When Privatization Fails: College Loans

Last week, Joe Nocera had an excellent piece in the NY Times about how college loans became so exorbitant. Nocera first relates his own college loan experience--in 1974:

...I was constantly falling behind on my payments. The bank that administered my federally guaranteed loans would send a stern notice whenever I got too far behind, which would prompt me to cobble together a few payments by skipping some other bill. Then I would start falling behind again.

Though I found the situation onerous at the time, what strikes me now is how benign it actually was. My bank probably didn't make a dime on me. It never raised my interest rate as punishment, nor did I ever have to pay any late fees. My chronic tardiness didn't even affect my credit rating. And had I defaulted, I would not have had my wages garnished, or been stuck with the debt if I had filed for bankruptcy. All of which can happen today.

He then asks a very important question:

How did this critically important social program become so unmoored from its original intent, which was to help poor and middle-class students pay for college? To put it another way, why did student loans become more about shareholders than about students?

GEORGE MILLER, a Democratic Congressman from California, has been obsessing about student loans for a long time. "If you were going to start this program all over again," he says "you would go back to the concept that this is a service, and an investment, provided by the federal government. And you would probably go back to a direct loan program, funded with some sort of revolving fund. That is how the G.I. bill worked. But that is now viewed as foreign and wrongheaded. Now we have this idea that there has to be a business model."

Granted, some university Boards of Directors would make you think that universities are businesses, but they are non-profit organizations that are supposed to serve the public welfare by educating the public. At its core, the loan problem stems from privatization (italics mine):

The critical markers in the evolution of the student loan begin, really, with the decision to offer federally guaranteed loans through banks and other financial institutions. It didn't have to be done that way. Congress could have decided that only the government could lend taxpayer dollars. But without a middleman, the loans would be listed as outstanding on the government's books, thus increasing the federal deficit. It was far more politically attractive to use banks to make the loans, and then guarantee them with the taxpayers' money.

Even with the guarantee, banks were not terribly excited about administering a loan program for college students with uncertain job prospects. So the government tried to make lending even more attractive. It subsidized the interest rates. In the case of a default, it guaranteed that banks would get back not just the principal but the interest. It took all the risk out of lending.

And to get more loans into the hands of students, in 1972 the government established a quasi-government entity, the Student Loan Marketing Association, now known as Sallie Mae. Sallie's role was to buy up student loans from banks, freeing capital for yet more loans. It could also market and service loans, but it could not originate them. Although always a corporation -- much the way Fannie Mae and Freddie Mac have both government status and corporate status -- "it didn't go all out in search of the next buck," Mr. Nassarian says.

In the 1990s, two important events took place. First, Congress finally decided to lend directly to students. The Direct Loan Program was an immediate hit; within a few years, it had 40 percent of the market. But this was not the kind of G.I. bill, revolving-fund loan that Representative Miller envisions; its intent was to minimize the cost to the taxpayer, not to the student. So it had many of the late fees and higher interest penalties that private lenders were allowed to impose, and the interest rate was the same, 6.8 percent. Shortly after the program passed, the Republicans won both houses of Congress, and began fighting a rear-guard action against it.

Second, Sallie Mae broke away from the federal government. Its chief executive was an aggressive, profit-oriented man named Albert L. Lord, who feared that the Direct Loan Program would hurt Sallie. Privatization would enable him to fight back.

Once it had the ability to originate loans, Sallie devised marketing plans, sought ways to undercut the government lending program and began convincing college financial aid officers to give it special preference. It wasn't too long before private lenders won back some of the market share they had lost to the Direct Loan Program; they now control about 75 percent of the market.

Nocera concludes:

But let's also keep in mind that student loans went from being a service to a business because that's the way the larger society has evolved over the past few decades. And until society changes, we can hardly expect the student loan business to change.

It's a sobering lesson in the limits of capitalism. As a culture, we praise the ability of the market to create the proper incentives and do more good than not. And mostly that's true. But there are some things that are too important to entrust to the profit motive. Shouldn't paying for a college education be one of them?

This is no way to run an empire.