Federal Family Education Loan Program: Statutory and Regulatory
Changes Could Avert Billions in Unnecessary Federal Subsidy
Payments (20-SEP-04, GAO-04-1070).
To encourage lenders to make student loans under the Federal
Family Education Loan Program (FFELP), the federal government
guarantees lenders a statutorily specified rate of return--called
lender yield. Some lenders may issue tax-exempt bonds to raise
capital to make or purchase loans; loans financed with such bonds
issued prior to 10/1/93 are guaranteed a minimum lender yield of
9.5% (hereafter called 9.5% loans). When the interest rate paid
by borrowers is less than the lender yield, the government pays
lenders the difference--a subsidy called special allowance
payments. In light of the upcoming reauthorization of the Higher
Education Act of 1965, we examined special allowance payments for
9.5% loans.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-04-1070
ACCNO: A12609
TITLE: Federal Family Education Loan Program: Statutory and
Regulatory Changes Could Avert Billions in Unnecessary Federal
Subsidy Payments
DATE: 09/20/2004
SUBJECT: Aid for education
Education or training
Education or training costs
Higher education
Internal controls
Loans
Strategic planning
Student loans
Dept. of Education Federal Family
Education Loan Program
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GAO-04-1070
United States Government Accountability Office
GAO
Report to Congressional Requesters
September 2004
FEDERAL FAMILY EDUCATION LOAN PROGRAM
Statutory and Regulatory Changes Could Avert Billions in Unnecessary Federal
Subsidy Payments
GAO-04-1070
[IMG]
September 2004
FEDERAL FAMILY EDUCATION LOAN PROGRAM
Statutory and Regulatory Changes Could Avert Billions in Unnecessary Federal
Subsidy Payments
What GAO Found
As shown below, special allowance payments for 9.5% loans have risen
dramatically in recent years, increasing from $209 million in FY 2001 to
well over $600 million as of June 30, 2004. A primary reason for the
increase is the sharp decline in the variable interest rates paid by
borrowers relative to the minimum 9.5% lender yield.
Another reason for the increase in special allowance payments is the
rising dollar volume of 9.5% loans, which increased from about $11 to over
$17 billion from FY 1995 to June 30, 2004. Given that current market
interest rates are at or near historic lows, lenders have a financial
incentive to maintain or increase their 9.5% loan volume and can do so in
three ways:
o After paying costs, including payments to bond investors, associated
with a pre 10/1/93 tax-exempt bond, lenders can use any remaining money to
reinvest in more FFELP loans that, by law, are also guaranteed a minimum
9.5% yield.
o Lenders can issue a new bond, called a refunding bond, to repay an
outstanding pre 10/1/93 tax-exempt bond that financed 9.5% loans.
Consequently, the refunding bond finances the 9.5% loans and may have a
later maturity date than the original bond, allowing lenders to maintain
their 9.5% loan volume for a longer time.
o By issuing a taxable bond and using the funds obtained to purchase
9.5% loans financed by a pre-10/1/93 tax-exempt bond, lenders can
significantly increase their loan volume. Lenders can use the proceeds
from the sale of loans previously financed by the pre-10/1/93 tax-exempt
bond to make or buy additional loans, which are also guaranteed a 9.5%
yield. Under Education's regulations, loans previously financed by a pre
10/1/93 tax-exempt bond and subsequently financed by (i.e., transferred
to) a taxable bond continue to be guaranteed a 9.5% yield.
Some Members of Congress and the Administration have proposed making
statutory changes with respect to 9.5% loans, which could save billions of
dollars in future special allowance payments. An official representing a
leading credit rating agency and some major lenders told us that making
changes to the minimum 9.5% yield for loans made or purchased in the
future should not affect lenders' ability to make required payments on
outstanding tax-exempt bonds.
United States Government Accountability Office
Contents
Letter 1
Special Allowance Payments For 9.5 Percent Loans Have
Increased
More Than Threefold Since Fiscal Year 2001 3
Changes to the Minimum 9.5 Percent Yield For Future Loans
Could
Save Billions and Is Unlikely to Cause Lenders to Default on
Outstanding Tax-Exempt Bonds 6
Conclusions 7
Matter for Congressional Consideration 7
Recommendation for Executive Action 7
Agency Comments 8
Appendix I Briefing Slides
Appendix II Comments from the Department of Education
Appendix III GAO Contacts and Staff Acknowledgments 45
GAO Contacts 45 Staff Acknowledgments 45
Abbreviations
FFELP Federal Family Education Loan Program
HEA Higher Education Act
IRC Internal Revenue Code
IRS Internal Revenue Service
SAP special allowance payment
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United States Government Accountability Office Washington, DC 20548
September 20, 2004
The Honorable Dale E. Kildee
Ranking Minority Member, Subcommittee on 21st Century Competitiveness
Committee on Education and the Workforce House of Representatives
The Honorable Chris Van Hollen House of Representatives
Under the Federal Family Education Loan Program (FFELP), lenders-
including banks, state agencies and other nonprofit and for-profit
organizations-annually make, or originate, billions of dollars in loans to
help students and families finance postsecondary education costs. To
encourage lenders to make loans, the federal government guarantees lenders
repayment and a statutorily specified rate of return-called lender
yield-on the loans they hold. Lender yields as well as the interest rates
paid by borrowers are typically tied to, and vary with, money market
financial instruments, such as the 91-day Treasury bill. When the interest
rate paid by borrowers is less than the guaranteed lender yield, the
government pays lenders the difference-a subsidy called special allowance
payments. In exercising its oversight of the FFELP, Congress has
periodically changed the formula for lender yields to better reflect
market interest rates, federal budget constraints, or the costs incurred
by lenders to finance loans. To finance loans, some lenders, specifically
state agencies and state-designated authorities, may issue tax-exempt
bonds to raise capital to make or purchase loans, thereby providing other
lenders with more funds to make more loans. Investors who buy these bonds
receive interest income that is exempt from federal taxation. Because
these investors do not pay taxes on their interest earnings, they are
willing to accept a lower pretax rate of return on their investment, which
lowers the financing costs for agencies and authorities issuing the bonds.
As student loan borrowers repay their loans, loan holders use the money to
repay, in turn, bond investors.
Concerned that the lender yield for loans financed with tax-exempt bonds
did not adequately reflect the lower costs associated with tax-exempt
financing, Congress reduced the yield in passing the Education Amendments
of 1980. To do so, Congress reduced the special allowance payments to be
paid on loans financed with tax-exempt bonds to one-half
of that otherwise payable. At the same time, however, Congress guaranteed
that the lender yield for loans financed with tax-exempt bonds would be no
less than 9.5 percent. Several years later, in passing the Omnibus Budget
Reconciliation Act of 19931, Congress eliminated the onehalf special
allowance payment and minimum 9.5 percent yield provision for loans
financed with tax-exempt bonds issued on or after October 1, 1993. In so
doing, Congress provided that lenders would receive the same yield on
loans, regardless of whether tax-exempt bonds or other sources of funds
had been used to finance the loans. Due to these changes, loans that are
financed with the proceeds of tax-exempt bonds issued prior to October 1,
1993 are guaranteed a minimum 9.5 percent yield. (These loans are
hereafter called 9.5 percent loans).
Believing that changes to the law should have resulted in a decline in
special allowance payments made for 9.5 percent loans since 1993, various
news media, policy makers, and others have recently raised questions about
the extent to which the government continues to make such payments. In
light of the upcoming reauthorization of the Higher Education Act of 1965,
which authorizes the FFELP, you asked us to examine special allowance
payments for 9.5 percent loans. To conduct our examination, we analyzed
the Department of Education's (Education) data on 9.5 percent loan volume
and special allowance payments paid to lenders from fiscal year 1986
through the third quarter of fiscal year 2004, the most current data
available at the time of our review. On the basis of our review of the
documentation for these data and our discussions with Education officials
about the steps they take to ensure the reliability and validity of these
data, we determined that the data were sufficiently reliable for the
purpose of our examination. In addition, we interviewed officials with
Education; the Internal Revenue Service; a major credit rating agency that
examines and rates the quality of student loan bonds, including those
issued by several holders of 9.5 percent loans; a leading bond counsel law
firm that provides legal advice to lenders that issue tax-exempt student
loan bonds; and 12 lenders that reported holding 9.5 percent loans in
fiscal year 2003. We gathered additional data on the amount of 9.5 percent
loans in taxable bonds from the top 10 holders of 9.5 percent loans in
fiscal year 2003. These 10 lenders held 70 percent of reported 9.5 percent
loan volume in fiscal year 2003.
1Public Law 103-66, secs. 4105 and 4111, 107 Stat. 312 (1993)
Special Allowance Payments For 9.5 Percent Loans Have Increased More Than
Threefold Since Fiscal Year 2001
On August 19, 2004, we briefed your staff on the results of our work. This
report summarizes the information we shared with your staff and transmits
the slides we used to brief your staff that day. In this report, we are
also making a recommendation to the Secretary of Education and suggesting
a matter for Congress's consideration. We conducted our work between
December 2003 and August 2004 in accordance with generally accepted
government auditing standards.
Special allowance payments for 9.5 percent loans have risen dramatically
in recent years, increasing from $209 million in fiscal year 2001, to $556
million in fiscal year 2003 and reached about $634 million at the end of
the third quarter of fiscal year 2004. Two reasons account for this
increase: (1) a decline in the interest rate paid by borrowers and (2) a
rise in the dollar volume of 9.5 percent loans. In some cases,
restrictions exist on how the nonprofit, for-profit, and state agency
lenders that hold 9.5 percent loans may use their earnings, including
their special allowance payments, from 9.5 percent loans.
Decline in Interest Rate Paid by Borrowers Is Primary Reason for Increase
in Special Allowance Payments
The primary factor influencing the increase in special allowance payments
has been the sharp decline in interest rates paid by borrowers relative to
the minimum 9.5 percent government guaranteed yield for lenders. As
borrower rates have declined, the amount the government has been required
to pay to make good on its promise to lenders has increased. To
illustrate, in 2001, the borrower interest rate was 8.2 percent.2 Because
this borrower rate is tied to the 91-day Treasury-bill rate and the
Treasury-bill rate subsequently declined, the borrower interest rate on
the same loan in 2003 was 5.4 percent. While the borrower rate declined,
the yield for a lender who used the proceeds, or funds obtained, of a
pre-October 1, 1993, tax-exempt bond to originate or purchase the loan
remained at 9.5 percent. Over this period, the difference, or spread,
between the borrower rate and the 9.5 percent lender yield increased from
1.3 percent to 4.1 percent. As a result, the special allowance payment
required to ensure a lender yield of 9.5 percent increased for each dollar
of loan volume in this example.
2Statutory formulas used to calculate borrower rates are based on several
factors, including when the loan was disbursed and loan type. The borrower
rates used for this example are for Stafford loans disbursed after July 1,
1998 and are now in repayment.
Increasing 9.5 Percent Loan Volume Is Another Reason for the Increase in
Special Allowance Payments
Another factor influencing the increase in special allowance payments has
been the rising dollar volume of 9.5 percent loans. Although the overall
volume of 9.5 percent loans has increased since fiscal year 1995, volume
among lenders has varied. Most lenders experienced a decrease in their 9.5
percent loan volume between fiscal years 1995 and 2003, but by the end of
the third quarter of fiscal year 2004, some of these lenders had sharply
increased their 9.5 percent loan volume. For example, one lenders' 9.5
percent loan volume had decreased by 46 percent between fiscal years 1995
and 2003 but then increased by 136 percent between 2003 and the end of the
third quarter of fiscal year 2004, making its 9.5 percent loan volume
greater than it was in 1995.
There are primarily three ways-referred to as recycling, refunding, and
transferring-that a lender can slow the decrease in, maintain, or increase
its 9.5 percent loan volume.
o First, after paying costs associated with a pre-October 1, 1993
taxexempt bond (such as payments of interest and principal to bond
investors), lenders can reinvest, or recycle, any remaining money earned
from 9.5 percent loans to make or purchase additional loans that, under
the law, are also guaranteed a minimum 9.5 percent lender yield. Using
this method, lenders are able to slow the decrease in, maintain, or
slightly increase their 9.5 percent loan volume.
o Second, lenders can issue a new bond, called a refunding bond, to
repay the principal, interest, and other costs of an outstanding
pre-October 1, 1993 tax-exempt bond. Based on how the HEA has been
interpreted, 9.5 percent loans originally financed with a pre-October 1,
1993 tax-exempt bond, but subsequently financed by a refunding bond,
continue to carry the government guaranteed minimum yield for lenders of
9.5 percent. Moreover, the refunding bond may have a later maturity, or
payoff, date than the original bond. Using this method, lenders can
maintain their 9.5 percent loan volume.
o Third, under Education regulations, a lender can significantly
increase its 9.5 percent loan volume by issuing a taxable bond and using
the proceeds to purchase 9.5 percent loans financed by a pre-October 1,
1993 tax-exempt bond. The lender then uses the cash available from the
pre-October 1, 1993 tax-exempt bond to make or buy additional loans, which
are guaranteed the minimum 9.5 percent yield. Under regulations issued in
1992, the loans transferred to the taxable bond continue to be guaranteed
the minimum 9.5 percent lender yield, so long as the original bond is not
retired or defeased. (At the time the regulation was promulgated,
Education anticipated that interest rates
would rise, resulting in a higher lender yield for loans financed with
taxable bonds than for loans financed with tax-exempt bonds. Education
believed that if the 1992 regulation was not promulgated, lenders would
have had an incentive to transfer loans from tax-exempt bonds to taxable
bonds in order to obtain a higher yield, thus resulting in higher special
allowance payments for the government.) Among the top 10 lenders holding
9.5 percent loans, more than half of the dollar volume of their 9.5
percent loans had been transferred to taxable bonds as of March 31, 2004.
The extent to which lenders have transferred 9.5 percent loans to taxable
bonds varies considerably. For example, one lender had none of its 9.5
percent loans in a taxable bond, while another held 90 percent of its 9.5
percent loans in a taxable bond as of March 31, 2004. Some lenders
interviewed have been transferring 9.5 percent loans for several years,
while another lender just started to transfer 9.5 percent loans in 2004.
Additionally, some lenders have also transferred 9.5 percent loans to
tax-exempt bonds issued after October 1, 1993, thereby continuing the 9.5
percent minimum guaranteed yield.
As a result of recycling, refunding, and transferring, the overall dollar
volume of 9.5 percent loans has increased from about $11 billion in fiscal
year 1995 to over $17 billion at the end of the third quarter of fiscal
year 2004. While the dollar volume of 9.5 percent loans presently accounts
for only about 8 percent of all outstanding FFELP loan volume, these loans
account for 78 percent of all special allowance payments made to FFELP
lenders thus far in fiscal year 2004.
Earnings on Tax-Exempt Bonds that Finance 9.5 percent Loans May be Used
for Borrower Benefits
Under the Internal Revenue Code (IRC), earnings on loans financed by
tax-exempt bonds are limited. 3 Lenders can reduce their earnings on loans
financed with tax-exempt bonds, and avoid exceeding IRC limitations, by
providing benefits to borrowers. Some lenders reported that they have
used, or plan to use, earnings in excess of IRC limits to provide interest
rate reductions or loan cancellation for borrowers. In contrast to
taxexempt bonds, earnings on taxable bonds are not limited. As a result,
lenders have discretion in how they use their earnings from taxable bonds
that have financed 9.5 percent loans.
3Special allowance payments may or may not be included in the calculation
of excess earnings for Internal Revenue Service purposes depending on when
a tax-exempt bond, or any associated refunding bond, was issued.
Changes to the Minimum 9.5 Percent Yield For Loans Made or Purchased in
the Future Could Save Billions and Is Unlikely to Cause Lenders to Default
on Outstanding Tax-Exempt Bonds
Changing law and regulations with respect to 9.5 percent loans made or
purchased in the future could reduce the amount of special allowance
payments required to be paid by the government without compromising
lenders' ability to meet their obligations under their outstanding
taxexempt bonds. The Administration and some members of Congress have, in
fact, already put forth proposals to make such changes. The Administration
has proposed limiting the extent to which lenders can receive the
substantially higher special allowance payments on 9.5 percent loans in
the future and estimates savings of $4.9 billion over fiscal years 2005
through 2014 by doing so. Proposed legislation introduced in the 108th
Congress also seeks to revise the law pertaining to 9.5 percent loans in
order to reduce special allowance payments and change lender yields to
reflect current market interest rates. 4
Changing current regulations that allow lenders to transfer 9.5 percent
loans to taxable bonds and retain the minimum 9.5 percent yield could also
significantly reduce potential special allowance payments in the future.
While Education officials told us that they had considered revising the
department's regulations, they believed that Congress could effect such a
change by law more quickly and easily. Education officials told us that
promulgating new FFELP regulations would likely be difficult and
time-consuming, in light of the HEA's requirement that the department
engage in negotiated rule making in promulgating FFELP regulations.
Negotiated rule making requires the department to convene a committee that
would include FFELP industry representatives, such as lenders, and attempt
to reach consensus among committee members on proposed regulations. Given
the interest of lenders who hold 9.5 percent loans, reaching consensus on
new regulations would likely prove to be very difficult, according to
Education officials. However, the inability to reach consensus does not
invalidate the negotiation of rules.5 Moreover, regulations are not
subject to the negotiated rulemaking requirement if the Secretary
determines that applying this requirement would be 'impracticable,
unnecessary, or contrary to the public interest.' Representatives from a
major credit rating agency as well as some lenders who hold 9.5 percent
loans told us that eliminating the minimum 9.5 percent yield for loans
made or purchased in the future should not affect lenders' ability to meet
their obligations under, and make required
4See, for example, the College Quality, Affordability, and Diversity
Improvement Act of 2003 (S. 1793) and the College Access and Opportunity
Act (H.R. 4283).
5See, U. S. Group Loan Servicing Inc. v. Riley, 82 F. 3d 708 (7th Cir
1996).
payments on, their outstanding tax-exempt bonds, nor should it have
longterm negative effects in the student loan bond market.
Conclusions Unlike other loans for which the lender yield varies with
current market interest rates, the lender yield for loans financed with
pre-October 1, 1993 tax-exempt bonds are guaranteed a minimum yield of 9.5
percent. Given that current market interest rates are at or near historic
lows, lenders have a significant financial incentive to slow the decrease
in, maintain, or increase the volume of loans that yield such a relatively
high rate of return unavailable on other FFELP loans. This incentive will
remain even if market interest rates gradually rise in the future.
Ironically, moreover, an Education regulation over 10 years old and
originally intended to limit the government's exposure to increased
special allowance payments has today presented lenders with an
extraordinary opportunity to generate additional loans that earn a 9.5
percent yield. As we have shown, lenders are taking advantage of these
opportunities. Industry experts acknowledge that the government could take
action to eliminate the 9.5 percent yield for loans made or purchased in
the future without compromising the ability of lenders to meet their
obligations with respect to their pre-October 1, 1993 tax-exempt bonds.
Without government action, the taxpayers remained exposed to additional
special allowance payments that can easily and rapidly escalate into the
billions of dollars.
Matter for Congressional Consideration
Recommendation for Executive Action
In light of the rapid increase in special allowance payments for loans
guaranteed a minimum 9.5 percent yield and the continuing financial
incentive for lenders to originate or purchase additional loans that
qualify for a guaranteed yield of 9.5 percent, Congress should consider
amending the HEA to address the issues identified by this report, but
particularly to change the yield for loans made or purchased in the future
with the proceeds of pre-October 1, 1993 tax-exempt bonds, and any
associated refunding bonds, to more closely reflect these loans' financing
costs and current market interest rates.
Given that lenders are increasing the volume of 9.5 percent loans based on
Education regulations that allow lenders to transfer 9.5 percent loans to
taxable bonds and tax-exempt bonds issued after October 1, 1993 while
retaining the special allowance payment provisions applicable to loans
financed with pre-October 1, 1993 tax-exempt bonds, and the resulting
increased costs for taxpayers, we recommend that the Secretary of
Education promulgate regulations to discontinue the payment of the
Agency Comments
special allowance applicable to loans financed with pre-October 1, 1993
tax-exempt bonds that are subsequently transferred to taxable bonds or
tax-exempt bonds issued on or after October 1, 1993.
We provided a draft of this report to Education for review and comment. In
commenting on our report, Education agreed that special allowance payments
for 9.5 percent loans should be scaled back considerably and that, as
noted in our report, such a proposal was included in the President's
fiscal year 2005 budget.6 Education also stated that it had considered
changing its regulation or its interpretation of the regulation last year,
but believed at that time that the HEA would be reauthorized and amended
to address the issues discussed in our report before any proposed
regulation or regulatory interpretation it might undertake could become
effective. Education stated this was the case because of certain
requirements contained in the HEA and other laws, including a requirement
that it engage in negotiated rule making.
Education also commented on the statutory exception to the general
requirement that it engage in negotiated rule making, which we highlighted
in our report. As mentioned in our report, the Secretary need not subject
a rule making to the negotiated rule making process if the Secretary
determines that the process would be "impracticable, unnecessary, or
contrary to the public interest." In its comments, Education stated that
the courts have construed this exception only to cover routine
determinations that are insignificant in nature and impact,
inconsequential to industry and to the public, or which raise issues of
public safety. While we believe that it is Education's responsibility to
interpret the law as it relates to its own programs, on the basis of our
review of the case law, we disagree with Education's characterization of
the case law concerning the scope of the exception in the Administrative
Procedure Act. Specifically, it does not fully address the courts'
treatment of the "public interest" prong of the three-pronged exception
noted above.
The federal courts have interpreted the three-pronged exception in many
cases involving a wide variety of factual situations. Education's
characterization of the case law describes the courts' discussion of the
first two prongs, "impracticable" or "unnecessary," but does not fully
address the potential applicability of the third prong, which, if met,
would independently justify use of the exception. In fact, in the case
cited by
6A similar proposal was made in the prior Administration's fiscal year
2001 budget.
Education in its comments, Utility Solid Waste Activities Group v. E.P.A.,
236 F.3d 749 (D.C. Cir. 2001), the court briefly explains the "public
interest exception" by pointing to a situation where announcement of the
rule in advance would "enable the sort of financial manipulation the rule
sought to prevent." Id. at 755; see also, Attorney General's Manual on the
Administrative Procedure Act, pp. 30-31. Thus, it is clear that the
applicability of the "public interest" exception turns neither on the
insignificance of the rule nor on whether it raises issues of public
safety. See also Nader v. Sawhill, 514 F.2d 1064 (D.C. Cir. 1975).
Moreover, in reviewing challenges to an agency's use of an exception, the
Court of Appeals for the District of Columbia has stated that it will
review the "totality of the circumstances," including the complexity of
the statute and congressionally imposed time frames. See Methodist Hosp.
of Sacramento v. Shalala, 38 F.3d 1225 (D.C. Cir. 1994); Petry v. Block,
737 F.2d 1193 (D.C. Cir. 1984).
Determining whether the unique circumstances present here support the
agency's use of an exception is beyond the scope of our report and is a
matter, in the first instance, for Education. Nevertheless, we continue to
believe that Education should consider all of its options in effecting the
desired policy change as we recommend in the report. This could include,
for example, determining whether Education could use less formal guidance,
as it has in the past, to clarify or alter its position; whether a full
consideration of all the facts and circumstances as well as all the
applicable case law would support use of an exception to the negotiated
rule making requirement; whether an interim final rule could be issued to
take effect immediately; or whether negotiated rule making could be
accomplished on an expedited basis. Given Education's position that it is
essentially unable to implement regulations until July 1, 2006, more than
21 months away, we think it is important that Education fully explore all
of its options, consistent with applicable law. Education's written
comments appear in appendix II.
We are sending copies of this report to the Secretary of Education,
appropriate congressional committees, and other interested parties. In
addition, the report will be available at no charge on GAO's Web site at
http://www.gao.gov.
If you or your staff have any questions about this report, please contact
me at (202) 512-8403 or Jeff Appel, Assistant Director, at (202) 512-9915.
You may also reach us by e-mail at [email protected] or [email protected]. Other
contacts and staff acknowledgments are listed in appendix III.
Cornelia M. Ashby Director, Education, Workforce, and Income Security
Issues
Percentage of Percentage
SAP for 9.5% of total
Number of loans in FY 9.5% loans
lenders 2003 in FY 2003
For-profit 4 37 36
Nonprofit and
state agency 33 63 64
Appendix II: Comments from the Department of Education
Appendix III: GAO Contacts and Staff Acknowledgments
GAO Contacts
Staff Acknowledgments
(130411)
Jeff Appel, Assistant Director (202) 512-9915
Andrea Romich Sykes, Analyst-in-Charge (202) 512-9660
In addition to those named above, the following people made significant
contributions to this report: Cynthia Decker, Margaret Armen, Richard
Burkard, Jason Kelly, Rebecca Christie, and Jeff Weinstein.
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