Archived Information


Statement by

Marshall S. Smith
Deputy Secretary (A)


The Federal Direct Student Loan Program

June 17, 1999

Committee on Government Reform
Subcommittee on Criminal Justice, Drug Policy, and Human Resources


Mr. Chairman and Members of the Subcommittee:

I welcome the opportunity to speak with you today about the Federal Direct Student Loan program, which I regard as a cornerstone for the federal government's efforts to reform its student loan programs to improve customer satisfaction, strengthen financial management, and reduce costs for both students and taxpayers.

As you know, prior to 1994, all of the Department of Education's Stafford student loans were made through the Federal Family Education Loan (FFEL) program. The FFEL program encourages private lenders to make loans to students by subsidizing lenders and guaranteeing student loans against default. In fiscal year 1994, the FFEL program provided $20.7 billion in new loans to 4.0 million students. This year, the FFEL program will provide a similar amount of new loans: $20.4 billion to 3.5 million students.

Established five years ago, the Direct Loan program funds student loans with federal capital and is administered by private companies under performance-based contracts that are awarded competitively. The Direct Loan program is roughly half the size of the FFEL program and will provide $10.6 billion in new loans this year to help 1.9 million students afford a postsecondary education.

Today, I will discuss (1) the impetus for the Direct Loan program in 1993 and the challenges it has faced, (2) how the competition between the two loan programs has benefited students, schools, and taxpayers, and (3) the federal costs of FFEL and direct loans and the recent study on this subject by the Department of Education's Inspector General.

The Origin of Direct Loans

In 1993, the FFEL program was in need of serious reform. Different lenders often had different paperwork, procedures, and schedules, causing confusion and increasing the administrative burdens placed on students and schools. For the most part, loans were processed on paper forms. Perhaps as a result, only 68 percent of schools expressed satisfaction with the FFEL program in a survey by Macro International conducted in 1994-95 (the first year for which data are available).

There was a longstanding need for the Department and our partners to strengthen the financial management of the FFEL program. A series of reports by the General Accounting Office documented its weaknesses and labeled it a "high risk" to taxpayers. The most recent cohort default rate, for students entered repayment during fiscal year 1990, was 22.4 percent. And the program had not received a clean audit opinion at least since the Department of Education was founded in 1980.

Federal subsidies for FFEL lenders and guaranty agencies were high, creating a large and unnecessary expense for taxpayers. Lenders and guaranty agencies faced rules that created financial disincentives to prevent loan defaults or spend federal dollars most prudently.

The Direct Loan program began a new approach. It reduced paperwork for students applying for loans. Graduates found greater flexibility in repaying their loans, including the income-contingent repayment option that allowed them to repay their loans as a share of their income. And direct loan borrowers had just one loan account with a single point of contact regardless of the number of loans they have borrowed, unlike some FFEL borrowers who were required to make payments to several different lenders.

Direct lending offered schools a single set of procedures, faster and more reliable delivery of funds, less paperwork, electronic loan processing, and an emphasis on customer service. Within three years, roughly one-quarter of all schools — over 1,200 of them — chose to leave the FFEL program and join direct lending.

In only five years, the Direct Loan program has become the largest single source of new student loans, originating as many loans as the largest 15 FFEL lenders together. It now holds one-third of one of the largest financial markets in the world.

In part because of its rapid expansion, the Direct Loan program — like many start-up ventures — experienced some growing pains. Federal constraints on procurement and personnel and the difficulty of planning investments through the cumbersome and sometimes contentious annual budget process contributed to this challenge.

A 1997 transition between private-sector contractors disrupted and delayed the origination of new loans. The transition also caused difficulties in consolidating loans, leading the Department to suspend accepting applications for direct consolidation loans for three months while it re-engineered the consolidation process.

However, the Direct Loan program's origination and consolidation operations under the new contractor have been running smoothly since late 1997. Our contractor processes 99 percent of loan origination records within 12 hours. The consolidation loan program is another success story: between July 1998 and January 1999, when a lower interest rate was temporarily available on direct consolidation loans, our contractor's weekly volume increased as much as tenfold. In those seven months, our contractor consolidated the loans of about 200,000 borrowers, usually faster than the expected 60 days. In calendar year 1998, the Direct Loan program consolidated $2.9 billion in student loans, nearly as many as the $3.1 billion consolidated by all FFEL lenders put together.

The Benefits of Competition

A new and strong competitor, the Direct Loan program helped inspire FFEL lenders to improve their service. Improvements to the FFEL program over the past five years include simpler and faster loan processing, new income-sensitive repayment options, a common manual of loan policies, and improved entrance and exit counseling to help borrowers understand their obligations and avoid default.

As a senior FFEL executive told Student Lending Update in 1998, "[Direct Loans] have introduced some ways of doing business and some delivery mechanisms that made the private enterprise wake up a little bit. To be perfectly honest, as a private enterprise we thought we were doing almost an A-plus job. When we stepped back a little bit, we saw some of the things the Department of Education was doing and we realized we weren't. . . It's been relatively good for the industry, particularly for the recipients in terms of students and schools."

And in a 1999 assessment of the Direct Loan program, Macro International stated, "Virtually no one disputes that the operation of an alternative loan program has produced a competition that inspired innovation and service — to the benefit of all borrowers and schools."

Due primarily to improved service in the FFEL program, satisfaction with both student loan programs among schools increased from 68 percent in 1994-95 to 81 percent in 1997-98.

While I am pleased by this increase, the satisfaction of direct loan schools remains too low. Satisfaction among direct loan schools dropped in academic year 1996-97, probably because of the service disruptions caused by a transition between contractors, and had not yet fully recovered by last year. The new performance-based organization has embraced this challenge and my colleague, Greg Woods, will speak to those efforts in a few minutes.

School Satisfaction by Program and Year
Academic Years 1994-95 to 1997-98
Academic Year All Schools Direct Loan Schools FFEL Schools
1994-95 68 % 91 % 68 %
1995-96 80 83 79
1996-97 78 64 83
1997-98 81 71 84

Source: Macro International, Survey of Institutions Participating in the Federal Direct Loan and Federal Family Education Loan Programs: Academic Year 1997-98, Appendix A, page 8.

Students and parents borrowing from both programs are generally satisfied with their loan experience. A 1998 Macro survey of borrowers in school found that 96 percent of direct loan borrowers and 93 percent of FFEL borrowers were satisfied with their loan program. And a 1999 Macro survey found that, among borrowers in repayment, 87 percent of direct loan borrowers and 91 percent of FFEL borrowers were satisfied. Of course, the Department is also looking at ways to improve satisfaction among these customers.

The Department is committed to continuing to evaluate ourselves against customer satisfaction. In fact, we plan to establish customer satisfaction as one of the performance-based organization's three core performance measures (along with employee satisfaction and reduced unit costs). We are now studying how best to collect satisfaction data.

With the help of Congress and our partners, the Department has also strengthened the financial management of the loan programs. The national cohort default rate has been reduced from 22.4 percent five years ago to a record-low 9.6 percent. At the same time, collections on defaulted loans have more than doubled, from $1 billion in fiscal 1993 to $2.2 billion in fiscal 1998. As a percentage of outstanding defaults, annual collections have increased by two-fifths, from 6.6 percent in fiscal 1993 to 9.2 percent fiscal 1998.

By improving the quality of data in the National Student Loan Data System, we have prevented the disbursement of as much as $400 million in grants and loans to ineligible students in academic year 1998-99. These and other improvements to the loan programs helped the Department receive an unqualified opinion from its auditors on its fiscal 1997 financial statement.

Federal subsidies for banks and guaranty agencies have been pared down, reducing costs to taxpayers and allowing Congress and the President to further reduce interest rates for students. As a result of the reforms of the past five years, taxpayers have saved $1.6 billion in payments to FFEL financial institutions while students have saved $4.7 billion on their loans.

In summary, there was little competition in the FFEL program in 1993. The Direct Loan program gave students and schools a choice, injecting healthy competition into the marketplace. Today, we have two leaner, more competitive, customer-focused, technology-based programs. That's good news for students, families, schools, and taxpayers.

Federal Cost of Student Loans

The Direct Loan program is substantially less expensive for taxpayers than the FFEL program. Each FFEL loan is nearly twice as expensive for taxpayers as a comparable direct loan, under current economic assumptions. As a result, Direct Loans will "save" taxpayers $700 million this year, compared to the federal cost if all direct loans had been made through the FFEL program.

Federal costs are categorized differently between the two loan programs and, therefore, it is easy to misunderstand the relative costs to taxpayers. Both loan programs incur administrative costs and "subsidy costs," which include interest subsidies, default costs, and other expenses.

However, Direct Loan administrative costs paid for by the federal government include all expenses for originating and servicing loans and maintaining loan data. Federal administrative funds for the FFEL program, in contrast, mainly pay for transmitting and receiving payments from FFEL financial institutions and for maintaining data. The costs of originating and servicing FFEL loans are paid by lenders and are not considered federal administrative costs (although taxpayers help pay for these costs indirectly through subsidies to lenders and guaranty agencies).

Because of these additional responsibilities, the federal government spends more to administer the Direct Loan program than to administer the FFEL program. However, the Direct Loan program is still less expensive for taxpayers because of the large difference in subsidy costs between the two programs.

Both the Administration and the Congressional Budget Office (CBO) estimate that subsidy costs are much higher in the FFEL program than in the Direct Loan program. The Administration estimates that the federal government will pay $13.32 in subsidy costs for every $100 loaned through the FFEL program this year over the life of those loans, compared to only $0.39 for every $100 of direct loans. The CBO estimates these subsidy cost figures to be $16.32 and $1.52, respectively. [1] (These subsidy cost estimates will vary over time with economic assumptions, as do many other estimated federal costs.)

The following table demonstrates that, despite its lower federal administrative costs, the FFEL program costs taxpayers nearly twice as much as the Direct Loan program per $100 in loans, under current economic assumptions.

Total Estimated Federal Costs Over the Life of the Loan, Per $100 in Loans
Loans Made in Fiscal Year 1999
  FFEL Program Direct Loan Program
Federal Administrative Costs $ 1.94 $7.82
Net Federal Subsidy Costs $13.32 $0.39
Total Federal Costs $15.26 $8.21

Source: U.S. Department of Education calculations.

The Subcommittee will hear today from the authors of a recent study — begun by Macro International and completed by the Department's Inspector General — of Direct Loan and FFEL costs. The report estimated that the Department paid $17 per loan to administer the Direct Loan program, $4 more than it might cost a large private lender manage a similar loan portfolio. We welcome the findings of this study, which I hope will help us reduce direct loan administrative costs and improve our internal accounting as we modernize the student aid systems.

However, I am concerned that some have misunderstood the study and wrongly concluded that the Direct Loan program is more expensive for taxpayers than the FFEL program. It is important to understand that the report does not indicate the total cost to the taxpayer of these programs. It examines administrative costs and subsidy costs separately and does not calculate a comparison of the total costs of the programs to taxpayers.

Nor does the Inspector General's report compare actual administrative costs between the two programs. It compares documented Direct Loan costs with estimates of what it might cost a large FFEL lender to manage the same loans, but it does not report actual administrative costs in the FFEL program or consider federal costs in running the FFEL program.

Nonetheless, the report's conclusion that the Department can reduce its Direct Loan administrative costs is well taken. The report set the bar high: the FFEL operations it considered are mature and among the most efficient in the FFEL industry. Moreover, private sector companies are generally more nimble and less constrained in managing personnel and procuring services.

However, reducing administrative costs is one of the statutory priorities of the new performance-based organization. Although we believe that our management costs are comparable to the more efficient private operations, we also believe that there is room for improvement. We accept the challenge and look forward to meeting it.


The student loan programs have come a long way since the Direct Loan program was established in 1994. Major improvements to the program include:

Now, the loan programs are poised for further improvements. Last fall, Congress passed legislation establishing the federal government's first performance-based organization (PBO) to administer the student aid programs with greater management flexibility, accountability for results, and incentives for high performance. The Administration supported this law and prepared to implement it many months before its passage by preparing to reorganize our offices and beginning a search for the first Chief Operating Officer (COO) for Student Financial Assistance.

We found that COO in Greg Woods, and he has hit the ground running. I believe Mr. Woods has the right mix of experience, including eight years as CEO of a software company and five years at the Reinventing Government initiative, to make the PBO a success. He is now working under a performance agreement with Secretary Riley, which describes his objectives and performance measures. I believe that the PBO has the potential to dramatically improve the operation of all of our student financial aid programs.

I will let Mr. Woods speak to his plans for improving the administration of student loans. After he concludes, I would be happy to answer any questions you may have.

1 Congressional Budget Office, Baseline Projections for the Student Aid Programs, March 1999.


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