Decline in Interest Rate Paid by Borrowers Is Primary Reason for Increase in Special Allowance Payments

The primary factor influencing the increase in special allowance payments  has been the sharp decline in interest rates paid by borrowers relative to  the minimum 9.5 percent government guaranteed yield for lenders. First, after paying costs associated with a pre-October 1, 1993 tax- exempt bond (such as payments of interest and principal to bond  investors), lenders can reinvest, or recycle, any remaining money  earned from 9.5 percent loans to make or purchase additional loans  that, under the law, are also guaranteed a minimum 9.5 percent lender  yield. Second, lenders can issue a new bond, called a refunding bond, to  repay the principal, interest, and other costs of an outstanding pre- October 1, 1993 tax-exempt bond. Using this method,  lenders can maintain their 9.5 percent loan volume. Third, under Education regulations, a lender can significantly increase  its 9.5 percent loan volume by issuing a taxable bond and using the  proceeds to purchase 9.5 percent loans financed by a pre-October 1,  1993 tax-exempt bond. The lender then uses the cash available from the  pre-October 1, 1993 tax-exempt bond to make or buy additional loans,  which are guaranteed the minimum 9.5 percent yield. The Administration and some members of Congress have,  in fact, already put forth proposals to make such changes. Representatives from a major credit rating agency as well as some lenders  who hold 9.5 percent loans told us that eliminating the minimum   9.5 percent yield for loans made or purchased in the future should not  affect lenders’ ability to meet their obligations under, and make required  payments on, their outstanding tax-exempt bonds, nor should it have long- term negative effects in the student loan bond market. Given  that current market interest rates are at or near historic lows, lenders have  a significant financial incentive to slow the decrease in, maintain, or  increase the volume of loans that yield such a relatively high rate of return  unavailable on other FFELP loans. Matter for Congressional Consideration

In light of the rapid increase in special allowance payments for loans  guaranteed a minimum 9.5 percent yield and the continuing financial  incentive for lenders to originate or purchase additional loans that qualify  for a guaranteed yield of 9.5 percent, Congress should consider amending  the HEA to address the issues identified by this report, but particularly to  change the yield for loans made or purchased in the future with the  proceeds of pre-October 1, 1993 tax-exempt bonds, and any associated  refunding bonds, to more closely reflect these loans’ financing costs and  current market interest rates. Recommendation for Executive Action

Given that lenders are increasing the volume of 9.5 percent loans based on  Education regulations that allow lenders to transfer 9.5 percent loans to  taxable bonds and tax-exempt bonds issued after October 1, 1993 while  retaining the special allowance payment provisions applicable to loans  financed with pre-October 1, 1993 tax-exempt bonds, and the resulting  increased costs for taxpayers, we recommend that the Secretary of  Education promulgate regulations to discontinue the payment of the  special allowance applicable to loans financed with pre-October 1, 1993  tax-exempt bonds that are subsequently transferred to taxable bonds or  tax-exempt bonds issued on or after October 1, 1993. To encourage lenders to make FFELP loans, the federal  government guarantees repayment and provides lenders a  guaranteed rate of return. When the borrower rate is less than the lender yield, the  government makes subsidy payments, called special allowance  payments (SAP), to lenders. Because of these changes, loans that are financed with tax-exempt  bonds issued prior to 10/1/93 are guaranteed a minimum 9.5 percent  yield, hereafter called 9.5 percent loans. Refunding a pre-10/1/93 tax-exempt bond extends the life of a bond, and loans continue to be guaranteed the minimum 9.5 percent yield Lenders may refund a pre-10/1/93 tax-exempt bond, and the

refunding bond may have a later maturity date than the original  bond.
Why GAO Did This Study

To encourage lenders to make student loans under the Federal Family Education Loan Program (FFELP), the federal government guarantees lenders a statutorily specified rate of return--called lender yield. Some lenders may issue tax-exempt bonds to raise capital to make or purchase loans; loans financed with such bonds issued prior to 10/1/93 are guaranteed a minimum lender yield of 9.5% (hereafter called 9.5% loans). When the interest rate paid by borrowers is less than the lender yield, the government pays lenders the difference--a subsidy called special allowance payments. In light of the upcoming reauthorization of the Higher Education Act of 1965, we examined special allowance payments for 9.5% loans.

What GAO Found

Special allowance payments for 9.5% loans have risen dramatically in recent years, increasing from $209 million in FY 2001 to well over $600 million as of June 30, 2004. A primary reason for the increase is the sharp decline in the variable interest rates paid by borrowers relative to the minimum 9.5% lender yield. Another reason for the increase in special allowance payments is the rising dollar volume of 9.5% loans, which increased from about $11 to over $17 billion from FY 1995 to June 30, 2004. Given that current market interest rates are at or near historic lows, lenders have a financial incentive to maintain or increase their 9.5% loan volume and can do so in three ways. After paying costs, including payments to bond investors, associated with a pre 10/1/93 tax-exempt bond, lenders can use any remaining money to reinvest in more FFELP loans that, by law, are also guaranteed a minimum 9.5% yield. Lenders can issue a new bond, called a refunding bond, to repay an outstanding pre 10/1/93 tax-exempt bond that financed 9.5% loans. Consequently, the refunding bond finances the 9.5% loans and may have a later maturity date than the original bond, allowing lenders to maintain their 9.5% loan volume for a longer time. By issuing a taxable bond and using the funds obtained to purchase 9.5% loans financed by a pre-10/1/93 tax-exempt bond, lenders can significantly increase their loan volume. Lenders can use the proceeds from the sale of loans previously financed by the pre-10/1/93 tax-exempt bond to make or buy additional loans, which are also guaranteed a 9.5% yield. Under Education's regulations, loans previously financed by a pre 10/1/93 tax-exempt bond and subsequently financed by (i.e., transferred to) a taxable bond continue to be guaranteed a 9.5% yield. Some Members of Congress and the Administration have proposed making statutory changes with respect to 9.5% loans, which could save billions of dollars in future special allowance payments. An official representing a leading credit rating agency and some major lenders told us that making changes to the minimum 9.5% yield for loans made or purchased in the future should not affect lenders' ability to make required payments on outstanding tax-exempt bonds.