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Widespread attention has focused on the Stafford Loan program as its costs have grown rapidly. In response to a request by Senator Pete V. Domenici, Ranking Minority Member of the Senate Committee on the Budget, this paper examines issues pertaining to the reauthorization of the Stafford Loan program. In particular, it analyzes recent trends in the program and examines possible incremental options for reform. In accordance with the Congressional Budget Office's (CBO's) mandate to provide objective and impartial analysis, the paper contains no recommendations.

Constance Rhind of the Human Resources and Community Development Division and Deborah Kalcevic of the Budget Analysis Division prepared the paper under the direction of Nancy Gordon and Bruce Vavrichek. The authors gratefully acknowledge the contributions of Harish Chand, Jerry Davis, Cathy Ellman, Arthur Hauptman, Jamie Merisotis, Michelle Mrdeza, and Jay Noell. Computer assistance was provided by Tahirih Senne and Jacquelyn Vander Brug.

Frank Pierce edited the manuscript; Chris Spoor provided editorial assistance. Kimberly Guise and Julia Jacobsen produced the graphs. Ronald Moore provided administrative assistance for the project and prepared the manuscript for publication.
 

Robert D. Reischauer
Director
December 1991

SUMMARY

CHAPTER I INTRODUCTION

• Rising Costs
• Rising Default Rates
• Falling Relative Loan Sizes
• Federal Loans in the Context of Federal Student Aid

CHAPTER II THE OPERATION AND OUTCOMES OF THE STAFFORD LOAN PROGRAM

• How the Program Works
• The Growth in Stafford Loans
• Characteristics of Stafford Loan Borrowers

CHAPTER III FACTORS DETERMINING THE FEDERAL COST

• Components of Federal Cost
• Variation in Federal Costs by Type of Student

CHAPTER IV RECENT POLICY ACTIONS AND ALTERNATIVES FOR THE FUTURE

• Recent Legislative Changes
• The Need for Further Change
• Improving the Outcomes for Students
• Reducing Federal Costs

APPENDIX A THE CALCULATION OF AND THE RELATIONSHIPS BETWEEN DEFAULT RATES

APPENDIX B AN ANALYSIS OF THE PROBABILITY OF DEFAULT IN THE STAFFORD LOAN PROGRAM

• The Sample Design
• The Statistical Technique and Results

In the 25 years since the inception of the first of the programs that now constitute the guaranteed student loan (GSL) programs, the federal government has become an important source of financial aid for students attending postsecondary schools. In 1990, it provided guarantees of over $12 billion on about 4.5 million loans and awarded more than $5 billion in grants to about 4 million students. GSLs include Stafford Loans, Supplemental Loans for Students, and PLUS loans (Parent Loans to Undergraduate Students).

Most GSLs are now made through the Stafford Loan program. In addition to insuring loans against default, the program provides substantial interest subsidies to borrowers and lenders because the federal government pays the interest costs on the loans while borrowers attend school, plus a portion of the interest costs after they leave school.

Growing pressures on the GSL programs have raised fears that they may not continue to be a viable form of student aid. Concerns have been voiced in three main areas. One concern is that costs are growing too rapidly. Total expenditures have more than tripled since 1979 in real (adjusted for inflation) dollars, rising to $4.2 billion in 1990. Another concern is that the default rate is too high. The annual default rate was about 7 percent in 1990, and is expected to rise significantly in 1991. At some institutions, the default rate is much higher than the average. Some observers argue that a high default rate demonstrates that the programs lack integrity-possibly indicating that some borrowers are receiving educations that provide them with little economic benefit while burdening them with loans that are difficult to repay. The resulting financial stress or lack of satisfaction with the programs may lead many of these borrowers to default on their loans.

A third concern is that the maximum loan in the Stafford Loan program has declined relative to the growing cost of postsecondary education. At $2,625 for first- and second-year students and $4,000 for other undergraduates (compared with an average cost of public education of $4,500), these loan limits may restrict the ability of some students to attend postsecondary schools or limit their choices to less expensive schools.

These concerns, plus the opportunity to reexamine federal student aid policy provided by the reauthorization of the Higher Education Act, have prompted some in the Congress to focus on the Stafford Loan program. Questions have been raised about how it could be modified to improve the outcomes for students and to reduce federal costs. This paper describes the operation of the Stafford Loan program and analyzes trends in its use and costs. It also considers a variety of specific options to help students or to reduce costs.
 

OPERATION OF THE STAFFORD LOAN PROGRAM

The Stafford Loan program is a decentralized system of lending in which banks lend to students attending postsecondary schools. State and private nonprofit guaranty agencies insure lenders against losses from default. In turn, these agencies are reinsured by the federal government. Borrowers pay no interest while they attend school, during a six-month grace period after they leave school, and during the time, if any, when they receive a deferment (that is, when they postpone loan repayment for reasons such as continuing education or unemployment). At other times, borrowers pay a fixed rate of interest on the loans. The rate of interest received by the lenders varies over time with market conditions and is 3.25 percentage points above the 91-day Treasury bill rate. The federal government pays the difference between the rate that borrowers pay and the rate that lenders receive.

The schools determine and verify the students' eligibility for the loans based on their families' resources and the costs of their educations. In disbursing the loans, the banks contact federally chartered guaranty agencies to have the loans certified as guaranteed. While borrowers attend school, the banks receive interest payments from the government and have few administrative responsibilities. After students graduate, the banks must be diligent in collecting payments on the loans.

Banks typically sell the loans in a secondary market, thereby increasing their ability to make additional loans. Some purchasers of student loans-including Sallie Mae (the Student Loan Marketing Association, a federally chartered, for-profit organization) and several large commercial banks-choose the loans according to the profit that they expect to make on them. State-level agencies also purchase loans to ensure that banks in their areas have sufficient funds to continue to lend to students.

Guaranty agencies insure the holders of student loans against default. The federal government, in turn, reimburses the guaranty agencies for most default losses, pays them a fee to cover part of their operational costs, and collects a reinsurance fee from them based on their default rates.
 

PROGRAM TRENDS

An increase in the number of borrowers-not an increase in the real average loan--has driven the growth in the Stafford Loan program. The number of borrowers has risen from an average of about 750,000 as the program became established to roughly 3.5 million annually since 1984 (see Summary Figure 1). Relaxing the eligibility standards between 1978 and 1981 to include students regardless of their family resources led to a large increase in the number of recipients. These patterns applied to borrowers attending all types of schools-public, private, and proprietary (that is, private for-profit schools that typically provide job training)--as shown in Summary Figure 2. In 1982, applicants again had to show financial need, leading to a drop in the number of new borrowers at public and private colleges. In contrast, the number of borrowers at proprietary schools has continued to increase.

Currently, 16 percent of all students attending postsecondary schools receive Stafford Loans. Students attending proprietary schools and private four-year colleges are the most likely to borrow, with 55 percent of all students at proprietary schools and about 25 percent of all students at private four-year colleges receiving Stafford Loans. Students from low-income families are considerably more likely to receive a Stafford Loan than are those from higher-income families, reflecting both their greater financial need and the income restrictions of the program.

Federal payments for net real interest costs, currently about $2.6 billion, have fluctuated considerably since 1979 as a result of changes in the Treasury bill rate and in the numbers of borrowers in school and repaying their loans (see Summary Figure 3). Net default costs, roughly $1.6 billion in 1990, have risen substantially since 1982, both because the number of borrowers repaying their loans has soared and because annual default rates have increased over parts of this period.

Students who borrow more, borrow for longer periods of time, borrow when interest rates are higher, or default on their loans account for larger shares of federal spending than do other borrowers. For example, the average recipient who completes four years of college or who attends graduate school borrows more than other recipients. In contrast to college graduates, the average borrower who does not complete a four-year college degree is more likely to default on a student loan. In general, students who borrowed during the early 1980s received greater subsidies than borrowers at other times because interest rates were higher then.
 

RECENT POLICY ACTIONS

The Omnibus Budget Reconciliation Act of 1990 made several changes in the budgetary context and operation of the GSL programs. These modifications will affect the ease with which future legislative changes can be made. The Budget Enforcement Act, a part of the Reconciliation Act of 1990, set new rules for federal spending through 1995 that potentially limit future changes in the Stafford Loan program. As an entitlement, the Stafford Loan program can now be expanded only if other entitlements are cut or if taxes or fees are increased. In addition, the trade-off between spending in entitlement programs and discretionary programs has been eliminated, because domestic discretionary programs now have a separate spending cap set forth in the new budget law. In other words, increases in spending on entitlements cannot be offset by reductions in spending for discretionary programs and vice versa. This feature is relevant for higher education programs because GSLs are entitlements while Pell Grants are part of discretionary spending.

The Budget Enforcement Act also changes the way that federal credit programs are reflected in the budget. Federal loan guarantees, such as those of the Stafford Loan program, were previously included in the budget on a cash-flow basis. Henceforth, the government's long-run cost, or subsidy, for a loan guarantee will be recorded as a budget outlay when the loan is disbursed. This change in accounting, which is part of broader changes under the rubric of credit reform, places loan guarantees and other federal spending on an equal footing.

The Reconciliation Act of 1990 also made several changes in the GSL programs, primarily to reduce their cost. These changes included eliminating schools whose former students have high rates of default, delaying the disbursement of loans to all first-time, first-year undergraduate borrowers, and requiring independent testing of federal student aid recipients without high school diplomas or General Education Development (GED) diplomas to see if they would benefit from further education. More recently, the Emergency Unemployment Compensation Act of 1991 added wage garnishment as a tool that can be used in all states for collecting defaulted loans.
 

POLICY OPTIONS

Some observers assert that further modifications in the GSL programs should await the effects of recent changes. But many others argue that the programs continue to have serious problems that need to be addressed during this reauthorization.

This paper considers two categories of changes that the Congress could make in the Stafford Loan program-improving the outcomes for students and reducing the costs of the program. While broader suggestions have been made to change the mix of aid between grants and loans or to fundamentally restructure the GSL programs, they are beyond the scope of this paper.

Options to Improve the Outcomes for Students

Critics assert that the Stafford Loan program could better serve the needs of borrowers in a number of ways. Some people argue that the receipt of a Stafford Loan no longer allows borrowers the freedom of choice that was originally intended, since the costs of higher education outpaced the increases in the maximum loan during the 1980s. To correct this situation, they would increase the maximum loan available to students. Opponents of this option worry that many students are already burdened with large debts when they leave school, and that some of them will not have higher future earnings as a result of their educations.

Others suggest that some schools now encourage students to borrow by overstating the economic benefits of the education. When the borrowers are unable to find the jobs they expected, many default on their loans. Several options are available to address these concerns. Requiring all loan applicants to obtain counseling from independent centers could improve their understanding of their choices and help them to select institutions and programs that would be well suited to their talents and goals. Doing so would add to the bureaucracy of the program, however, and accomplish nothing for students who are well informed now. Strengthening the accreditation of postsecondary institutions has also been suggested by some who think that this could help reduce the incidence of fraud and abuse. Others argue, however, that the program needs better enforcement of existing rules and not additional regulations. Finally, requiring schools to share in the default costs of their former students might improve the outcomes for students because schools would then have a financial incentive to admit only those who can benefit from their education. Some schools might respond, however, by increasing tuition to all their students, rather than by improving the quality of their education.

Options for Decreasing the Costs of the Program

Other options would reduce the federal cost of the Stafford Loan program. Such changes could respond to the desire for additional spending on other high-priority programs (including more targeted spending on student aid) or for reducing the federal budget deficit. The federal government could, for example, further restrict the allowable cohort default rates of schools participating in the program. (A cohort default rate is the proportion of borrowers entering repayment who default.) Doing so could eliminate from the program schools that provide poor educations, but it could also eliminate some schools that provide high-quality educations but serve a large proportion of disadvantaged students.

Another group of options would reduce the federal subsidies that go to borrowers, lenders, and guaranty agencies. Currently many borrowers, particularly those attending graduate schools or four-year colleges, receive large interest subsidies. These subsidies could be reduced by requiring students to pay a larger share of their interest costs. Some students, particularly those not completing a four-year college degree, might be unable to repay the increased debt, however, and would either default on their loans or not take out the loans (and perhaps, therefore, not attend postsecondary school).

Subsidies to lenders could also be cut by reducing their 3.25 percentage-point premium above the 91-day Treasury bill rate. This rate is often much greater than their costs. Some smaller banks with higher costs would probably cease lending through the program if their premium were cut substantially, perhaps making borrowing difficult for students in some areas.

Finally, the administrative cost allowance provided to guaranty agencies could be eliminated, thereby reducing federal costs. A few financially insecure guaranty agencies might become bankrupt if this were done, however, thus potentially raising federal costs and leading to further questions about the integrity of the system.

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