The Selling of Student Loans

Twenty years ago, a U.S. Senate aide walked into a bank in Maine and saw a sign that read “Take out a student loan today, get a toaster.”

The aide, concerned that students would be tempted to take out loans they didn’t need, drafted legislation barring lenders from offering “inducements” to borrow. That language was added to the Higher Education Act in 1986, and for the next two decades, the “toaster provision” remained a backwater of student-aid policy.

That all changed in April, when New York State’s attorney general, Andrew M. Cuomo, announced the first settlements stemming from his investigation into conflicts of interests in the student-loan industry. Suddenly, inducements are front-page news. Colleges and their alumni associations stand accused of taking kickbacks, financial-aid officers have been fired for accepting consulting fees and stock options from lenders, and the Education Department is being blamed for its lax oversight of the industry.

How did colleges get from toasters to stock options? The story begins almost 15 years ago, with the creation of the federal direct-loan program.

An End to Marketing

When Congress and the Clinton administration created direct lending in the early 1990s, it was seen by many student-aid experts as a major breakthrough.

For years policy makers had accused banks and loan guarantors of growing rich from the subsidies they received to provide federally backed loans to students. By bypassing those banks and guarantors, and lending directly to students, the government would be able to free up billions for student aid, supporters argued.

With that goal in mind, Congressional Democrats approved a bill in 1993 that called for the program to make up 60 percent of federal-loan volume by 1998-99. Within two years, 1,300 colleges — a third of the market — had made the switch from the guaranteed-loan program.

But just as direct lending was taking off, Republicans regained control of Congress. At first they tried to kill the program, arguing that it cost taxpayers more than guaranteed loans. When that tactic failed, Republicans threatened to block its growth if President Bill Clinton continued to market it.

“They told him he wouldn’t get anything if he continued to push direct lending,” says Robert M. Shireman, who was a top aide to Sen. Paul Simon, the sponsor of the 1993 direct-lending bill, at the time. “They saw it as a Clinton program, and anything that was Clinton, they wanted to undo.”

To appease Congressional Republicans, Mr. Clinton agreed to stop pushing direct lending and allow the two programs to compete. That concession stopped the growth of direct lending, allowing the loan industry to refocus its efforts on “repatriating” colleges into the guaranteed-loan program.

“The department wasn’t doing anything to get more schools in, and the industry was doing everything it could to get schools out” of direct lending, recalls Eileen O’Leary, immediate past chair of the National Direct Student Loan Coalition, a lobbying organization. “So direct lending saw its market share go down.”

To lure colleges back to the guaranteed-loan program, Sallie Mae and other large lenders began offering borrowers discounts that the Education Department — bound by fees set in federal law — couldn’t match. When President Clinton tried to lower the fees on direct loans administratively, lenders sued, citing a provision of the Higher Education Act that requires the government to charge borrowers in the program a certain amount.

The discounted fees and interest rates in the guaranteed-loan program made it difficult for colleges to justify remaining in direct lending, proponents of both programs say.

“The argument was, if you don’t drop direct lending, you’re shortchanging your students,” says Jon H. Oberg, who worked at the Education Department at the time.

Still, many colleges remained, citing the program’s administrative ease. In direct lending, colleges don’t have to process loans for multiple lenders because the Education Department is the sole lender.

Imitating Direct Lending

To win over more colleges, the loan industry had to make the delivery of loans to students as quick and as easy in the guaranteed-loan program as it was in direct lending. They started by using the Internet.

One of the first products the loan industry developed was Laureate, a system that allowed students to get approval for loans online and allowed college officials to process the loans online. Laureate was also a way for its creator, Sallie Mae, to expand its loan portfolio. Lenders that used the proprietary system to originate loans were required to sell those loans to Sallie Mae.

Around the same time, newer, less-established companies, like the Education Lending Group and the U.S. Education Finance Corporation, began marketing another way to ease the administrative burden of guaranteed loans: the school-as-lender program. Under that program, colleges make loans directly to their graduate students and then sell them to a single lender at a premium, reducing the number of lenders that the college must deal with to one. Colleges then use the revenue from the sale of the loans to provide more student aid.

Those new entrants focused their pitches on colleges with large graduate and professional programs, offering them thousands of dollars to leave direct lending. In some cases, the lenders offered colleges a higher premium if the institutions agreed to switch to the guaranteed-loan program for their undergraduates as well.

The offer proved irresistible for several of direct lending’s public-university participants, particularly in a time of shrinking state budgets. Within a few years, a dozen such institutions had jumped ship, including the University of Nebraska and the University of Missouri at Kansas City.

With so much money on the table, it didn’t take long for colleges to realize that they could use their loan volume as leverage. In 2003, Michigan State University, the second-largest participant in the direct-loan program, put its loan volume up for bid, forcing lenders to compete to provide the best deal for borrowers and the most money for the university.

“They were asking, What will you do for us if we leave direct lending?” says Barmak Nassirian, associate executive director of the American Association of Collegiate Registrars and Admissions Officers. “It was a very public auction for their business.”

Mr. Nassirian says Michigan State’s success — and the fact that it was so public about its intentions — emboldened other institutions to start soliciting other benefits from lenders, such as staff support during peak processing periods and assistance with counseling student borrowers. “It was a signal that, ‘Look, we could take this model and tweak it and make it work for us,’” he says. “A giant sucking sound was inaugurated with this deal.”

Three years later, Congress placed a moratorium on the school-as-lender program, saying that it created a conflict of interest for colleges because the institutions profited from their graduate students’ debt. But instead of backing down, advocates for the program began taking advantage of a legal loophole that allowed colleges to act as lenders if they hired banks to serve as trustees for the loans they made.

Lenders Compete

At the same time that lenders were trying to lure colleges away from direct lending, they were also fighting among themselves for a piece of the growing guaranteed-student-loan market. With college costs rising rapidly, more students were borrowing, and lenders were competing vigorously for their business.

“The stakes had grown,” says Thomas R. Wolanin, a longtime Democratic aide in Congress who is now retired. For banks, “student lending was no longer a sleepy sideline — it was a major piece of the business.”

The easiest way for lenders to expand their portfolios was to get on an institution’s preferred-lender list, which college financial-aid offices give to prospective borrowers as guidance. While students are not required to pick a lender on the list, as many as 90 percent do. To secure a spot on a list, lenders began offering discounts to borrowers and staff support, free software, and other perks to colleges. Some student-loan companies hired financial-aid officers to market their loans to former colleagues.

Lenders also began courting financial-aid officials, offering them tickets to sporting events, free lunches, and happy hours. At the annual conferences of the National Association of Student Financial Aid Administrators, lenders wooed college administrators over lavish dinners and at parties.

“Lenders learned that it’s much easier and more effective to market their goods and services to a couple of people at an institution than to thousands of customers,” says Craig Munier, director of financial aid at the University of Nebraska at Lincoln and chair of the National Direct Student Loan Coalition. “It’s easier to wine and dine a financial-aid officer and let that person bring you their business.”

If those efforts failed, consolidation offered a second shot at a college’s borrowers. With interest rates dropping, lenders could use refinancing to steal business from the competition as well as from direct lending.

By 2002 some lenders had begun paying alumni associations and athletics associations to recommend their consolidation loans. Leading the way was the National Education Loan Network, or Nelnet, which now has agreements with 120 college alumni associations nationwide. Another lender, Education Finance Partners, paid college athletics departments $75 for every consolidation-loan application submitted by the college’s students, staff members, and alumni. It canceled that offer last year, citing a lack of interest.

Other companies have sidestepped colleges altogether, offering inducements directly to borrowers. Some lenders have sent students checks for hundreds of dollars that they can cash when they make their first payment on a consolidation loan. Others have offered students upfront rebates for taking out consolidation loans.

Private Loan Market Grows

But some of the most creative — and most questionable — practices have occurred in the largely unregulated private-loan market, which has expanded rapidly in recent years.

Until recently, most private loans went to graduate and professional students, particularly those pursuing careers in high-paying fields like law and medicine. But with college prices climbing, and federal-loan limits lagging (the current ceiling is $23,000, a figure that was set in 1992), more and more undergraduates have turned to private loans to close the gap.

Since 2000, private lending to college students has quadrupled, from $4-billion to over $17-billion, according to the College Board.

Private loans are not regulated by the Education Department and are not subject to the federal ban on inducements.

One of the first lenders to take advantage of that exemption was Sallie Mae. In 2000 it began offering pools of private-loan money to colleges that agreed to make Sallie Mae a preferred provider of federally guaranteed loans. In one case, it offered Pace University $4-million if it agreed to leave direct lending and make Sallie Mae its “exclusive” lender.

Sallie Mae has defended the deals, arguing that its “opportunity loans,” which colleges can make to students who are at high risk of default, help international students and students with bad credit to attend college.

But competitors, critics, and even an inspector general at the Education Department have questioned if opportunity loans are legal. In 2003, Cathy H. Lewis, an assistant inspector general at the Education Department, wrote a memo urging agency officials to take a closer look.

At first, agency officials told Ms. Lewis that they preferred to wait and see if self-regulation by the industry would work. When she said the department should “take a stronger role,” officials offered to “conduct reviews of lender agreements with institutions” and issue new guidance to colleges and lenders.

Two years later, after requesting multiple extensions on the deadline for the guidance, the department drafted a “Dear Colleague” letter to colleges and lenders that simply repeated advice the department had issued in 1989. When the inspector general’s office said the letter did not go far enough, the department abandoned the effort altogether. Some lenders read the department’s inaction as a tacit approval of opportunity loans.

It was not the first time that the agency had ignored the advice of one of its own. In 2001, John Reeves, a Clinton-era appointee who was then general manager of the department’s financial-partners office, had tried to persuade his colleagues to crack down on inducements. He proposed that the department assume that a violation of the inducements ban had occurred if a lender held a certain percentage of the loan volume at a particular college. It would then be up to the lenders to prove otherwise. But Sallie Mae and other lenders lobbied against the proposal, and it died.

Cuomo Cracks Down

Meanwhile, some of the newer private-loan companies were going even further in their competition with more-established lenders. In 2003 one of those companies, Education Finance Partners, began providing colleges a portion of the profits on loans taken out by their students.

Such offers were hardly a secret. Indeed, most financial-aid offices and college lobbyists knew that lenders were offering opportunity loans, school-as-lender arrangements, and other deals, and believed they were within the bounds of the inducements law, says Terry W. Hartle, senior vice president for government and public affairs at the American Council on Education.

But behind the scenes, some lenders began to grumble. Chief among them was MyRichUncle, a relatively new student-loan company that was finding it difficult to break into the market, even though it was offering borrowers a reduction of 1 percentage point in the interest rate.

Fed up, the company took out an ad in The New York Times and a handful of other major publications accusing financial-aid officers of denying students access to the lowest-cost loans because of the cozy relationships the aid officers have with private lenders.

The ads, which accused financial-aid offices of taking “kickbacks” and “payola” from lenders, got the attention of New York State’s attorney general, Eliot Spitzer, who opened an investigation into “potential conflicts of interest in the student loan industry” last November. When he became governor, his successor, Mr. Cuomo, took over.

In April, Mr. Cuomo announced the first settlements in his investigation. By mid-May, more than 22 colleges had committed to Mr. Cuomo’s Code of Conduct, and eight had agreed to reimburse students the over $3-million they made through revenue-sharing agreements. Sallie Mae had agreed to stop offering opportunity loans, and Education Finance Partners and Citibank had agreed to stop offering revenue sharing.

Mr. Cuomo is still investigating consolidation-loan deals between lenders and alumni associations.

In testimony before Congress last month, Mr. Cuomo accused the Education Department of being “asleep at the switch” when it came to regulating student-loan companies. Secretary of Education Margaret Spellings has defended her agency’s record of enforcement, arguing that violations of the inducements ban are difficult to prove.

In 20 years, the department has taken only one enforcement action under the inducements ban. In 1995 it took action against Sallie Mae over its school-as-lender deal with the Dr. William M. Scholl College of Podiatric Medicine.

An administrative judge found in the lender’s favor, ruling that the arrangement was “typical of the traditional loan servicing, forward financing, and loan sale contracts used in the industry.”

http://chronicle.com Section: Government & Politics Volume 53, Issue 39, Page A15