based on the Administration's interest 
rate projections.

Figure 2: Illustration of Assumed Discount Rate and Fixed-and Variable 
Borrower Interest Rates on a FDLP Consolidation Loan Originated from 
October to June of Fiscal Year 2006:

[See PDF for image]

Note: The estimated variable borrower rate does not vary after fiscal 
year 2011 because the Administration's interest rate projections do not 
vary after fiscal year 2011. The estimated fixed borrower rate is for a 
consolidation loan originated from October to June of fiscal year 2006 
and whose underlying loans are Stafford loans disbursed after July 1, 
1998, and in repayment at time of consolidation. Under current law, 
borrower rates on Stafford loans are scheduled to become a fixed rate 
of 6.8 percent on July 1, 2006.

[End of figure] 

As figure 2 shows, based on current interest rate projections, the 
discount rate is projected to be less than the fixed borrower rate for 
a consolidation loan made in fiscal year 2006. As a result, Education 
would receive more interest from borrowers than it would pay in 
interest to Treasury. As figure 2 also shows, the spread between the 
discount rate and the variable borrower rate the Administration 
proposes would result in Education receiving an even greater amount of 
interest from borrowers, thereby decreasing the subsidy cost of, or 
increasing the gain to the government from, an FDLP consolidation loan. 
If, however, market interest rates were to decline, rather than 
increase as projected, a variable borrower rate would also decline, 
resulting in Education receiving less interest from borrowers than 
shown above. If interest rates declined below the discount rate, such a 
scenario could result in Education paying more in interest to Treasury 
than it receives from borrowers.

ADMINSTRATION ESTIMATES THAT A VARIABLE BORROWER RATE WOULD RESULT IN 
SAVINGS OF $2.6 BILLION OVER FISCAL YEARS 2006-2015:

The proposal in the President's Budget for Fiscal Year 2006 to replace 
the current fixed-rate interest formula for consolidation loans with a 
variable rate formula is one of several proposals in a package of 
proposed changes for the consolidation loan program designed to reduce 
overall program costs. Compared to its baseline estimates of FFELP and 
FDLP subsidy costs, which assume no changes are made in the loan 
programs, the Administration estimates that implementing a variable 
borrower interest rate would reduce subsidy costs by about $2.6 billion 
for consolidation loans originated in the 2006-2015 period. The 
Administration's estimates of the change in estimated subsidy costs for 
both FFELP and FDLP consolidation loans, by fiscal year, are shown in 
table 1.

Table 1: Change in Estimated Costs of Consolidation Loans from 
Implementing:

Variable Borrower Interest Rate Proposal, by Program and Fiscal Year ($ 
in millions):

Fiscal Year: 2006;
Change in FFELP Subsidy Costs: (166);
Change in FDLP Subsidy Costs: (71);
Total: (238).
 
Fiscal Year: 2007;
Change in FFELP Subsidy Costs: (451);
Change in FDLP Subsidy Costs: (76);
Total: (527).
 
Fiscal Year: 2008;
Change in FFELP Subsidy Costs: (403);
Change in FDLP Subsidy Costs: (46);
Total: (449).
 
Fiscal Year: 2009;
Change in FFELP Subsidy Costs: (361);
Change in FDLP Subsidy Costs: (16);
Total: (377).
 
Fiscal Year: 2010;
Change in FFELP Subsidy Costs: (373);
Change in FDLP Subsidy Costs: (12);
Total: (384).
 
Fiscal Year: 2011;
Change in FFELP Subsidy Costs: (297);
Change in FDLP Subsidy Costs: 18;
Total: (279).
 
Fiscal Year: 2012;
Change in FFELP Subsidy Costs: (186);
Change in FDLP Subsidy Costs: 45;
Total: (141).
 
Fiscal Year: 2013;
Change in FFELP Subsidy Costs: (161);
Change in FDLP Subsidy Costs: 48;
Total: (113).
 
Fiscal Year: 2014;
Change in FFELP Subsidy Costs: (88);
Change in FDLP Subsidy Costs: 55;
Total: (33).
 
Fiscal Year: 2015;
Change in FFELP Subsidy Costs: (100);
Change in FDLP Subsidy Costs: 57;
Total: (43).
 
Total;
Change in FFELP Subsidy Costs: (2,586);
Change in FDLP Subsidy Costs: 2;
Total: (2,584).

Source: Department of Education.

Notes:

These estimated savings are based on the assumption that several 
Administration policy proposals concerning student loans are enacted. 
Because certain proposals may impact others, these estimated savings 
may vary depending on the specific proposals enacted.

Totals may not add due to rounding.

We did not examine the reasonableness of the Administration's estimates.

[End of table]

As shown in table 1, the estimated savings over the 10-year period 
would vary by program and fiscal year. Actual savings will be affected 
by a number of factors, including the extent to which forecasted 
interest rates vary from actual interest rates. Additional factors 
include the extent to which actual consolidation loan volume and 
characteristics of loans underlying consolidation loans, and rates of 
loan repayment and default vary from assumptions Education used in 
making its estimates.

In closing, the Department of Education's proposal to change from a 
fixed to a variable rate the interest charged to borrowers on 
consolidation loans, as well as its other consolidation loan reform 
proposals included in the President's Budget for Fiscal Year 2006, is 
consistent with the recommendation we made in our October 31, 2003, 
report that the Secretary of Education identify options for reducing 
federal costs.

In providing updated information for this letter, we reviewed the 
President's Budget for Fiscal Year 2006, obtained and reviewed 
additional information from Education concerning the assumptions used 
in preparing the President's budget and the Administration's student 
loan program policy proposals, and interviewed knowledgeable Education 
officials. We conducted our work in February 2005 in accordance with 
generally accepted government auditing standards. We provided Education 
with a copy of our draft letter for review and comment. Education 
provided a technical comment, which we incorporated.

As agreed with your office, unless you publicly announce its contents 
earlier, we plan no further distribution of this letter until 30 days 
after its date. At that time, we will send copies of this letter to the 
Secretary of Education and other interested parties. The letter will 
also be available on GAO's home page at http://www.gao.gov. If you have 
any questions about this letter, please contact me at (202) 512-8403 or 
Jeff Appel, Assistant Director, at (202) 512-9915. You may also reach 
us by e-mail at ashbyc@gao.gov or appelc@gao.gov. Susan Chin and Chuck 
Novak were also key contributors to this letter.

Signed by: 

Cornelia M. Ashby:

Director, Education, Workforce, and Income Security Issues:

(130454):

FOOTNOTES

[1] Subsidy costs are the net present value of cash flows to and from 
the government, excluding administration costs, that result from 
providing loans to borrowers.

[2] The borrower interest rate on consolidation loans is currently 
calculated as the weighted average of the interest rates in effect on 
the loans being consolidated rounded up to the nearest one-eighth of 1 
percent, capped at 8.25 percent. 

[3] The SAP is based on a formula specified in law and paid by 
Education to lenders on a quarterly basis when the "guaranteed lender 
yield" exceeds the borrower rate. This guaranteed lender yield is 
currently based on the average 3-month commercial paper interest rate 
plus 2.64 percent. The amount of quarterly SAP paid to loan holders 
equals the difference between the guaranteed lender yield and the 
borrower rate divided by 4 and multiplied by the average unpaid 
principal balance for all loans the lender holds. 

[4] Borrowers may also consolidate other types of student loans, 
including PLUS loans, Perkins loans, Health Professions Student Loans, 
Nursing Student Loans, and Health Education Assistance Loans.

[5] For Stafford loans originated between July 1, 1998 and June 30, 
2006 the borrower interest rate is the bond equivalent rate of the 91- 
day Treasury bill at the final auction held prior to June 1 (rates 
become effective July 1 through the following 12-month period) plus 1.7 
percent during in-school, grace, and deferment periods and 2.3 percent 
during repayment periods, capped at 8.25 percent. Under current law, 
borrower rates on Stafford loans are scheduled to become a fixed rate 
of 6.8 percent on July 1, 2006. Among the Administration's other 
student loan program proposals is one to retain the variable borrower 
interest rate on Stafford loans.

[6] While the discount rate is the interest rate used to calculate the 
present value of the estimated future cash flows to determine subsidy 
cost estimates, it is also generally the same rate at which interest is 
paid by Education on the amounts borrowed from Treasury to finance the 
direct loan program.