March 5, 1998
Subcommittee on Postsecondary Education, Training and Life-Long Learning
United States House of Representatives
Committee on Education and the Workforce
Mr. Chairman, Members of the Subcommittee, and Members of the Full Committee,
I am pleased to appear before you today to discuss the Administration's response to concerns regarding the change in student loan interest rates that is scheduled to take place on July 1st. This is an issue of great importance to us, and we are pleased to have the opportunity to share our research and proposal with you.
As you know, the Administration is striving on a variety of fronts to make college more affordable for all students and their families. Last year, the Administration proposed its own increase in the Pell Grant maximum and proposed the HOPE Scholarship tax credit and the Lifetime Learning credit which, thanks to the help of members of this Committee and others in Congress, will provide assistance to up to 12.8 million students and families next year. This year, to complement these tax benefits, the Administration has submitted a variety of proposals for reauthorization of the Higher Education Act that would reduce costs for students even further. In particular, the Administration's proposal would reduce loan fees by 1 percent for all borrowers next year and phase out the fees for the most needy borrowers by 2003. Further, the President's Fiscal Year 1999 budget proposes to increase the maximum Pell Grant award to $3,100, which represents a 35 percent increase since President Clinton took office. The budget also proposes to increase Work-Study funds to $900 million, giving more than one million students the opportunity to work their way through college next year.
The Administration is strongly committed to both the Federal Family Education Loan (FFEL) Program and the Direct Loan Program. Competition between these programs has improved benefits and services for students and their families and has prompted innovation in both programs.
As you know, the change in student loan interest rates that was enacted by Congress in 1993 and is scheduled to go into effect on July 1st would reduce the cost of new borrowing for all students by approximately 10 percent. Because the change also creates inefficiencies for banks, it would reduce lenders' profits below a reasonable rate of return, raising the possibility that the change could reduce the availability of funds in the FFEL program. For this reason, this issue is a high priority for the Administration, and we have thought long and hard about our proposal.
The Treasury Department conducted a study on the scheduled interest rate change and its probable effects on lenders. Jon Gruber, Deputy Assistant Secretary for Economic Policy at the Treasury Department, is here with me today and will testify as to the details of the study. In general, the study concluded that banks are currently receiving profits on student loans in excess of a competitive target rate of return. This is further evidenced by Citibank's recent announcement that it is unilaterally reducing interest rates for borrowers by 25 basis points. However, the study further concluded that banks would earn less than a competitive rate of return on student loans if the scheduled change in interest rate goes into effect as currently structured. Such a reduction need not imply an immediate crisis in the market for guaranteed student loans, but it could be problematic for lenders in the long term. The study also found that it is not efficient for banks for interest rates to be tied to a long-term interest rate (as would occur under the scheduled change), because banks borrow money on a short-term, rather than long-term, basis, and the funding mismatch creates additional costs for the banks.
In seeking a solution to the problem, we had two goals: (1) to provide the lowest interest rate for students and (2) to maintain access in both the Direct Loan and FFEL programs. The proposal announced by Vice President Gore last week is designed to meet these goals. The proposal will provide students with the same low interest rate that they would receive under the scheduled change and provide a rate of return to lenders that is the target rate of return identified by the Treasury Department study. Under this alternative approach, student interest rates will be tied to the 91-day Treasury Bill rate, the same benchmark used currently, rather than to the 10 to 20 year note used in the scheduled change. This proposal would reduce lender costs, because the use of this benchmark would more closely match their own financing practices. Based on Treasury's analysis, we believe that changing the benchmark would allow us to preserve the scheduled 10 percent reduction in student interest rates, while providing a competitive yield for lenders. Specifically, we propose that, as of July 1st, maximum student interest rates should be the 91-day Treasury Bill rate plus 1.7 percentage points during the in-school period, and the 91-day Treasury Bill rate plus 2.3 percentage points during repayment. For PLUS loans, the interest rate would be reduced to the 91-day Treasury Bill rate plus 3.2 percent.
This proposal will benefit both students and the FFEL program. Students will retain attractive interest rates on their loans. Under the rate currently used to calculate student loan interest rates (the 91-day Treasury Bill rate plus 3.1 percent), the projected 5-year weighted average interest rate for students is 7.8 percent. Under both the scheduled change and the Administration's proposal, that rate will decrease to 7 percent for loans made after July 1st -- a decrease of more than 10 percent. For students, this means significant savings compared to today's formula. For example, a student at a four-year private college who borrows $16,000 would save $850 in interest under the Administration's proposal. A professional degree student with $60,000 of borrowing would save $3,200 in interest. The savings would be even higher for borrowers who choose to spread their payments out for longer than 10 years. We estimate that students who borrow over the next five years will save $11 billion over the life of their loans compared to the rates that students currently pay.
The proposal also benefits lenders. Unnecessary costs are eliminated by tracking lenders' own financing practices more closely. Under the current law, lenders will incur added risk beginning July 1st, because of the mismatch between the rates that lenders earn on student loans that are based on a long-term instrument and the short-term rates at which they fund their holdings. Lenders can eliminate the mismatch through the use of interest-rate swaps, but this adds an additional funding cost. The Administration's proposal eliminates this cost by basing student interest rates on a short-term rather than a long-term instrument. This represents a savings of 30 basis points for lenders, and ensures that student loans will provide sufficient profitability to remain a competitive component of most lenders' portfolios.
To help ease burdens on lenders, the Administration is also proposing a number of items to further improve lender profitability. As part of reauthorization of the Higher Education Act, the Administration has proposed a comprehensive plan to restructure the guaranty agencies that would more accurately reflect their role in the FFEL program, increase accountability, standardize policies and procedures, and reward guaranty agencies for good performance of clearly defined services. By substituting a direct guarantee from the Secretary for the current fiction that guaranty agencies are insurers, compliance costs will be substantially reduced for lenders that currently must track and comply with the changing practices of the 36 guaranty agencies. Additionally, the reduction of the program's complexity would provide an opportunity for us to consider new approaches to streamline lender operations, reduce unnecessary paperwork, and take full advantage of new technologies. This can reduce lender costs making student loans more profitable. The Administration is also pursuing other methods of improving lender profitability, such as reducing regulatory burdens, and is willing to explore using an instrument to set the interest rate that may be even more efficient for lenders than the Treasury Bill.
We have been asked whether our interest rate proposal will encourage smaller banks to leave the FFEL program en masse. The answer is no. Most of the smallest banks that participate in the FFEL program sell their loans shortly after origination to secondary markets and large banks. These small originators frequently receive capital and servicing capacity from the secondary markets, are guaranteed a net interest spread while they own the loans, and then transfer the loans to the secondary markets, usually at a premium guaranteed by the secondary market in advance. Such originating banks are essentially in a service business, acting as brokers for the secondary markets. Since secondary market participants will still find this a profitable activity, there should still remain scope for small lenders to participate as brokers for secondary markets.
Furthermore, smaller banks have been leaving the FFEL program for a variety of reasons including consolidation in the financial services industry, transfer of over 34 percent of the loan volume to the Direct Loan program, and the small size of most banks' loan volume. Since the mid 1980s, the number of lenders in the FFEL program has declined from over 11,000 to under 5,000. This reduction in the number of lenders has not resulted in inadequate capital in the FFEL program, but rather in a concentration of loans with the largest lenders -- currently, the 25 largest banks account for about 55 percent of new loan volume. This consolidation is likely to continue regardless of how interest rates are calculated for student loans. We have no reason to believe that the Administration's proposal will dramatically accelerate the existing trend, even for those few small banks that still hold loans through repayment. However, if these lenders did leave the program, we expect that other FFEL lenders could easily step in to fill the gap. Half of the banks currently originate less than one percent of the total origination volume.
Congress has ample time to act on the Administration's proposal before the July 1 scheduled change. Therefore, we do not anticipate any problems with the availability of loan capital in the FFEL program. If there are any problems, however, the Department is prepared to ensure the availability of FFEL loans for all students. Congress has given to the Department two tools to ensure that students continue to have access to the funds they need in the FFEL program. First, if called upon by the Secretary of Education, Sallie Mae is required by law to act as a lender of last resort and to serve any eligible students who cannot get loans from other sources. Second, the guaranty agencies are also required by law to act as lenders of last resort or to arrange for other entities to act as a lenders of last resort on their behalf, and the Secretary of Education has the authority to advance federal capital to guaranty agencies to be used for funding last-resort loans. With regard to the Direct Loan program, schools are always welcome to enter the program, and we must ensure that we have the capacity to respond to these requests. However, we neither seek nor expect to use the Direct Loan program as the primary "backstop" for loan access. As always, it remains an option for schools that choose it. We are absolutely committed to ensuring that all students have access to the loans they need to attend college.
Thank you for this opportunity to share the Administration's position on this pressing issue. We look forward to working with you to enact legislation that ensures continued access to FFEL loan funds, while providing the lowest interest rates possible for students. It has been my pleasure to testify before you today, and I would be happy to respond to any questions that you may have.-###-