The Obama Budget: A Stick In The Eye For Banks

With all the fuss over Wall Street bailouts and AIG bonuses, one banking breakthrough is going unnoticed. Obama's proposed budget completely eliminates [1]an unnecessary, obsolete bank subsidy: College student loans – where the subsidy goes to the bank, not the student. It’s a stick in the eye of the banking industry, and the banks aren’t taking it lightly [2].

Today we publish a new report [3]that shows how the loss for the banks is a gain for the students. We present the newest data on how college costs continue to rise [4](5% last year, compared to 3% inflation) even as wages stagnate and savings tank. We talk about students priced out of college [5](1.7 to 3.2 million over ten years) and graduating with crippling levels of debt [5]. We talk about the lost value of the Pell Grant [6](half the buying power of thirty years ago) and the Obama plan to restore its value.

We need to hear all of that – again and again. But the best part is about the banks. The report describes the history of bank involvement in student loans, and government management of the banks. It explains where Obama’s move comes from and how it puts us on the right side of history.

Uncle Sam gets it started

When the program began, students looked like poor financial risks. Young in age, with little credit history and few personal assets, students were not attractive candidates for private-sector lending – certainly not for the large sums needed to finance a college education.

In 1966, the federal government helped solve the problem by creating incentives for banks to lend. The Federal Family Education Loan Program (FFELP) guarantees lenders a higher interest rate than the base market rate, ensuring a healthy profit on monies loaned. On top of that, Uncle Sam guaranteed payment of principle and interest in case of default. For the banks, it was a win-win proposition: higher interest rates with no real risk. The Student Loan Marketing Association (Sallie Mae) was created to manage the money, and the program helped millions of Americans reach their college dreams.

Now the market is mature. Well-educated, high-earning college graduates have proven to be excellent credit risks. Student lending has grown into a highly profitable industry. Dozens of new banks and lending institutions have entered the field. Sallie Mae herself has spun off and privatized into SLM Corporation [7], whose stock can be bought and sold on the New York Stock Exchange.

Clintonian Reinvention

While “reinventing government” in the 1990s, President Bill Clinton reexamined whether subsidies were still needed to encourage banks to lend to students. Indeed, Clinton questioned whether the bank middleman was necessary at all. In 1993, the Department of Education created a Federal Direct Loan (FDL) program that loaned money to students at low rates available only to the U.S. Treasury. Such loans reduced payments for students and did not increase the government’s risk because the old system already used the government to guarantee defaults.

Students flocked to the new program. By 1997, direct loans had grown to 33% of student borrowing, nearly $11 billion.

Experience showed that direct lending works. The administrative costs are lower, the design is simpler and it eliminates subsidies to the private loan industry. The General Accounting Office found that the Direct Loan program cost the federal government $1.70 for every $100 of loans, compared to $9.20 per $100 of loans through the FFEL program, with bank intermediaries. In other words, taxpayers save $7.50 for every $100 loaned [8]. Thus, the direct loan program wasn’t just better for students; it was better for taxpayers too. Clinton’s question of whether the government should administer the loans directly had been answered: Yes.

The Bush Hiatus

But President Bush didn’t like the direct lending program. His loyalty was to the banks. He staffed the Department of Education with bankers and bank sympathizers [9], including the former CEO of the lenders’ trade association, who had sued to limit the direct lending program. He didn’t eliminate the direct lending program, but it withered from malnutrition.

History Resumes

Now Barack Obama is starting where Clinton left off. He is eliminating the FFEL program that subsidizes banks to lend to students. He is relying entirely on the FDL program that lends money directly to students from the U.S. treasury. It has lower interest rates and no middleman. The 2010 budget projects a savings of $5 billion, and intends to redirect those funds towards students.

To estimate the benefit that such redirection could have for students, we estimated the impact on the Pell Grant program, the nation’s preeminent means of providing need-based financial assistance. In 2007, 5.4 million American students nationwide received a Pell grant.

Our new report [3]estimates how many students in each state would benefit if the full $5 billion taken from the banks were redirected to the Pell Grant program. We estimate how the average Pell Grant would grow for each student ($121 nationally) and how many new students could enroll (260,000). In short, we show the direct benefit to Pell recipients if this budget passes. The key is to move the money from banks to students.

• National increase in Pell grant: $121
• National new Pell Grant recipients: 260,000.

Now a $121 increase in grant aid doesn't solve all the problems -- but it's much better than a stick in the eye. It also shows how our government can help when it takes our side. Read the report to learn the full benefit in every state [3].