Federal Family Education Loan Program:

Statutory and Regulatory Changes Could Avert Billions in Unnecessary Federal Subsidy Payments

GAO-04-1070: Published: Sep 20, 2004. Publicly Released: Sep 20, 2004.

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Cornelia M. Ashby
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To encourage lenders to make student loans under the Federal Family Education Loan Program (FFELP), the federal government guarantees lenders a statutorily specified rate of return--called lender yield. Some lenders may issue tax-exempt bonds to raise capital to make or purchase loans; loans financed with such bonds issued prior to 10/1/93 are guaranteed a minimum lender yield of 9.5% (hereafter called 9.5% loans). When the interest rate paid by borrowers is less than the lender yield, the government pays lenders the difference--a subsidy called special allowance payments. In light of the upcoming reauthorization of the Higher Education Act of 1965, we examined special allowance payments for 9.5% loans.

Special allowance payments for 9.5% loans have risen dramatically in recent years, increasing from $209 million in FY 2001 to well over $600 million as of June 30, 2004. A primary reason for the increase is the sharp decline in the variable interest rates paid by borrowers relative to the minimum 9.5% lender yield. Another reason for the increase in special allowance payments is the rising dollar volume of 9.5% loans, which increased from about $11 to over $17 billion from FY 1995 to June 30, 2004. Given that current market interest rates are at or near historic lows, lenders have a financial incentive to maintain or increase their 9.5% loan volume and can do so in three ways. After paying costs, including payments to bond investors, associated with a pre 10/1/93 tax-exempt bond, lenders can use any remaining money to reinvest in more FFELP loans that, by law, are also guaranteed a minimum 9.5% yield. Lenders can issue a new bond, called a refunding bond, to repay an outstanding pre 10/1/93 tax-exempt bond that financed 9.5% loans. Consequently, the refunding bond finances the 9.5% loans and may have a later maturity date than the original bond, allowing lenders to maintain their 9.5% loan volume for a longer time. By issuing a taxable bond and using the funds obtained to purchase 9.5% loans financed by a pre-10/1/93 tax-exempt bond, lenders can significantly increase their loan volume. Lenders can use the proceeds from the sale of loans previously financed by the pre-10/1/93 tax-exempt bond to make or buy additional loans, which are also guaranteed a 9.5% yield. Under Education's regulations, loans previously financed by a pre 10/1/93 tax-exempt bond and subsequently financed by (i.e., transferred to) a taxable bond continue to be guaranteed a 9.5% yield. Some Members of Congress and the Administration have proposed making statutory changes with respect to 9.5% loans, which could save billions of dollars in future special allowance payments. An official representing a leading credit rating agency and some major lenders told us that making changes to the minimum 9.5% yield for loans made or purchased in the future should not affect lenders' ability to make required payments on outstanding tax-exempt bonds.

Matter for Congressional Consideration

  1. Status: Closed - Implemented

    Comments: HR 5186 Taxpayer-Teacher Protection Act was signed into law on October 30, 2004. The bill temporarily changed the lender yields on 9.5% student loans originated or purchased between October 1, 2004 and December 31, 2005 to a yield similar to that for other guaranteed loans. The savings from this provision were used to expand a teacher loan forgiveness program targeted to certain borrowers who teach in elementary schools. When deliberating the temporary changes, members of Congress agreed that permanent changes to the lender yield were needed, and in February 2006 Congress passed legislation that permanently changed the lender yield on loans financed with pre-October 1, 1993, tax-exempt bonds. Under the Deficit Reduction Act of 2005, loans made or purchased after February 8, 2006, with proceeds of tax-exempt bonds issued prior to October 1, 1993, will have a lender yield based on market interest rates. Lenders that hold less than $100 million in 9.5% loans will be able to continue to receive the minimum 9.5% yield until December 31, 2010, at which time the yield will change to one based on market interest rates.

    Matter: In light of the rapid increase in special allowance payments for loans guaranteed a minimum 9.5 percent yield and the continuing financial incentive for lenders to originate or purchase additional loans that qualify for a guaranteed yield of 9.5 percent, Congress may wish to consider amending the HEA to address the issues identified by this report, but particularly to change the yield for loans made or purchased in the future with the proceeds of pre-October 1, 1993 tax-exempt bonds, and any associated refunding bonds, to more closely reflect these loans' financing costs and current market interest rates.

Recommendation for Executive Action

  1. Status: Closed - Implemented

    Comments: Education considered undertaking the process to issue new regulations, but determined that action could be taken sooner through the legislative process because of timeframes specified in the Higher Education Act and the requirement for a negotiated rulemaking process. Moreover, Education continued to assert that it could not waive the requirement for negotiated rulemaking by using the "public interest" exception. Education reported that it worked with Congress in passing the Taxpayer-Teacher Protection Act, which temporarily changed the yield for loans financed with tax-exempt bonds issued prior to October 1, 1993, (also called 9.5% loans). Congress then made permanent changes to the yield for 9.5% loans in the Deficit Reduction Act of 2005. Education issued regulations regarding the changes to the lender yield for 9.5% loans in March 2006.

    Recommendation: Given that lenders are increasing the volume of 9.5 percent loans based on Education regulations that allow lenders to transfer 9.5 percent loans to taxable bonds and tax-exempt bonds issued after October 1, 1993 while retaining the special allowance payment provisions applicable to loans financed with pre-October 1, 1993 tax-exempt bonds, and the resulting increased costs for taxpayers, the Secretary of Education should promulgate regulations to discontinue the payment of the special allowance applicable to loans financed with pre-October 1, 1993 tax-exempt bonds that are subsequently transferred to taxable bonds or tax-exempt bonds issued on or after October 1, 1993.

    Agency Affected: Department of Education


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