Using Regulation to Pay for Government Spending
Will increased subsidies for student loans benefit students?

19 Jan 2007 in Regulatory Economics, Legislation

The House of Representatives has passed legislation that would lower the interest rates on federally insured student loans. These changes increase federal budget outlays, and under new pay-as-you-go budgeting rules ("PAYGO"), revenues must be found to offset these increases. That's accomplished by changing the regulations under which lenders must operate to issue these loans.

To cover the estimated $7 billion outlays from reduced interest rates, new regulations will increase fees charged to lenders by an estimated $14 billion. If lenders pass on just half of these added costs to borrowers, all gains students obtain from the reduced interest rate will be offset by higher fees. If lenders pass on more than half, this student loan program could get smaller.

H.R. 5 (George Miller and 211 co-sponsors) passed on January 17 by a vote of 356-71. The bill is widely reported as reducing the cost of college education by such media outlets as Bloomberg ("House votes to cut rates on student loans by half"); the Associated Press ("House approves cutting rates on student loans"), Reuters ("House votes to halve student-loan interest rates"), and the Christian Science Monitor ("Congress moves to cut college loan costs"). At least one press account delivers the same message even though their headlines convey the opposite message ("Lawmakers Want To Slash Student Loans"). Dozens of college newspapers have covered H.R. 5 in the conventional manner, characterizing it as a boon to college students.

Is it really?

If enacted, H.R. 5 would reduce the interest rate on federally insured student loans in stages from 2007 through 2011, after which the rate would return to the 2006 level. The Congressional Budget Office estimates that reducing interest rates will federal budget outlays will rise by $7.1 billion over the period 2007-2017. (Additional outlays will occur after 2017, but budget rules require Congress to account only for outlays accruing over the next 10 years.)

It's not clear how much benefit students would get from the bill. New PAYGO rules require that these 10-year outlays (but not their entire amounts) be balanced by spending cuts elsewhere or increases in revenue. H.R. 5 would do this by changing several regulatory aspects of the program. Each of these changes generates additional revenue from lenders. Some fraction of each increase in lenders' costs will be passed on to student borrowers or their parents:

• Reduced lender insurance: The amount paid to lenders by the federal government would be reduced an estimated $2.8 billion. This will increase the risk borne by lenders of originating federally insured student loans. They probably will tighten their underwriting standards to compensate for this increase in risk, that that should mean fewer loans originated -- especially to those borrowers whose creditworthiness is marginal.
• Reduced retention of guaranty fees: The amount non-federal guaranty agencies are allowed to retain would be reduced by $2.2 billion. This regulatory change will make it more expensive for these entities to guarantee loans.
• Reduced "special allowance payments" to lenders: Under current law, private lenders receive payments from the government when the interest rate formula used to pay lenders would provide an interest rate higher than that which would apply to borrowers. These payments would be reduced $4.3 billion.
• Increased loan fees: The fee charged by the federal government would be doubled. This change would increase payments by lenders to the federal government by an estimated $4.9 billion.
• Increased payment rebate rate: Fees charged by the federal government to lenders who consolidate loans would increase by $210 million.

CBO estimates that these regulatory provisions in H.R. 5 would increase federal revenues by $14 billion. That's twice the amount of increased government outlays attributable to reduced interest rates. It's net effect is to make federally insured student loans more expensive. By regulation it removes $2 from supply for every $1 in federal funds it adds. Leaving aside the merits of federally-subsidized student loans as public policy, if enacted H.R. 5 would reduce the number of college students who receive such loans, reduce the "list price" for those who do get them, and increase these loans' actual cost in hidden ways.

H.R. 5 has too many supporters to list. However, Neutral Source has not found any who address the net effect of reduced interest rates and regulatory changes.

H.R. 5 also has a few detractors. Richard Vedder says "the federal student-loan program is already Byzantine in its complexity, and has even been harmful to some students," primarily by leading to more rapid increases in tuition.The Heritage Foundation's Brian Riedl objects on a variety of grounds but also does not address the bill's regulatory provisions: "Congress' focus on interest rates is curious because current rates are quite low by historical standards." Both Vedder nor Riedl appear to interpret H.R. 5 as an expansion of the program (as advertised by its proponents) rather than a change in the program's structure that could reduce its size.

Even if the countervailing effects of regulatory changes are ignored, the gross benefit to student borrowers appears to be small, and it's back-loaded into later years where it's less valuable. The maximum benefit is obtained by a student matriculating in fall 2008 and completing a 4-year degree in 2001.

Below we summarize a student borrower's first-year cost savings.

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