Congressional Budget Office
Director's Blog

The federal government helps students finance higher education through two major loan programs—one that guarantees loans made by private lenders, and one that makes loans directly to borrowers. Between 2000 and 2009, the volume of outstanding federal student loans more than quadrupled, from about $149 billion to about $630 billion.

Although both programs offer similar types of loans on similar terms to borrowers, they differ significantly in how they are funded and administered. In the guaranteed loan program, loans are made and administered by financial institutions—such as Sallie Mae, commercial banks, and nonprofit agencies. The government bears almost all of the risk of borrowers defaulting and makes certain payments to the lenders. Those lenders usually raise the money to make loans in the private capital markets. By contrast, in the direct loan program, the Department of Education and its contractors bear all of the risks and manage most administrative functions; those loans are funded through the Treasury. Those differences cause the guaranteed loan program to be more costly to the federal government per dollar of lending than the direct loan program.

Today CBO released a study—prepared at the request of the Ranking Member of the Senate Budget Committee—examining the costs of the federal student loan programs, calculated two different ways. One estimate follows the methodology delineated by the Federal Credit Reform Act of 1990, which governs the treatment of credit programs (including student loans) in the federal budget. The other estimate was done on a so-called “fair-value basis,” which provides a more comprehensive measure of cost by including administrative costs and the cost of market risk (the risk that losses from defaults will be higher during periods of market stress, when resources are scarce and hence most valuable). A fair-value estimate represents what a private entity would need to be paid to assume the costs and risks to the government of providing the loans or guarantees.

CBO’s calculations indicate that:

• For both programs, subsidies calculated on a fair-value basis show substantially higher costs than those based on the standard budgetary treatment.
• Regardless of which methodology is used, for a given set of borrowers and loan types, the guaranteed loans cost the government more than those it makes directly.

For example, on a fair-value basis, a mix of representative guaranteed loans would typically cost the government about 20 percent of the principal amount of the loans. Those same loans, made directly by the government to the same people, would typically cost about 12 percent of the principal amount.

The study also looks at several proposals for modifying the student loan programs. For example, the President’s 2011 budget calls for ending the guarantee program’s authority to make new loans on July 1, 2010, and switching entirely to the direct lending program to realize the savings from that program’s lower costs. (CBO recently provided a cost estimate for that particular proposal in a letter to Senator Gregg on March 15 and in our Analysis of the President’s Budget released yesterday.) The House of Representatives and the Senate have both passed legislation (H.R. 4872, the Health Care and Education Affordability Reconciliation Act of 2010) to carry out a similar change.

Other policy options, some of which would reduce costs to the government and others that would increase those costs, include:

• Reducing the cost of the guarantee program by cutting government payments to lenders, reducing the guarantee percentage on loans, or auctioning off the right to lend under the program;
• Indexing interest rates to market rates, allowing federal costs to be more predictable;
• Improving the affordability of student loans by lowering interest rates; and
• Lessening the hardships that borrowers face in repaying loans by making repayment of loans contingent on income, for example.

This study was prepared by Deborah Lucas, CBO’s Associate Director for Financial Analysis, and Damien Moore of CBO’s Macroeconomic Analysis Division.

This afternoon CBO responded to Senator Gregg’s request for estimates of the budgetary impact of the President’s proposal to eliminate the federal program that provides guarantees for student loans and to replace those loans with direct loans made by the Department of Education.
 
The Federal Family Education Loan Program (guaranteed loan program) provides federal guarantees on loans for higher education that are administered and funded by private lenders. The guarantee ensures that lenders will receive almost all of the principal and accrued interest owed to them if borrowers default. The William D. Ford Direct Loan Program offers eligible borrowers nearly identical loans that are administered by the Department of Education and funded through the U.S. Treasury. Under the President’s proposal, all federal student loans originated after July 1, 2010, would be made by the direct loan program.

CBO constructed two estimates of the budgetary impact of that proposal. One estimate follows the methodology delineated by the Federal Credit Reform Act of 1990 (FCRA), which CBO is required to use in cost estimates for most credit programs including student loans. The other estimate was done on a so-called “fair value basis” that provides a more comprehensive measure of cost by including administrative costs and the cost of market risk (the risk that losses from defaults will be higher during periods of market stress, when resources are scarce and hence most valuable). The idea of a fair value estimate is to represent what a private entity would need to be paid to assume the costs and risks to the government from providing loans or guarantees.

Taking into account administrative costs and the cost of risk increases the estimated costs of both the guaranteed and direct loan programs: Using the fair-value methodology, CBO estimates that under current law, the net budgetary costs of new direct and guaranteed student loans during the 2010-2020 period would total about $158 billion, as compared to total net receipts for the government of $25 billion using the FCRA methodology.

CBO estimates that the President’s proposal would generate significant cost savings using both the FCRA and fair value approaches, but the savings would be smaller under the fair-value approach. (Both estimates were constructed relative to CBO’s most recent set of baseline budget projections, which were issued earlier this month.) Using the FCRA methodology, CBO estimates that replacing new guarantees of student loans with direct lending would yield savings in mandatory spending of about $68 billion over the 11 years from 2010 through 2020. That figure represents the estimated savings in mandatory costs that would be shown in a CBO cost estimate for legislation under consideration by the Congress. However, adjusting for the projected increase in annual discretionary administrative costs in the direct loan program, the net reduction in federal costs from the proposal would be about $62 billion. On a fair value basis, incorporating administrative costs and the cost of risk, CBO estimates that replacing new guarantees of student loans with direct lending would yield savings of about $40 billion over the 2010-2020 period. The primary reason for that $22 billion difference is that payments from the government to lenders are risky—they terminate when a borrower defaults on or prepays a loan. Those payments are less valuable to lenders and less costly to the government when the cost of that risk is taken into account, so terminating those payments by eliminating the guaranteed loan program yields smaller savings for the government.