Bills Are Bad News for Lenders, Good News for Students

Student loan reform bills would fund education grants by slashing lender subsidies.
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The bill for scandals that have rocked the student loan industry is about to come due.

Lawmakers in both houses of Congress have approved bills slashing the subsidies and other perks lenders get for providing low-cost, federally guaranteed student loans. And the lenders' pain will be borrowers' gain, as much of the savings will be diverted into grants and other types of financial aid that students won't have to pay back.

A reconciled version of the bill should reach the White House by the end of the summer, where it is expected to get the president's approval.

Conflicts of interest in the student loan industry have made it an easy target for budget cuts. Over the past several months, an investigation by New York State Attorney General Andrew Cuomo uncovered evidence that these companies showered employees at major colleges and universities with expensive gifts in exchange for sweetheart deals and preferential treatment.

As a result of Cuomo's findings, several schools including New York University, Syracuse University and the University of Pennsylvania have reimbursed students hundreds of thousands of dollars, while companies such as

Citigroup

(C) - Get Report

are donating millions to financial aid education efforts. Many lenders and the schools they work with are also voluntarily adopting codes of conduct drawn up by the attorney general.

A report released by Sen. Ted Kennedy (D., Mass.), chairman of the Senate committee that oversees education, cites documents that paint a picture of an industry rife with unethical behavior, where college employees who were supposed to be looking out for students were cozying up to loan companies for their own financial gain. A

Bank of America

(BAC) - Get Report

email lists the lavish demands of one financial aid officer, who expected lenders to pay for birthday parties, sporting events, wine and tequila (the bank did not provide any sports tickets, though it did buy him alcohol on one occasion).

In other cases, school officials were employed by or given stock in financial institutions that made their way onto "preferred lender lists" provided to students and their parents.

"The findings underscore the urgent need for systemic reform in the student loan system," Sen. Kennedy says in a statement.

"Reform" will cost the student loan industry dearly. Both the House and the Senate bills call for deep cuts in the subsidies the government pays lenders to lend money to students at below-market rates. The House bill slashes $19 billion in subsidies, while the Senate offering reduces them by $18.3 billion.

Both proposals also reduce loan insurance rates -- the amount of money the government gives a lender when a federally guaranteed student loan goes into default. At the same time, the plans increase the origination fees lenders are charged by the government for making new loans under the Federal Family Education Loan Program.

Lobbyists for a group that represents lenders including

Nelnet

(NNI) - Get Report

,

CIT Group's

(CIT) - Get Report

Student Loan Xpress and

Wells Fargo

(WFC) - Get Report

say the legislation could actually harm borrowers by driving some smaller student loan companies out of the business while forcing others to eliminate interest rate discounts and raise fees.

Kevin Bruns, executive director of America's Student Loan Providers, says in a statement that changes called for in both bills would "make college more expensive for millions of middle class families, creating more anxiety for those already struggling with skyrocketing college costs."

Others see more pluses for students than minuses. Mark Kantrowitz, who advises student borrowers through his Web site

FinAid.org, says he expects to see some "token cuts" in the discounts lenders give to students, but no major changes.

Kantrowitz also doesn't see anything in the current legislation that would complicate the $25 billion sale of student loan giant

Sallie Mae

(SLM) - Get Report

to an investor group led by J.C. Flowers.

On the other hand, he says, key provisions could make life easier for college students and their parents. Both bills cap the repayment amount on federally backed student loans at 15% of the borrowers' discretionary income. Some loans would also be forgiven after 25 years.

Graduates who go on to work as teachers or in public-service jobs could receive additional financial assistance or breaks on their loans.

Such changes would address some of the most significant criticisms of the student lending industry. According to the College Board, nearly two-thirds of students at four-year colleges and universities finance at least part of their education. The average graduating senior with loans owes more than $19,000. Some observers worry that these massive debt loads are preventing young adults from buying homes, saving for retirement or starting a family.

The legislation also diverts money currently given to lenders in the form of subsidies to student grants. The Senate plan pushes the maximum Pell Grant amount for low-income students to $5,400 per year by 2011. The maximum Pell Grant amount has been frozen at $4,050 since 2003, although it is slated to go up to $4,310 in the coming academic year.

The House proposal calls for a smaller (but still significant) Pell Grant increase while also slashing the interest rates on student loans in half to 3.4% from 6.8%. That would cut the total amount of interest paid on a 10-year loan with a $20,000 balance to around $3,620 from $7,619.

Both the House and the Senate are also calling on colleges and lenders to clean up their acts by eliminating the financial incentives some financial aid officers have to steer students toward certain lenders. The Senate plan would ban "gifts" from lenders to college employees and require disclosure when a faculty member is paid to sit on a loan company's advisory board or participate in a professional development program.

The full House and Senate should vote on the plans by the end of July. After that, they will go to a conference committee, where significant last-minute changes could arise. However, FinAid.org's Kantrowitz says that given the mood in Washington, student lenders may choose to simply take their lumps and move on.

"You've had bad news coming out on a daily basis," he says. "What they would like to see is this entire situation resolved as quickly as possible."