Evaluating Student Loan Auctions

The following discussion paper was released by NASFAA on 10/24/07. This discussion paper has been adapted from a portion of my graduate level dissertation for my MBA. I’ve included the Executive Summary below. The entire discussion paper can be found online.

Executive Summary

A fundamental challenge with student loan subsidization is determining the appropriate subsidy rate that will encourage lenders to participate in the Federal Family Education Loan (FFEL) program without receiving taxpayer-funded windfall of revenues. Since federal student loan subsidies began in 1966, Congress has taken a “guess” approach to setting subsidy rates. Now lawmakers have implemented an auction system (only partially on parent PLUS loans) that would instead inject market conditions into the equation, forcing lenders to compete for the lowest subsidy rate in order to originate loans. On the surface, an auction system for federal student loans seems to inject market conditions into a government controlled and subsidized system. But the current auction system has been implemented based on several faulty assumptions.

• Assumption: Competition will drive down subsidy rates.
• More Likely: Competition will drive down subsidy rates only in a few states and only for a few years. Most states will likely see very little competition and in states where there is competition subsidy rates are likely to rise after a few years.

• Assumption: Taxpayers will save money by lenders competing for the right to originate loans.
• More Likely: Increased financial incentives built into the loan auction system to encourage lender participation will diminish potential savings and in some cases could actually cost taxpayers more than loans originated outside of the auction system.

• Assumption: Borrowers will not be affected by loan auctions because many do not qualify for borrower benefits anyway.
• More Likely: Loan providers will compete for the right to originate loans, not for the customers who use them. Currently, most borrowers qualify for some sort of borrower benefit, even if it is only an origination fee reimbursement. Borrower services such as default prevention, financial literacy, and electronic processing, are also likely to be less funded as borrowers compete only to originate.

• Assumption: The parent PLUS loan auctions will provide a good indication of what loan auctions will be like for all FFEL loans.
• More Likely: Parent PLUS loans make up a fraction of Stafford loan volume and will not realistically provide any indication of how an auction system would work across the significantly larger FFEL program.

• Assumption: Market consolidation may occur on a limited basis, but the market is already dominated by a few large lenders.
• More Likely: A comprehensive loan auction system would lead to fewer loan providers competing for loans as smaller lenders are starved out of the program or merge in an attempt to compete. Large loan providers have acknowledged that currently the presence of smaller loan providers in the market, particularly nonprofits, force loan costs down for borrowers.

The student loan auction system presupposes that the current system is broken beyond repair. Finding the appropriate subsidization amount is difficult, but the “guess” approach previously used by the federal government may not be wrong. The subsidy rate may just need more frequent adjustments based on empirical evidence.

A closer look reveals that an auction system in the FFEL program will likely result in market consolidations, fewer loan providers, fewer benefits for borrowers, and limited savings for taxpayers that will diminish over time. A more sound and realistic approach would be to work with loan providers, stakeholders, and other non-partisan analysts to adjust subsidization levels on a more frequent and independent basis than has been done in the past.