The Obama Administration’s Perpetual Motion Machine: A New Student Loan Program

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How does the Obama Administration freeze non-security discretionary spending in its fiscal year 2012 budget yet manage to boost spending on key priorities like education programs? In the case of the Pell Grant program for needy college students, the Administration would “pay for” a share of the program’s ballooning $37 billion budget by creating a new subsidized student loan program that appears to generate new profits for the government.

But can supposed profits from one government program really pay for another? Has the Obama Administration discovered the budgeting equivalent of a perpetual motion machine where one government program’s “free lunch” is shared with another program and taxpayers don’t have to pony up a dime?

Hardly.

The Administration’s claim that its program will earn profits by lending to college students from low income families at generous terms is pure accounting illusion. As explained in earlier e21 commentary (Credit Reform Act: Another Budget Loophole), a loophole in the Federal Credit Reform Act of 1990 makes many government loan programs appear as though they both provide subsidies to borrowers and earn profits for the government. This apparent “free lunch” arises not because the government is inherently better at lending than private companies, but because the current budget rules that are used to calculate loan costs don’t factor in any cost for market risk. That is, by discounting expected loan performance at risk-free U.S. Treasury interest rates, the rules ignore the fact that loan performance is unpredictable over time and that defaults will be more frequent and costly in bad economic climates. As a result, risky loans made at below-market rates can appear profitable, but only when the government makes them. No private lender would risk its capital to make similar loans because the risks do not justify the potential gains.

The accounting loophole in the Federal Credit Reform Act is particularly ripe for abuse among policymakers who want to appear fiscally austere but don’t actually want to rein in government spending. It’s not surprising then that the Obama Administration sought to shore up the finances of the rapidly growing Pell Grant program by taking advantage of the accounting loophole for loan programs. What could be a better offset for new spending than a new loan program that provides subsidies to college students but appears to impose no costs on taxpayers – and actually even appears to earn some profits for the government?

Here’s what the Obama Administration proposes in its 2012 budget.

The new budget scraps the decades-old Perkins loan program, a revolving loan fund, and replaces it with a new direct loan program. The Perkins program currently operates alongside the government's much larger Stafford and PLUS loan programs, and the Administration would replace it by letting the most financially needy students take out more Stafford loans ($5,500 more each year per student), totaling $8.5 billion in new loans annually. Like Stafford loans, these new loans would come with more generous terms than those available in the private market. Interest rates would be fixed at 6.8% for up to 25 years, repayment deferred until borrowers leave school, forbearances offered for financial hardship, and loans would even be forgiven under a variety of circumstances. Also, no earnings, co-signer or credit history would be required for borrowers to get loans.

That hardly sounds like a money-making endeavor – or one that the private sector would want to pursue to earn profits. And it shouldn’t be, given that the goal of the program is to subsidize the cost of college education for students from low-income families. But under Federal Credit Reform Act rules the White House Office of Management and Budget (OMB) estimates the program will earn $7.3 billion over the next 10 years, all of which the Administration would spend on sustaining the Pell Grant program. According to OMB, the loans are subsidized at negative 26%; meaning for every $100 that gets lent out the government will earn $26 over the life of the loan.

Of course, once market risk is factored into the estimates, the loans don’t look like such a good deal for taxpayers. In a 2010 paper, the Congressional Budget Office estimated that the federal government’s student loan programs on average actually have a positive subsidy of 12% when market risk is fully factored in. (Administrative costs account for about 2 percentage points of that figure). That is, it costs taxpayers $12 for every $100 the government lends. (This is also the amount of subsidy that borrowers receive.) That means if the government paid a private company to make the loans and bear all of the costs and risks, it would have to pay the company $12 for every $100 that it lent out. This is the market’s value of the costs taxpayers bear when the government makes loans to students at favorable terms.

The Obama Administration isn’t alone in exploiting the accounting loophole in the Federal Credit Reform Act, especially when it comes to student loans. In 2005, Senate Republicans included a provision in the Deficit Reduction Act that allows graduate students to take out government-backed loans to pay for the full cost of their education. In the past, Congress had restricted graduate students from taking on more than $10,000 a year in government-backed loans. In pushing to remove this restriction, the sponsors could claim that these new loans would earn money for the government and would therefore help reduce projected budget deficits. Similarly, a bill introduced in the Senate last year, the Student Loan Debt Swap Act, would have generated some $9 billion in fictitious earnings if enacted. The bill would have let borrowers exchange risky private student loans for government subsidized ones.

Congress can end these misleading cost estimates by amending the Federal Credit Reform Act so that budget analysts are required to take market risk into account when they calculate the costs of all loan programs. Simply removing the law’s requirement that estimates be calculated with U.S. Treasury interest rates would suffice. The federal budget would then include a fair assessment of the risks taxpayers bear when they subsidize students or any other group through a government loan program. It would also show that perpetual motion machines don’t really exist – not even if the Obama Administration puts one into its budget.

Jason Delisle is the Director of the Federal Education Budget Project at the New America Foundation.