Federal Student Loans: Flexible Agreements with Guaranty Agencies
Warrant Careful Evaluation (31-JAN-02, GAO-02-254).		 
                                                                 
The relationship between the Department of Education and	 
state-designated guaranty agencies that run the largest federal  
student loan program is changing in order to achieve program and 
cost efficiencies and improve delivery of student financial aid. 
These state or private not-for-profit agencies guarantee payment 
if students fail to repay loans obtained through the Federal	 
Family Education Loan programs. The 1998 Amendments to the Higher
Education Act authorize the Secretary of Education to enter into 
"voluntary flexible agreements" (VFA) with individual guaranty	 
agencies. These agreements allow a guaranty agency to waive or	 
modify some of the federal requirements that apply to other	 
guaranty agencies. GAO found that the process for developing the 
agreements did not fully meet the needs of the guaranty agencies 
and other program participants. The process frustrated guaranty  
agency officials GAO talked to, especially those who ultimately  
chose not to apply for a VFA and those who were not granted a	 
VFA. Agency officials said that Education's communication about  
the VFA development process was poor and that Education was	 
unable to meet its own timetable. The VFAs generally complied	 
with most of the legislative requirements. However, one of the	 
four agreements does not conform to the requirement that	 
projected federal program costs not increase due to the 	 
agreements. The key changes implemented under the VFAs include	 
incentive pay structures for guaranty agencies and waivers of	 
certain statutory and regulatory requirements. Each VFA contains 
provisions for paying the guaranty agency incentive amounts on	 
the basis of specific performance measures, such as default	 
rates. Education is not prepared to assess the effects of VFAs	 
because it lacks a way to adequately measure changes in guaranty 
agency performance. The lack of uniform measures makes it	 
difficult to distinguish the results of the VFAs from the effects
of other factors, such as the general condition of the economy.  
Although the Department is required to report on the status of	 
the VFA by September 2001, no reports have been issued so far.	 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-02-254 					        
    ACCNO:   A02664						        
  TITLE:     Federal Student Loans: Flexible Agreements with Guaranty 
Agencies Warrant Careful Evaluation				 
     DATE:   01/31/2002 
  SUBJECT:   Delinquent loans					 
	     Student financial aid				 
	     Student loans					 
	     Lending institutions				 
	     Loan defaults					 
	     Loan repayments					 
	     Federal/state relations				 
	     Federal Family Education Loan Program		 
	     William D. Ford Federal Direct Loan		 
	     Program						 
                                                                 

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GAO-02-254
     
                  United States General Accounting Office

GAO

Report to the Honorable

James M. Jeffords, U.S. Senate

January 2002

FEDERAL STUDENT LOANS

Flexible Agreements with Guaranty Agencies Warrant Careful Evaluation

GAO-02-254

Contents

Letter

Results in Brief
Background
VFA Development Process Did Not Fully Meet Participants' Needs
Most VFA Provisions Complied with Legislative Requirements;

However, Compliance with the Projected Federal Cost

Requirement Is Questionable Changes Offer Potential for Improved Performance
Education Is Not Fully Prepared to Evaluate VFAS Conclusions Recommendations
for Executive Action Agency Comments 1

2 4 7

9 12 16 18 19 20

Appendix I Scope and Methodology

Appendix II Comparison of Projected Federal Costs with California Trigger
Default Rate at 2.6 or 3 Percent

Appendix III Summary of VFA Financial Provisions

Appendix IV Comments from the Department of Education

Appendix V GAO Contacts and Staff Acknowledgments 36

GAO Contacts 36 Staff Acknowledgments 36

Tables

Table 1: Status of VFA Proposals from the Nine Guaranty Agencies That
Applied 6

Table 2: Education's Projected Increase (Decrease) in Net Federal Program
Costs as a Result of Voluntary Flexible Agreements 10

Table 3: Estimated Present Value Noninterest Federal Costs for

California Loans That Would Default at a 3 and a 2.6

Percent Trigger Default Rate  in Fiscal Year 2001-27 Table 4: Summary of VFA
Financial Provisions 30

 Figures
                     Figure 1: National Trigger Loan Default Ratea Declined until an
                                 Increase in Fiscal Year 2001.                        16
                             Figure 2: VFA and Non-VFA Guaranty Agencies Experienced
                          Trigger Default Rate Declines through 2000                  29

Abbreviations

FDLP William D. Ford Direct Loan program
FFELP Federal Family Education Loan Program
HEA Higher Education Act
VFAs voluntary flexible agreements

United States General Accounting Office Washington, DC 20548

January 31, 2002

The Honorable James M. Jeffords United States Senate

Dear Senator Jeffords:

In an attempt to achieve program and cost efficiencies and improve delivery
of student financial aid, the relationship between the Department of
Education (Education) and state-designated guaranty agencies that administer
the nation's largest federally supported student loan program continues to
change. These state or private not-for-profit agencies, which guarantee
payment to banks and other lending institutions if students fail to repay
loans obtained through the Federal Family Education Loan Program, operate
under federal regulations issued by Education and agreements with Education.
The 1998 amendments to the Higher Education Act (HEA) authorize the
secretary of Education to enter into "voluntary flexible agreements" (VFAs)
with individual guaranty agencies. Each VFA provides a guaranty agency
flexibility to implement new business practices by waiving or modifying some
of the requirements established under federal regulations that apply to
other guaranty agencies. As of November 2001, Education had signed VFAs with
four of the nation's 36 guaranty agencies. Five other guaranty agencies
applied, but were not selected, withdrew, or did not reach agreement with
Education.

Although the 1998 VFA legislation gave Education flexibility in developing
these agreements with the guaranty agencies, it also imposed some
restrictions. For example, while the agreements could potentially change
almost any aspect of how the guaranty agencies are compensated for services
by Education, the VFA legislation prohibited the agreements from increasing
projected federal program costs. Additionally, the agreements could change
how the guaranty agencies process loans, but the VFA legislation prohibited
the agreements from changing the statutory terms and conditions of loans,
such as the borrowers' interest rate. Some guaranty agencies and other
program participants, such as representatives of lender and loan servicing
groups, told us that Education could have done a better job in developing
the agreements and some expressed concern that the agreements may not have
entirely complied with the restrictions contained in law. You asked us to
examine these matters. Specifically, as agreed, we focused on answering the
following questions:

1. To what extent did the VFA development process meet the needs of guaranty
agencies and other program participants?

2. To what extent do VFAs comply with requirements in the VFA legislation?

3. What changes are being implemented under the VFAs?

4. How well prepared is Education to assess the effects of the VFAs?

For this study, we interviewed Education officials involved in the
development of the VFAs as well as officials at each of the 9 guaranty
agencies that applied for an agreement and 10 of the guaranty agencies that
chose not to apply. We also discussed the VFAs with other program
participants, such as representatives of lender and loan servicing groups.
We reviewed the four, signed agreements for compliance with the provisions
in the VFA legislation. We used Education's analyses to determine whether
the VFAs complied with the requirement not to increase projected federal
program costs. We performed our work between February and December 2001 in
accordance with generally accepted government auditing standards. For
details concerning our scope and methodology, see appendix I.

The VFA development process did not fully meet the needs of the guaranty
agencies and other program participants. The overall process, which began
when Education invited all guaranty agencies to submit a VFA proposal,
frustrated guaranty agency officials we talked to, especially those who
ultimately chose not to apply for a VFA and those that were not granted a
VFA. Frustrations stemmed, in part, from Education's insufficient
communication regarding the VFA development process and its inability to
meet its own timetable-the first VFA was not signed until almost a year
after Education's scheduled date. Most of the officials from agencies that
submitted proposals expressed some dissatisfaction with the delays and the
lack of communication from Education about their proposals-especially with
respect to how the cost analyses were performed by Education. In addition,
program participants other than guaranty agencies said that Education
provided them insufficient opportunities and information to examine and
comment on the proposed agreements. These participants were also concerned
about the absence of a more formal process for determining VFA selection
criteria and for inviting VFA proposals.

Results in Brief

The VFAs generally complied with most of the legislative requirements. For
example, we found that as required by the VFA legislation, the agreements
made no changes to the statutory terms and conditions of the loans. However,
one of the four agreements does not conform to the requirement that the
projected federal program costs not increase due to the agreements. The
agreement increased projected costs for the guaranty agency by about $1
million per year-an increase Education considered insignificant when
compared with the federal cash flows being estimated. In addition, Education
limited the projected cost comparisons of the VFAs to the first 3 years; by
doing this, Education concluded that the agreements complied with the
statutory requirement that the VFAs not increase projected federal program
costs. This may not be a valid conclusion because three of the four VFAs
last for an indefinite period of time, and after year 3, Education's
analysis showed that projected costs for these agreements would increase
substantially.

The key changes implemented under the VFAs include incentive pay structures
for guaranty agencies and waivers of certain statutory and regulatory
requirements. Each VFA contains provisions for paying the guaranty agency
incentive amounts based on specific performance measures, such as default
rates. The VFA agencies are establishing programs aimed at enhancing
performance to earn incentive payments. The VFAs also waive certain
statutory and regulatory requirements for servicing loans and processing
claim payments for defaulted loans to test whether alternative processes are
more effective. In contrast, guaranty agencies without VFAs do not receive
similar incentive payments for improved performance and do not have
regulatory requirements waived; however, officials from several of these
agencies told us they have efforts under way to reduce defaults.

Education is not fully prepared to assess the effects of VFAs. The
agreements went into effect without Education having established a way to
adequately measure changes in guaranty agency performance as a result of the
VFA through comparisons with past performance and with the performance of
other guaranty agencies. For example, Education does not have a way to
uniformly measure the net effect of activities such as customer service or
agencies' efforts to keep delinquent loans from defaulting. For the latter,
a commonly used measure is the "cure rate" (the rate at which guaranty
agencies and lenders keep borrowers who are delinquent in their payments
from defaulting on their loans). How this measure is calculated currently
varies from guaranty agency to guaranty agency. Without uniform measures it
would be difficult to distinguish the results of the VFAs from the effects
of other factors, such as the general

condition of the economy. The VFA legislation did require that, by September
30, 2001, Education report on the status of the VFAs, including a
description of the standards by which each agency's performance under the
agreement was assessed and the degree to which each agency achieved the
performance standards. However, as of this time, no report had been issued.

We are making recommendations to the secretary of Education to improve the
four current VFAs and the development of any additional VFAs. We provided
Education a draft of this report for comment. In a letter dated January 23,
2002, Education indicated that they had some concerns about the report. In
general, Education had concerns about our characterization of the VFA
development process, and our conclusions related to the cost analyses and
about the need for additional uniform measures of performance. For example,
Education said that in its view the VFAs comply with the requirement that
projected federal costs not increase due to the VFAs. We continue to
question this view and maintain that a reassessment of projected costs is
needed. We discuss these and other comments from Education and where
appropriate, we made changes to the report to address Education's comments.
(See app. IV for a copy of Education's letter).

                                 Background

The federal government supports two major loan programs for postsecondary
students under Title IV of HEA: the Federal Family Education Loan Program
(FFELP) and the William D. Ford Direct Loan Program (FDLP). In 2000, FFELP
and FDLP provided approximately $23 billion and $10 billion, respectively,
in loans and loan guarantees to postsecondary students and their parents.
Both programs provide subsidized and unsubsidized Stafford loans, Parent
Loans for Undergraduate Students and Consolidation loans. Under the FFELP,
private lenders, such as banks, provide loan capital. The federal government
guarantees the loans but uses 36 guaranty agencies to administer many
aspects of the program. With federal funding, these guaranty agencies
generally provide insurance to the lenders for 98 percent of the unpaid
amount of defaulted loans.1 The guaranty agencies also work with lenders and
borrowers to prevent loan defaults and collect

1 For eligible loans first disbursed before October 1, 1993, 100 percent of
the amount of the loan is insured.

on the loans after default. In contrast, under the FDLP the federal
government provides the loan capital to borrowers.

For over a decade, GAO has included student aid programs on a list of
"high-risk" federal programs. These programs are designated high-risk
primarily because of deficiencies in Education's maintenance of the
financial and management information required to administer the student aid
programs and the internal controls needed to maintain the integrity of the
programs. Over the years Education has addressed many of the high-risk
issues identified by GAO; however, these long-standing conditions continue
to plague the student aid programs.

To achieve FFEL program and cost efficiencies, and to improve the
availability and delivery of loans, the VFA legislation of 1998 authorized
VFAs between Education and the state-designated guaranty agencies. The VFA
legislation restricted Education to six VFAs through fiscal year 2001, and
as of January 2002, Education had entered into agreements with four guaranty
agencies. Five other guaranty agencies applied for VFAs but either were not
selected or failed to reach agreement with Education (see table 1). Since
the beginning of fiscal year 2002, Education has had the authority to enter
into VFAs with all of the guaranty agencies.

    Table 1: Status of VFA Proposals from the Nine Guaranty Agencies That
                                  Applied

Guaranty agency

Status of VFA

Great Lakes Higher Education Guaranty Agreement signed November 27,
Corporation serving Minnesota, Ohio, Puerto 2000; effective October 1, 2000
Rico, Wisconsin, and the Virgin Islands

California Student Aid Commission Agreement signed March 15, 2001; effective
January 31, 2001

The Massachusetts Higher Education Agreement signed March 15, 2001;
effective January 1, 2001Assistance Corporation (American Student
Assistance) serving the District of Columbia and Massachusetts

Texas Guaranteed Student Loan Corporation Agreement signed March 15, 2001,
effective March 15, 2001, with financial provisions effective October 1,
2000 Pennsylvania Higher Education Assistance Agency serving Delaware,
Pennsylvania, and West Virginia

                            Withdrew application

Colorado Student  Loan Program Selected, but negotiations  did not result in
an agreement

New York State Higher Education Services

                                Not selected

Corporationa

Illinois Student Assistance Commissiona Not selected

Georgia Higher Education Assistance Withdrew application Corporation

aThe New York and Illinois guaranty agencies submitted a joint application.

In May 1999, Education officials discussed VFAs with guaranty agency
representatives who were attending a conference hosted by the National
Council of Higher Education Loan Programs, Inc. Two months later, notice of
invitation for any of the 36 guaranty agencies to apply for a VFA appeared
in the Federal Register. The Register Notice included five "criteria"
Education planned to use in its evaluation of the proposals for the VFAs,
including (1) how the agency's proposed VFA could be extrapolated and easily
used by other FFEL participants; (2) how the proposal would improve the
"system" for delivering and servicing of loans for borrowers and schools;
(3) if and how the proposal uses new technology; (4) the impact the proposal
would have on overall operating costs for the agency and its partners,
including Education; and (5) a description of any proposed waiver of the
prohibited inducement restrictions (prohibited inducements are efforts by
guaranty agencies to encourage schools, borrowers, or lenders to submit
applications for loan guarantees through direct or indirect premiums,
payments, or, for example, uncompensated services such as loan processing
services normally performed by lenders).

VFA Development Process Did Not Fully Meet Participants' Needs

The VFA development process did not fully meet the needs of guaranty
agencies and other program participants. Most of the guaranty agency
officials we talked to indicated frustration in one or more steps of the
process, which began when Education invited all guaranty agencies to submit
VFA proposals. Guaranty agency officials were particularly dissatisfied with
Education's lack of communication about the VFA development process and its
inability to meet its own timetable. Program participants other than
guaranty agencies, such as representatives of lender and loan servicing
groups, said that the opportunities for examining the proposed agreements
were insufficient. Also, these program participants criticized Education for
not using a more formal process for determining VFA selection criteria and
inviting VFA proposals. In response to these criticisms, Education explained
that some of the delay in the VFA development process was the result of
broader changes at Education and turnover of key staff assigned to the VFA
project. Additionally, Education noted that it had taken extra actions-such
as posting the draft agreements to an Internet site-to facilitate public
comment on the VFA draft agreements. In commenting on a draft of the report
it also noted that some guaranty agencies and other program participants
that we consulted had been opposed to the VFA legislation from its
inception.

Guaranty Agencies Criticize Education's Efforts during VFA Development
Process

According to the guaranty agency officials we talked to, after the
invitation process, Education did not communicate adequately with guaranty
agencies after failing to stay on schedule. Most of these guaranty agency
officials, including those that were generally supportive of Education,
expressed a variety of concerns about Education's communication efforts
during the VFA development process. For instance, several guaranty agencies
indicated a need for more information on Education's methodology for
analyzing the projected federal program costs of the VFAs, or on Education's
five criteria for selecting the VFAs.

Furthermore, the established timetable was not met. Education indicated it
would select the six initial guaranty agencies within two weeks after the
application deadline of August 27, 1999, but the notice of selections did
not occur until February 2000. Education set December 1, 1999, as the target
date for signing the VFAs; however, the first VFA was not signed until
November of 2000 and the other three were not signed until March 2001.
Guaranty agency officials told us that criticisms of Education's failure to
meet its own timetable would have been somewhat mitigated if Education had
done a better job in communicating the status of the VFAs to the guaranty
agencies. In response to these criticisms, Education officials explained
that the process was hampered by organizational

changes and staff turnover that occurred during the VFA development process.
For instance, officials told us that delays were partially the result of
Education's decision to place a higher priority on developing regulations
for implementing other 1998 HEA amendments and on reorganizing the Office of
Student Financial Assistance as a performance-based organization.2 Education
officials also indicated that turnover of key personnel assigned to the VFA
project as well as disagreements within Education concerning, for example,
evaluations of the costs of VFAs contributed to the delays in the VFA
development process.

Other Program Participants Also Had Concerns about the Development Process

Although Education provided opportunity for public comment, program
participants other than guaranty agencies-for instance, representatives of
lender groups such as the Consumer Bankers Association-said these
opportunities were insufficient. Education posted each draft agreement for
about a 2-week period on the Internet in order to allow interested third
parties the opportunity to comment on the agreements. However, some third
parties told us that information available on the Web site was insufficient
to evaluate the draft agreements and that Education did not provide
responses to those who commented on the draft agreements. In response to
this, Education officials told us that the Internet posting was not required
by the VFA legislation, but that they did so to increase opportunities for
public comment. Additionally, Education staff have recently begun meeting
with a variety of student loan industry participants to discuss ongoing VFA
concerns.

Program participants other than guaranty agencies also criticized Education
for not using a more formal process in determining VFA selection criteria
and inviting VFA proposals. A couple of third party participants we talked
to said the selection criteria should have been developed through a
rulemaking process similar to that used to develop federal regulations.
Another participant said that VFA proposals should have been solicited
through a more formal process, such as those used in federal contracting
procedures. According to Education, however, because the agreements were
specifically authorized by statute and involved state-designated, not
competitively selected, entities, Education

2Authorized by the 1998 HEA amendments, the performance-based organization
concept creates a "results-driven" organizational structure that uses
incentives to encourage high performance while establishing explicit
performance objectives to enhance accountability. This approach allows for
greater managerial flexibility in an effort to seek innovations and achieve
efficiencies.

Most VFA Provisions Complied with Legislative Requirements; However,
Compliance with the Projected Federal Cost Requirement Is Questionable

was not subject to legal requirements applicable to the rulemaking process
and that it was not required to use the more formal contracting process.

In commenting on a draft of this report, Education noted that some guaranty
agencies and third party program participants had been opposed to the VFA
legislation from its inception, and not surprisingly continued to be
dissatisfied with the implementation of the VFAs.

VFA provisions complied with most of the legislative requirements. For
instance, we found that as required by the VFA legislation, the agreements
made no changes to the statutory terms and conditions of the loans. However,
we were not convinced that the agreements conform to the requirement that
the projected program cost to the government not increase due to the VFAs.
For one VFA, Education projected federal program costs would increase each
year of the 3-year analysis period. Furthermore, the agreements appear to
have violated the cost requirement if Education's cost determination had
been based on a different time period, or if the analyses had been based on
changes in assumptions about certain factors, such as default rates.

The authorizing statute specifies, "in no case may the cost to the Secretary
of the agreement, as reasonably projected by the Secretary, exceed the cost
to the Secretary, as similarly projected, in the absence of the agreement."
Education's budget service analyzed each of the four VFAs in the course of
Education's negotiations with the guaranty agencies and concluded that each
agreement met the requirement. However, Education's analysis of the Texas
VFA projected that federal costs will increase an average of about $1
million a year. Budget service staff indicated that they regarded this
amount as insignificant compared with total federal cash flows being
estimated. Education's estimates for the Texas agency show that the
projected amount of collections on defaulted loans less federal program
costs is an average of $161 million per year over fiscal years 2001 to 2003.
An alternative basis of comparison could be to use the projected net amount
of the agency's receipts from federal sources and its retentions of
collections (an average of $71 million per year over the same time period).
In either case, the projected increase is not consistent with the VFA
legislative requirement that the projected federal program costs not
increase due to the VFA.

Our review of Education's analyses raised two additional questions about
Education's conclusion that the VFAs would not increase projected federal
costs.

Costs considered for first 3 years only. First, Education based its
conclusion on projected costs for only the first 3 years, while Education's
projections show that costs for three VFAs would increase substantially in
years 4 and 5. As table 2 shows, during the first 3 years, only the Texas
agreement (discussed above) was projected to cause an increase in federal
costs. By including projections for the fourth year or for both the fourth
and fifth year, however, costs for three of the four VFAs would rise, with
costs for the Texas and Great Lakes guaranty agencies rising substantially.
These increases would occur as the size of these guaranty agencies' loan
volumes and the cumulative size of their portfolios increase.

Table 2:  Education's Projected  Increase (Decrease) in  Net Federal Program
Costs as a Result of Voluntary Flexible Agreements

  Projected cumulative cost increase (decrease) beginning fiscal year 2001

       VFA guaranty agency 3-year period 4-year period 5-year period

                     California Student Aid $ 0 $ 0 $ 0

Commission

        American Student Assistance $ (122,184) $ 101,886 $ 259,849

Texas Guaranteed Student Loan Corporation

                    $ 2,972,499 $ 4,624,526 $ 6,206,608

Great Lakes Higher Education Guaranty Corporation

                   $ (1,000,000) $ 5,000,000 $ 11,000,000

                 Total $ 1,850,315 $ 9,726,412 $ 17,466,457

Education officials and Office of Management and Budget officials said they
took this approach because they viewed the VFAs as demonstration programs of
limited duration to be evaluated by the Congress during the next
reauthorization of HEA. This act is due for reauthorization at the end of
fiscal year 2003. Although the American Student Assistance VFA specifies a
termination date at the end of fiscal year 2003, the other three agreements
have no specified termination date. They each remain in effect until either
the guaranty agency or Education chooses to withdraw with advanced written
notice.

Effects of changes in performance not adequately considered. Second, budget
service officials reached their conclusions about the cost effects of the
VFAs using a set of base year assumptions that did not adequately consider
the effect of changes in guaranty agency performance-that is, they assumed
that such things as default rates, collection rates, and delinquency rates
would remain unchanged in future years. The VFAs were designed to improve
guaranty agency performance

and under the agreements, doing so would mean higher payments to the
guaranty agencies for their improved performance. Thus, analyzing the
proposed payment structures to estimate how such improvements would affect
net federal costs-in the form of lower default rates, for example- seems
warranted. However, according to budget service officials this happened in
only one case and to a limited extent.

In that particular case, budget service staff analyzed the effect of a
decline in loan defaults for the California VFA, and its estimates
illustrate the importance of considering the effect of changes in guaranty
agency performance on federal costs. A provision in the California VFA
provides an incentive payment to the guaranty agency for achieving lower
default payments. At the time this VFA was being developed Education staff
calculated that California's fiscal year 1998 "trigger default rate"3 -was
3.1 percent compared with the aggregate national rate of 2.9 percent. In an
effort to encourage the California guaranty agency to reduce its trigger
default rate, the VFA provides for a payment from Education to the guaranty
agency equal to half of the amount of claims payments avoided by having a
trigger rate below 3 percent. Budget service staff then analyzed the effects
of a decline in trigger default rates below 3 percent- to see how much the
payment would be in the event the agency was able to reduce it's trigger
default rate that much. Education found that the payment to California would
be greater than the savings from the reduced defaults-and thus would result
in increases in federal costs. However, in doing their formal analysis of
the California's VFA, budget service staff did not include the results of
their default analysis and instead assumed no change in the base-year 3.1
percent trigger default rate; thus as table 2 shows, there are no projected
increases or decreases to the costs for that VFA. Subsequently, California's
trigger default rate did drop below 3 percent-down to 2.6 percent for fiscal
year 2001. Our analysis based on Education's estimates shows that the
California guaranty agency's fiscal year 2001 trigger rate of 2.6 percent
entitles it to a VFA incentive payment of about $17.3 million-an amount
approximately $2.6 million greater than the estimated total the government
saved due to the lower volume of defaulted loans. Because there were no
other projected cost

3 The trigger default rate is used to calculate the level of federal
reinsurance payments to guaranty agencies. Higher default rates trigger
lower rates of reinsurance payments- payments from Education to guaranty
agencies' Federal funds reimbursing them for payments to lenders for
defaulted loans. The trigger default rate differs from the more commonly
used "cohort default rates," which generally are the rates at which
borrowers default on their loans within 2 years of beginning repayment.

considerations for this VFA, the decline in loan defaults under the VFA
resulted in an increase in projected net federal costs. Appendix II
discusses this analysis in more detail.

Changes Offer All four agreements contain provisions for incentive payments
for

improved guaranty agency performance, and all four grant waivers to
Potential for certain statutory and regulatory requirements. For the most
part these Improved changes are designed to enhance agency performance, such
as reduce

delinquencies and defaults, while increasing guaranty agency efficiencies.

Performance At the same time, however, guaranty agencies without VFAs told
us that they have efforts under way to improve their agencies' performance-
efforts that did not require the incentive payment structure or waivers
granted for the VFA agencies.

Incentive Payments Reward Improved Performance

The VFAs establish incentive payments that reward a guaranty agency for
better performance.4 The use of these incentive payments offers an
alternative to the traditional guaranty agency payment structure-a structure
some participants describe as containing a perverse payment incentive for
the guaranty agencies. Under the traditional payment structure that
continues to be used for the non-VFA agencies, it is financially more
beneficial for a guaranty agency to allow borrowers to default on their
loans and to subsequently collect on the loans than to prevent defaults in
the first place. A guaranty agency currently retains 24 percent of the money
that it recovers from borrowers whose loans are in default-that is, the
borrowers who are more than 270 days behind in making payments. According to
some guaranty agency officials, this percentage is typically higher than a
guaranty agency's actual cost of collecting on defaulted loans. As a result,
a non-VFA guaranty agency has more financial incentive to "allow" borrowers
to default than to prevent the default upfront.

Three of the four VFAs have incentive provisions that reduce the guaranty
agencies' share of collections on defaulted loans. To compensate for this
lower collection retention rate, the VFAs have enhanced incentives for
better performance. For example, the American Student Assistance VFA reduces
the collection retention rate from 24 percent to 18.5 percent for

4 The cost of these payments was included in Education's overall cost
projections for the VFAs, assuming no change in agency performance.

regular collections on defaulted loans in exchange for potentially greater
incentive payments for lower defaults. To implement such incentive
provisions, VFA agencies have created programs aimed at improving their
performance, particularly in the areas of reducing delinquencies and net
defaults. For example:

* To help borrowers with defaulted loans, American Student Assistance
created Bright Beginnings. This program focuses on providing support to the
borrowers and finding solutions to loan default instead of making payment
demands and threatening sanctions for nonpayment, such as wage garnishment
and negative reports to credit bureaus. Help may involve, for example,
working with the borrowers on a strategy to get the education or training
necessary to obtain employment that would provide the income needed to repay
their loans. Additionally, the program points out to borrowers the
advantages of making payments on their loans. For example, if borrowers make
nine consecutive monthly payments they will be eligible for rehabilitation,
a process by which the guaranty agency sells the defaulted loan back to a
lender. Rehabilitation is important because, in addition to being current on
their loan payments, the borrowers become eligible for additional Title IV
student financial aid.

* To avert defaults by borrowers who withdraw from school without completing
their educational program, the California Student Aid Commission is planning
an early-withdrawal counseling program. Individuals who withdraw from school
early are at high risk of defaulting on their loans and the Commission
believes that early intervention by the guaranty agency is more likely to
result in the borrowers being able to avoid default. Under current
regulations, a guaranty agency provides default aversion assistance to
borrowers only after they become 60 or more days delinquent on their loan.
Under the early-withdrawal counseling program, the Commission will contact
borrowers as soon as they withdraw from school. The program plans to educate
borrowers through a variety of services and provide information about their
responsibilities and options for avoiding default.

* To help keep delinquent borrowers from defaulting, Great Lakes Higher
Education Guaranty Corporation and the Texas Guaranteed Student Loan
Corporation are both requiring lenders to submit requests for default
aversion assistance between the 60th and the 70th day of

delinquency.5 Under current regulation lenders can submit requests as soon
as the 60th day or as late as the 120th day to submit such a request. Great
Lakes and Texas guaranty agency officials believe that by helping to contact
delinquent borrowers earlier, they have a better chance to prevent defaults.

Statutory and Regulatory Waivers Are Aimed at Enhancing Guaranty Agency
Performance

The statutory and regulatory waivers granted under VFAs attempt to improve
guaranty agency performance in two ways-by eliminating duplicate or less
effective fiscal, administrative, and enforcement requirements; and by
substituting more efficient and effective alternatives. For example:

* The Great Lakes VFA allows for the elimination of some duplicative
collection efforts that lenders or loan servicers and the guaranty agency
are both required to perform when a borrower became delinquent. Officials
from Great Lakes explained that they were concerned that the duplication of
effort can be confusing and unnecessarily frustrating to borrowers.

* The American Student Assistance VFA grants authority to replace certain
administrative requirements for collection efforts on defaulted loans with
new, more targeted approaches. Current regulations specify in considerable
detail what collection actions must be taken and during what time periods.
For example, after 45 days of delinquency, the guaranty agencies must
"diligently attempt to contact the borrower by telephone." Between 46 and
180 days of delinquency, the agencies must "send at least three written
notices to the borrower forcefully demanding immediate commencement of
repayment." Under the VFA, American Student Assistance has flexibility to
develop procedures it considers to be more efficient utilizing best
practices common to the financial services industry. Agency officials told
us of plans to study borrower behavior to determine the characteristics of
borrowers that are most apt to respond to particular default aversion or
collection efforts.

Guaranty Agencies without While VFAs represent a new approach to such
matters as reducing VFAs Also Taking Steps to perverse payment incentives
and allowing guaranty agencies to be more Improve Performance innovative in
efforts to prevent defaults, they are not the only avenue

5 The  Texas agency allows 5  additional days for receipt  of the request by
mail.

through which important attempts are being made to seek improvements and
innovations in the FFEL program. Guaranty agencies without VFAs are
introducing efforts to reduce delinquencies and defaults. Some of the
non-VFA guaranty agency officials we contacted indicated that they were
uncertain that VFAs are needed in order to improve performance. They believe
their mission provides sufficient motivation to increase efforts to prevent
defaults by, for example, devoting more resources to work with delinquent
borrowers and improving the exchange of information between guaranty
agencies, lenders, schools, and Education. They also said that any
innovations in customer service could be accomplished under current
regulations. For example, the largest guaranty agency, USA Funds, Inc., is
working in cooperation with other guaranty agencies on electronic data
exchange and electronic signature authority. The agency is also implementing
a program to provide students with current and historical student financial
aid information from guarantors, lenders, and secondary-markets, as well as
to deliver services over the Internet.

For most of the guaranty agencies, the trend in recent years has been a
decline in default rates. As figure 1 shows, trigger default rates decreased
steadily through fiscal year 2000. The reasons for this reduction are likely
multiple, including a low unemployment rate (giving more people jobs to pay
off their student loans) resulting from generally favorable economic
conditions during that period. Although many observers also credit the
decline to the effect of more diligent or effective efforts by guaranty
agencies, how much these efforts have contributed is unclear. We were not
able to identify any study that has isolated the effects of these influences
on default rates.

Figure 1: National Trigger Loan Default Ratea Declined until an Increase in
Fiscal

4 Percentage

3

2

1

0

1997 1998 1999 2000 2001

Fiscal Year Year 2001.

aThe trigger default rate, generally, is the amount of defaulted loans as a
percent of the amount of guaranteed loans in repayment. See footnote 3 on
page 11 for details.

Education is not fully prepared to evaluate the results of the VFA
agreements. The agreements went into effect without Education having
developed a clear way to measure changes in guaranty agency performance. For
example, Education does not have a way to uniformly measure satisfaction
among the agencies' customers. Furthermore, it cannot adequately determine
what has happened as a result of the VFAs through, for instance, comparisons
with the results of past efforts to cure delinquent loans and comparisons of
the results of similar efforts by other guaranty agencies. For the latter, a
commonly used measure is the "cure rate" (the rate at which guaranty
agencies and lenders keep borrowers who are delinquent in their payments
from defaulting on their loans). This measure currently varies from guaranty
agency to guaranty agency. It is likely to be difficult to distinguish the
results of the VFAs from the effects of other factors, such as the general
condition of the economy, but without uniform measures the task becomes even
more difficult.

To measure and compare the benefits that result from VFAs, Education needs
uniform performance measures. The data Education routinely

Education Is Not Fully Prepared to Evaluate VFAS

collects from guaranty agencies will provide several comparable measures of
guaranty agencies' performance, such as certain default rates and the
delinquency status of guaranteed loans in repayment.

According to an Education official, Education is working with a consulting
firm to develop additional evaluation measures. Additionally, in commenting
on a draft of this report, Education noted that it is establishing common
measures to evaluate the performance of each VFA. These measures should
provide useful data for comparing non-VFA and VFA guaranty agencies.
However, other measures of VFA guaranty agency performance might not be as
easily compared across the guaranty agencies. For example, Education
currently lacks a means of calculating the cost of the VFAs. Specifically,
it cannot calculate the amount by which VFA provisions increase federal
payments to the VFA agencies, because it does not have a way to determine
the amount of default aversion fees6 that each agency would have received in
the absence of the VFA agreements. Also, the Great Lakes guaranty agency
plans to measure VFA performance, in part, by measuring customer
satisfaction. However, according to guaranty agency and Education officials,
no effort is under way to measure other guaranty agencies' customer
satisfaction in a similar manner, thus making comparisons difficult.

Another example is the lack of uniformity in calculating a cure rate.
Although two of the VFAs specify cure rates as performance measures, these
two guaranty agencies calculate cure rates differently and another guaranty
agency uses a third method to calculate a cure rate.7 A uniformly calculated
cure rate could be a useful indicator of guaranty agencies' success in
preventing defaults for loans that are prone to default

6 HSA provides for default aversion payments of one percent of the amount of
delinquent loans that the guaranty agency helps keep from defaulting. The
amounts received by each agency are subject to independent audit
requirements and Departmental audit, but Education cannot independently
calculate the amounts of the default aversion payments based on data the
guaranty agencies routinely provide to Education.

7 The Great Lakes calculation in based on numbers of accounts cured, not the
dollar amounts involved, and the calculation includes delinquent loans for
which default is averted whether or not the loan had been cured before. The
Texas cure rate is based on the dollar amount of cured loans including loans
that had been cured at least 12 months earlier. Texas counts loans as cured
as long as they do not result in a default claim by the end of the
claim-filing deadline. The guaranty agency with the largest portfolio of
loan guarantees, United Student Aid Funds, Inc, calculates cure rates by
dividing the number of 60-day-or-more delinquent loans that become less than
60 days delinquent by the total number of 60-day-or-more delinquent loans
for which lenders requested default aversion assistance.

Conclusions

(delinquent loans).8 The current inconsistencies in methods of calculating
cure rates make systematic evaluation of VFA results difficult.

The VFA legislation required that Education report on the status of the
VFAs, including a description of the standards by which each agency's
performance under the agreement was assessed and the degree to which each
agency achieved the performance standards. Additionally, Education was
required to include an analysis of the fees paid by the secretary, and the
costs and efficiencies achieved under each agreement. The report was due no
later than September 30, 2001; however, as of this time, no report has been
issued.

The VFA development process did not fully meet the needs of the guaranty
agencies or other program participants. Despite circumstances at Education
that hampered VFA development, such as turnover of key staff, Education
might have been able to develop the VFA with fewer frustrations had
officials better communicated with participants, particularly with respect
to how the cost projections were done. Additionally, a more realistic
initial timetable might have lessened some of the criticism from guaranty
agency officials.

Education's evaluation of the cost effects of the current agreements raises
concerns about whether the federal program costs of current VFAs will grow
in the years ahead to the point that they exceed projected costs in the
absence of the agreements. In particular, we question the time period
Education used for making the cost estimates and the fact that Education did
not generally consider potential changes in agency performance for the cost
estimates. Although projected cost increases were relatively small in
comparison with the total amount of program costs during the first 3 years,
estimates for years 4 and 5 showed substantial growth. Also, the general
lack of a more thorough analysis of VFA costs-including an analysis of how
factors, such as changing default rates might change projected costs-could
leave the government vulnerable to greater than projected costs for the
VFAs.

VFAs are principally aimed at improving guaranty agency performance through
innovative incentive payment structures and in granting waivers

8 Uniform cure rates could be useful whether or not VFAs specify uniquely
calculated cure rates for calculating federal payments.

to statutory and regulatory procedures that might be hampering agency
performance. To that end, the VFAs afforded the guaranty agencies the
opportunity to try new ways of operating. Whether the incentive payments and
waivers used by the VFA agencies improve guaranty agency performance more
than the self-initiated efforts of the non-VFA agencies remains to be
determined.

Measuring the benefits of the VFAs is central in deciding if more VFAs
should be entered into and if current VFA practices should be replicated at
other guaranty agencies. We found that Education is not fully prepared to
evaluate the success of VFAs in part because it does not have adequate
standardized performance measures, such as delinquent loan cure rates.
Without adequate performance measures Education is not well positioned to
judge the success or failure of the VFA provisions.

Recommendations for Executive Action

To improve the VFA development process for any future VFAs, we recommend
that the secretary of Education develop

* a plan to more regularly communicate with guaranty agencies concerning the
status of VFA development efforts, including disclosing to program
participants the planned methods for projecting the federal program cost
effects of VFAs; and

* a timetable for selection, negotiation, and completion of agreements based
on experience developing the first four VFAs.

In order to ensure that all VFAs are in compliance with statutory
requirements, we recommend that the secretary of Education

* renegotiate the Texas VFA as soon as practicable to obtain changes
necessary to ensure that the VFA does not increase projected federal costs;

* renegotiate the California VFA as soon as practicable to obtain changes
necessary to ensure that the VFA does not increase projected federal costs,
with or without changing the trigger default rate;

* renegotiate the Great Lakes and American Student Assistance VFAs for time
periods after fiscal year 2003 to ensure that the VFAs do not increase
projected federal program costs; and

* improve projections of the cost effects of renegotiated VFAs and any
future VFA proposals by (1) requiring that each VFA specify an

Agency Comments

effective time period, (2) conducting a cost analysis covering that period,
and (3) conducting analyses to project the cost effects of changes in
assumptions regarding guaranty agency performance, such as default rates, in
making the cost projections.

To ensure that the results of the VFAs can be effectively evaluated, we
recommend that the secretary of Education

* develop specific evaluation plans enabling Education to compare VFA
guaranty agency performance with past performance and the performance of
other guaranty agencies using uniformly defined performance measures,
including delinquent loan cure rates.

We provided a draft of this report to Education for comment. In its
response, Education indicated that it had a number of concerns about the
report.

Education stated that our mention of GAO's designation of the student
financial assistance programs as "high-risk" (in the Background section) was
beyond the scope of our review and that it detracts from the analysis in the
report. We disagree. The report contains analyses and descriptive
information on many aspects of the FFEL program, which provided
approximately $23 billion of loans for postsecondary students in fiscal year
2000. The mention of the student loan programs as high risk and the ensuing
discussion are important to help establish the significance that any
changes-including the VFAs-might have on the program.

Regarding the development of the VFAs, Education said that it appears that
our conclusions were based primarily on conversations with individual
guaranty agencies that did not apply for a VFA and representatives of
various interest groups, many of which had consistently opposed the VFAs. In
fact, as indicated in our report, our conclusions are largely based on
comments from representatives of 18 guaranty agencies-including
representatives from all four agencies with VFAs; representatives from those
agencies that had unsuccessfully sought a VFA; representatives from agencies
that did not seek a VFA, but may wish to in the future; and representatives
from agencies that had opposed the VFA legislation from the beginning.

Concerning the cost effects of the VFAs, Education stated that it had, in
keeping with its standard procedures for estimating costs, (1) used a closed
time period (in this case, 3 years) to project costs; (2) not

considered the impact of possible changes to borrower or institutional
behavior in projecting costs; and (3) appropriately treated the $1 million
per year projected cost increase for the Texas VFA as "insignificant."

First, in looking at the 3-year time period, Education said that its
conclusions about the cost effects of the VFAs were appropriately limited to
the first 3 years because there was no reason to expect that the agreements
would necessarily remain in effect beyond the time period for
reauthorization of HEA, which may bring changes that could alter any cost
analyses. We agree that the projected increases in federal costs in the
fourth and fifth years would not be relevant if the current agreements no
longer remain in effect after the end of fiscal year 2003. However, since
three of the VFAs are open-ended, there is reason to believe they could
extend beyond three years. Therefore, to ensure that projected federal costs
do not increase due to the VFAs, Education would need to renegotiate the
VFAs for the time period beyond 3 years. Education's statement that, "GAO's
interpretation of the statute as requiring strict 'cost neutrality' over a
long period of time is not supported in the statute or the legislative
history," is incorrect. We did not interpret the statute in this manner.
Instead, our reading of the statute is that the period of time to be
examined should correspond to the projected life of the agreement. As
mentioned above, three of the agreements we reviewed were for an open-ended
period of time. Education chose a 3-year period for their cost analysis,
which is within its discretion and not inconsistent with the statute.
However, the report was intended to make clear that, given the open-ended
nature of the agreements, a decision by Education not to terminate the
agreements after 3 years would warrant a reassessment of the cost
projections and a renegotiation of the agreements, if necessary.

Second, Education stated that it does not base cost estimates on behavioral
assumptions that cannot be supported by available data. We agree that this
is appropriate for baseline estimates, however one of the purposes of the
VFAs is to improve guaranty agency performance, and thus the cost effects of
potential improvements need to be considered in Education's cost
projections. Accordingly, we recommended that Education supplement baseline
estimates with sensitivity analyses in order to avoid provisions that
increase federal costs when an agency's performance improves, by reducing
default rates for example.

Third, with respect to Education's assertion that the projected increase of
$1 million per year for the Texas VFA is "insignificant," we disagree.
Education based its assertion on a comparison of the $1 million to the total
federal cash flows being estimated. The projected amount of

collections on defaulted loans less federal program costs averaged $161
million per year for the 3-year period-an amount lower than the "hundreds of
million of dollars per year" Education cited in its comments. Additionally,
an alternative basis of comparison could be to use the projected net amount
of the agency's receipts from federal sources and its retentions of
collections (an average of $71 million per year for the 3-year period). In
either case, the projected increase is not consistent with the VFA
legislative requirement that the projected federal program costs not
increase due to the VFAs.

Regarding preparations to evaluate the VFAs, Education said that it is
establishing common, general measures to evaluate the performance of each
VFA and, whenever possible, to compare VFA guaranty agency performance with
other non-VFA guaranty agencies. Education noted that it has had preliminary
discussions with representatives of the 36 guaranty agencies regarding
uniform performance measures. Also, it noted that the guaranty agencies are
in the process of establishing an eight-member task force to assist in
determining the specific formulae for measuring VFA performance. As our
report indicates, Education does currently have several possible uniform
measures of agency performance. We welcome its efforts to develop additional
measures, but conclude that a uniform cure rate measure would assist in
evaluating the performance of the VFAs, considering that two guaranty
agencies with VFAs specifically identified a cure rate as a performance
indicator.

We reviewed these and additional Education comments and modified the draft
as appropriate. Education's comments are included in appendix IV.

We are sending copies of this report to Honorable Roderick R. Paige,
secretary of Education; appropriate congressional committees; the guaranty
agencies with VFAs; and other interested parties. Please call me

at (202) 512-8403 if you or your staff have any questions about this report.
Key contacts and staff acknowledgements for this report are listed in
appendix V.

Sincerely yours,

Cornelia M. Ashby Director, Education, Workforce, and Income Security

                      Appendix I: Scope and Methodology

As agreed with your office, we focused our review of voluntary flexible
agreements (VFA) on addressing the following questions:

1. To what extent did the VFA development process meet the needs of guaranty
agencies and other program participants?

2. To what extent do VFAs comply with requirements in the VFA legislation?

3. What changes are being implemented under the VFAs?

4. How well prepared is Education to assess the effects of the VFAs?

To determine the extent to which Education's VFA development process met the
needs of guaranty agencies and other program participants, we interviewed
Education officials involved in the development of the VFAs, officials at
each of the nine guaranty agencies that submitted an application for a VFA,
and nine guaranty agencies that did not submit applications. The nine
guaranty agencies that did not submit applications included the five
guaranty agencies with the largest amounts of loan guarantees and four
randomly selected smaller guaranty agencies that did not submit
applications. 1 We also reviewed VFA proposals and comments Education
received during the public comment period.

To determine the extent to which the VFAs complied with statutory
requirements we reviewed the VFA agreements, provisions of the Higher
Education Act (HEA) concerning the Federal Family Education Loan Program
(FFELP), and related regulations. We also discussed the agreements with
Education and guaranty agency officials, and representatives of industry
associations including the National Council of Higher Education Loan
Programs, Inc. and the Consumer Bankers Association. To review Education's
methods for projecting the costs of the VFA agreements, we examined
computerized schedules Education used to project each VFA guaranty agency's
costs and financial data compiled by Education staff from submissions by the
guaranty agencies. We also discussed these projections with Education's
budget service staff and Congressional Budget Office and Office of
Management and Budget officials.

1 One of five smaller guaranty agencies selected did not respond to GAO
request for input.

Appendix I: Scope and Methodology

To identify changes being implemented under the VFAs we reviewed the VFAs
and discussed them with the guaranty agency officials and reviewed documents
they provided concerning their programs.

In addition, to determine how well prepared Education is to identify the
effects of the VFAs, we discussed plans for evaluation of the VFAs with
guaranty agency officials and Education officials responsible for collecting
and analyzing data from guaranty agencies.

Appendix II: Comparison of Projected Federal Costs with California Trigger
Default Rate at 2.6 or 3 Percent

On the basis of budget service subsidy rate estimates, we projected the
level of noninterest federal costs for $263 million of loans-the amount of
loans that would default if the California guaranty agency's trigger default
rate1 were 3 percent in fiscal year 2001. As shown in table 3 below, we
estimated the net federal costs of these loans (excluding interest subsidy
costs that the budget service indicated would not be affected) under four
different scenarios: (1) a 3 percent trigger default rate with all $263
million of these loans defaulting without the VFA in effect, (2) a 3 percent
trigger default rate with the VFA in effect, (3) a 2.6 percent trigger
default rate with $228 million of the $263 million of loans defaulting
without the VFA in effect, and (4) a 2.6 percent trigger default rate with
the VFA in effect. As shown in table 3, federal noninterest costs for these
loans would be about $107 million under either scenario 1 or scenario 2. In
scenario 3, federal costs would decline by about $15 million to $92 million
as trigger basis defaults decline from 3 percent to 2.6 percent.

Under scenario 4, however, Education would benefit from lower loan defaults,
but it would also have to pay the California guaranty agency half of the
$34.7 million reduction in the amount of claims payments to lenders (a $17.3
million VFA fee). Because the VFA fee exceeds the benefit Education would
realize from the lower level of defaults, federal costs would increase by an
estimated $2.6 million.

1 The trigger default rates are calculated by dividing the total annual
amount of reinsurance payments for defaulted loans (adjusted for loans
brought back from default into repayment status) by the original principal
amount of loans in repayment at the end of the preceding fiscal year.

Appendix II: Comparison of Projected Federal Costs with California Trigger
Default Rate at 2.6 or 3 Percent

Table 3:  Estimated Present  Value Noninterest Federal  Costs for California
Loans That  Would Default at a  3 and a 2.6 Percent  Trigger Default Rate in
Fiscal Year 2001-

a

                            Millions of dollars

                      At a 3.0 % trigger default rateb

Without VFA- scenario 1 With VFA- scenario 2 Difference

              Net default costsc                         $111.3       $111.3       $ 0.0
  VFA fee for default rate below 3 percentd       Not applicable          0
            eDefault aversion fees                             0          0
          fAccount maintenance fees                         1.2         1.2
                    Otherg                                 (5.7)      (5.7)
                    Totalh                                106.8       106.8
       At a 2.6 % trigger default rateb            Without VFA-  With VFA-    Difference
                                                     scenario 3  scenario 4
              Net default costsc                           96.7        96.7
  VFA fee for default rate below 3 percentd      Not applicable        17.3
            eDefault aversion fees                           0.3        0.3
          fAccount maintenance fees                         1.4         1.4
                    Otherg                                (6.3)       (6.3)
                    Totalh                                 92.1       109.4

Increase (decrease) in costs due to decline in trigger default
rate from 3 percent to 2.6 percent $(14.7) $2.6 $17.3

aThe present value of a series of future payments is the sum of the
payments, with each payment discounted by an appropriate interest rate over
the number of years in the future that payment occurs. Budget service
estimates indicate that interest costs, including interest benefits covering
students' share of interest while in school and during the grace period,
would be the same with or without the VFA. These estimates are based on
budget service subsidy calculations in March 2000 using a 6.77 percent
discount rate. As of March 2000 the applicable discount rate for FY 2001 was
6.25 percent. The use of a lower discount rate would result in lower subsidy
rates for defaulted loans, as collections in the future would be discounted
at a lower rate. Although the budget service subsidy estimates upon which
these estimates were based were calculations for subsidized Stafford loans
(loans for which the federal government rather than the borrower bears
interest costs while the student is in school and during a grace period),
budget service staff explained that the subsidy rates for other loan types
would be similar apart from the interest subsidy costs. The figures shown
are expressed in present value terms as of FY 2001 and the calculations
reflect adjustments for the effect of loan cancellations.

bA 3.0 percent trigger default rate in fiscal year 2001 would correspond to
net default claims of $263 million. A 2.6 percent rigger default rate would
correspond to net default claims of $228 million.

cNet default costs are the federal costs associated with default adjusted
for the present value of subsequent collections on the loans.

dThe VFA fee is calculated based on a provision in the California VFA
agreement. Budget service staff estimated that none of the California VFA
provisions would change federal program costs under baseline conditions
assuming that the guaranty agency's trigger default rate remained above 3
percent.

eGuaranty agencies receive a default aversion fee equal to 1 percent of the
principal and interest amount of delinquent loans for efforts to prevent
defaults. Amounts of any loan defaults are deducted from these payments.

fGuaranty agencies receive from Education account maintenance fees equal to
0.1 percent of the original principal amount of outstanding loans
guaranteed. These fees are not paid on loans for which the guaranty agency
has paid default claims.

Appendix II: Comparison of Projected Federal Costs with California Trigger
Default Rate at 2.6 or 3 Percent

gOther costs include origination fees and federal payments for death,
disability, and bankruptcies.

hThe totals may not be equal to the sum of items shown due to rounding.

The VFA default rate incentive payment, one-half of the claims payments
avoided with a trigger default rate below 3 percent, was identified in the
VFA agreement as "50% of the savings in claim payments resulting from its
default aversion activities under this VFA." This calculation, however,
fails to take into account two potentially significant factors. First, the
federal cost of loan default is mitigated in part by subsequent collections
on the defaulted loan. If the guaranty agency receives payment on a loan
after the loan defaults it generally is allowed to retain 24 percent of the
amount collected.2 The remaining 76 percent must be remitted to Education.
Budget service staff looked to see how the present value of these payments
would affect the present value of program costs for Subsidized Stafford
loans. They concluded that the federal cost (aside from federal
administrative costs) on a subsidized Stafford loan that defaults is on
average about 47.5 percent of the amount of the loan. The comparable figure
for the same loan without default, but with the VFA incentive payment was
51.7 percent. In other words, the incentive payment to California's guaranty
agency exceeded the present value of the federal cost of the default
adjusted for the subsequent collections on the loan. Instead of benefiting
from fewer defaults of loans guaranteed by the California guaranty agency,
Education stands to benefit from increases in defaults until the guaranty
agency's trigger default rate reaches 3 percent. Above that point the
guaranty agency would not receive an incentive payment and Education would
not benefit from higher levels of defaults.

The second reason for questioning the provision's definition of federal cost
savings resulting from the VFAs default aversion activities is that the
entire decline in default costs may not be solely attributable to the VFA.
Default rates change for many reasons. According to guaranty agency and
Education officials, declines in default rates are due to such factors as a
change in definition of default from 180 to 270 days of delinquency brought
by the VFA legislation, increased default aversion assistance activities by
all guaranty agencies, enhancements in loan servicing methods, and a
prosperous economy. The VFA incentive payment to

2 The Higher Education Act provides that this retention rate will decline to
23 percent after fiscal year 2003. If a defaulted loan is consolidated in
the form or either a FFELP or a FDLP consolidated loan, the agency may
retain 18.5 percent.

Appendix II: Comparison of Projected Federal Costs with California Trigger
Default Rate at 2.6 or 3 Percent

California rewards the guaranty agency for any decline in default rates
whether it is due to VFA prompted efforts or to other factors.

As shown in figure 2 below, generally guaranty agencies have seen declines
in trigger default rates. Guaranty agencies that received VFAs and guaranty
agencies that did not both saw declines in default rates from fiscal year
1997 to fiscal year 2000, with increases in fiscal year 2001. For example,
the largest guaranty agency, USA Funds, Inc. had a higher default rate than
California's in fiscal years 1997 and 1998. However, by fiscal year 2001,
its default rate was slightly lower than California's.

Figure 2: VFA and Non-VFA Guaranty Agencies Experienced Trigger Default Rate
Declines through 2000

5 Percentage 1

0

1997 1998 1999 2000 2001 Fiscal Year

California
United Student Aid Funds, Inc.
Other VFA Agencies
Other Non-VFA Agencies

Appendix III: Summary of VFA Financial Provisions

                Table 4: Summary of VFA Financial Provisions

Guaranty agencies California Massachusetts Texas Wisconsin without VFAs

Place federal reserve funds in escrow and receive reimbursement for 100% of
claims payments

             No Yes Yes Yes No Loan Processing and Issuance Fee

                          Yes    Yes       Yes       aNo           0.65% of net
                                                                         commitments to
                                                                   0.4% in 2004
        Account           Yes     No       Yes       Noa           0.1% of the original
    Maintenance Fee                                                principal amounts of
                                                                 all outstanding
                                                                    guarantees
    Default Aversion      Yesb    No     Variable    Noa            1% of principal and
          Fee                                                         interest on cured
                                                                   loans, but only once
                                                                     per loan

Appendix III: Summary of VFA Financial Provisions

                                                                        Guaranty agencies
                California    Massachusetts     Texas      Wisconsin      without VFAs
                                                               Equal to          24%; 23%
 Guaranty agency Variable    18.5% on regular  Variable     collection         beginning
    Share of                   collections,                            in FY 2004; 18.5%
  Collections                                                cost
                                 rehabilitated
                                        loans                           for rehabilitated
                            and consolidations                             loans and
                            of delinquent and                           consolidation of
                             defaulted loans                            defaulted loans
   New ED       50% of                  Default          Performance
  payments     claims     Wellness fee  aversion fee         fee       Not applicable
              savings if  calculated as  from 1.25% to  based on cure
to guaranty    trigger         a              4%        rate
  agencies     rate is    percentage of  depending on    from 25.9 to
 with VFAs    below 3%        the                           31.9
                         amount of        performance   basis points
                         loans not                      of the
                             delinquent;                   original
                               base fee                   principal
                           equal to 22
                             basis                        amount of
                         points;                          guaranteed
                         variable fee                       loans
                         equal to 0.25
                         basis
                           points for
                              each
                           percentage
                             point
                         improvement in
                            defaults
                          relative to
                            national
                            trigger
                         default rates

If the California Reduction in Guaranty agency guaranty agency's wellness
fee for share of collections collection rate poorer than varies with the
exceeds the national specified accuracy recovery rate; 19.5% average it
receives in data provided to to 23% for regular the normal retention the
National Student and 18.5% to 20% percentage plus a Loan Data System for
rehabilitation and percentage equal to consolidations the percent
Delinquency improvement in its prevention fee; collection recovery 0.05% to
.12% of rate loans in repayment

w/o default aversion request

aComponents of the performance fee for Great Lakes have these labels, but
they are computed differently under the VFA.

bCalifornia's guaranty agency receives a default aversion fee when the
borrower begins receiving early separation counseling with or without
delinquency

Appendix IV: Comments from the Department of Education

Appendix IV: Comments from the Department of Education Appendix IV: Comments
 from the Department of Education Appendix IV: Comments from the Department
                                of Education

Appendix V: GAO Contacts and Staff Acknowledgments

GAO Contacts

Staff Acknowledgments

(130032)

Kelsey M. Bright, (202) 512-9037 Benjamin P. Pfeiffer, (206) 287-4832

In addition to the individuals named above, Jonathan H. Barker, Daniel R.
Blair, Christine E. Bonham, Richard P. Burkard, Timothy A. Burke, Aaron M.
Holling, Stanley G. Stenersen, and James P. Wright made key contributions to
this report.

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