American colleges accept a variety of financial incentives from some large student-loan companies, like Sallie Mae, to steer students to borrow from them, New York State Atty. Gen. Andrew Cuomo charged on March 15. Goodies include substantial cash payments, free trips to resort destinations for campus financial-aid officers, and company-manned call centers to answer students' financial-aid questions.
Mr. Cuomo's complaint will no doubt energize politicians eager to take credit for clipping the wings of private lenders who earn profits from federally guaranteed student loans. The alternative they favor would increase direct lending by the government.
But such a shift could increase the taxpayers' burden and drive up the overall costs of college.
As many taxpayers may not be aware, the U.S. Department of Education operates two competing loan programs, and the taxpayers bear the risk burdens of both. Under the William D. Ford Direct Loan Program, the department makes and administers loans directly to borrowers. Under the Federal Family Education Loan (FFEL) program, private companies provide the capital and administer the loans, but these loans are largely subsidized and insured by the federal government.
Some believe that one way to rein in costs would be to scale back the FFEL program and expand the Ford Direct Loan program, thereby cutting out the middleman and potentially reducing costs.
But the devil is in the details - or, in this case, the defaults. The default rates under the Ford Direct Loan Program are higher than under the FFEL program, and the gap is widening. When a college grad defaults on a federally insured student loan, the taxpayer is on the hook for most of the balance.
According to the Office of Management and Budget, the 2007 projected weighted average default rate under the FFEL program is 11.7 percent; under the Ford program, it is a whopping 16.65 percent. Already more than 3.1 million Direct Loans are expected, and taxpayers can expect an increased burden should the program be expanded.
What accounts for the difference in the default rates? Private companies have both the incentive and the ability to be innovative in keeping track of borrowers, enabling them to prevent and recover bad debts.
Students are a poor credit risk. They typically have limited credit histories, no secure jobs and an immature sense of responsibility. That's one of the main reasons why the federal government insures student loans.