Bipartisan Deal to Reduce Deficit on Backs of Student Borrowers

Congress and the President are making huge decisions about
the future of our biggest consumer credit markets – mortgages for homebuyers
and college loans for students. 
Unfortunately critical policy choices are being avoided, ignored, or
obfuscated.  I’ll comment on student
loans in this post, housing finance reform in a future post.

The student loan bill about to be signed by the President is
touted as “reducing” interest rates for students.  This is nonsense. The “reduction” is only
from the jacked-up rates that went into effect a few weeks ago on July 1
because of a prior legislative gimmick. 
The basic undergrad student loan rate of 3.4% was scheduled to go up to
6.8% on July 1 mostly so that the federal deficit over multiple years would
appear smaller in out years.  Most
observers assumed that the rate hike would not happen, but deficit hawks used
this gimmick as another pressure point to advance their agenda.  If you compare interest rates before July 1
with rates being charged under the new law, students are paying more interest,
not less.  The CBO scores the bill as reducing
the federal deficit by about $700 million. 
Instead of a fixed 3.4%, students will pay 3.9% this year, and the
10-year Treasury bill rate plus 2.05% in future years.  Graduate students will pay much more (and are
lower credit risks.)

More problematically, the “rate reduction” bill continues a
practice, never fully debated, of using student loan interest as a profit
center for the federal Treasury. The student loan Treasury profit is a
consequence of the Clinton Administration’s Direct Loan program.   Under
that program, instead of subsidizing banks to fund student loans, the Treasury
lends money directly to students (albeit through private servicing contractors)
instead.  In the 1990s, banks and their
Congressional mouthpieces vigorously disputed the proposition that direct
Treasury lending would be cheaper than the old system of subsidizing the banks
to fund student loans.  Not only were
they wrong, but they were so wrong that the same interest rates that had to be
subsidized when offered by banks produced a net profit to the Treasury under the Direct Loan program.  For many years, Congress was not willing to
offer cheaper interest rates on Direct Loans than on bank loans, so the Direct
Loan borrowers effectively subsidized the guaranteed bank loans.  The fact that the government could be the
low-cost provider was just too mind-blowing for the Washington consensus.  In recent years, it has been convenient for
Congress to ignore the fact that Direct Loan student borrowers pay much higher
interest rates than are necessary to cover the costs of the program.

Senator Warren has proposed pegging student loan rates to
the low rates paid by banks borrowing from the Federal Reserve.  This is an interesting idea, but it seems to
me we should begin with the proposition that students pay no more interest than
is needed to cover the cost of the student loan program, i.e. that we run it as
a break-even operation rather than a money-maker for the Treasury. 

Here is the Senate vote on the bill, and here is the House roll call.