Are Lenders Crying Wolf?

In yesterday’s Washington Post, Michael Dannenberg and Phillip Longman of the New America Foundation proposed a fundamental change in how subsidy amounts to student loan companies are set (see here for the full idea). They proposed changing from the current system, in which Congress sets the subsidy rate, to a system in which lenders bid for the right to make government-guaranteed loans – one way lenders would sweeten their bids is by offering to take lower subsidies. Dannenberg and Longman argue that using an auction will minimize federal subsidy payments on loans. Not surprisingly, lenders are resistant to this idea.

When John Kerry proposed something similar in 2004, the lending industry responded by saying that an auction mechanism would create too much uncertainty for banks, would cause smaller lenders to withdraw from the federal loan program, and that promised savings were uncertain and services to students might be reduced. Interestingly, very similar claims were made against President Bush’s proposed subsidy cuts in his 2008 budget, released yesterday.

President Bush’s proposed cuts, including a ½ percent cut in the interest subsidy, an increase in fees charged to lenders, and a reduction in the amount lenders are reimbursed for defaulted loans, caused a steep decline in lender stocks – Sallie Mae saw a 9% drop, it’s largest in 14 years*. Predictably, lenders are up in arms, claiming that the reductions will result in higher fees charged to students and other reduced borrower benefits, as well as claiming that it will push out small and medium sized lenders from the industry.

There are a lot of difficult decisions to make about the details of a lender auction plan - details that are important to ensuring that there is sufficient loan money available and that students are not the ones footing the bill through higher loan fees (see this 2002 GAO report for a discussion). Still, the lending industry’s constant doomsday cries are not as effective as they once were, evidenced by Bush’s budget proposal. It’s time for the lending industry to stop crying wolf about cuts to subsidies and start cooperating to create a system that works both for them and for students and taxpayers. While the lending industry claims that the instability of an auction system would make it too hard for them to do business, I can’t imagine that the current system of relying on lobbyists and keeping friends in office is a particularly stable way of ensuring profits.

* Fortunately, Sallie Mae's CEO saved himself over $1 million by selling less than 5% of his stock last week.