On April 13, 2021, Senator Elizabeth Warren (D-MA) conducted her first hearing on student loans as chair of the Senate Subcommittee on Economic Policy, during which time the bulk of her attention was aimed toward John Remondi, president and chief executive officer of Navient Corporation, the nation’s largest administrator of education-related debts and also the subject of numerous alleged abusive and misleading practices. 

Much of the hearing was spent on the difficulties eligible borrowers have had arranging for the discharge of their remaining loan balances under the Department of Education’s (ED) Public Service Loan Forgiveness program (PSLF) and the continuing frustrations of those who qualify for but fail to receive relief under the department’s various income-based repayment plans (IBR). 

The legitimate furor over these mistreatments is well documented. But I also suspect it has more to do with loans that were originated under the Federal Family Education Loan (FFEL) program, discontinued in 2010, and not the Federal Direct loan program that is currently in place. Here’s why.

The FFEL program, conceived under the Higher Education Act of 1965, was designed as a public/private collaboration in which private-sector financial institutions originated student loans that the federal government agreed to guarantee against default. To be clear, the federal government did not finance these loans as it does those that now originate under its Federal Direct Loan program. Rather, the private sector arranged its own funding, which often took the form of complex financial transactions known as securitization. 

As part of that process, ownership of the tens of thousands of loans that typically comprise a singular transaction are transferred by the originating financial institutions to a pool of investors who purchase “pieces” of the whole in the form of securities. Complications arise, however, when the financial interests of those investors end up at cross-purposes with that of the government guarantor. 

Loan durations, for example, that are extended for financially distressed borrowers under the ED’s various IBR plans (so that payments will be more affordable), subject investors to heightened inflationary risk because the same number of dollars they receive over the course of 20 years instead of 10 lose even more value over time. And although investors are held harmless for the loss of principal and interest on defaulted and, it appears, forgiven loan balances, the availability of comparable reinvestment opportunities for the capital that is returned to them prematurely is not assured. 

The point is, administrators that are responsible for servicing these loans—of which Navient is the largest when it comes to FFELs—have a dilemma: To whom do they have a fiduciary responsibility? The investors who are paying them to manage these loans, or to the federal government, which backstops their clients against the financial consequences of default? 

This is the crux of the problem and the reason why financially distressed borrowers have had such a rough time arranging for the relief to which they are legally entitled. 

The good news is that the portfolio of FFEL loans is rapidly diminishing. Per the notes of the ED’s September 30, 2020, financial statements, $128.9 billion was outstanding at that time. So too then is the tug of war between the federal government and private sector investors diminishing, but only for these loans. That’s because the U.S. Treasury fully funds and retains ownership to its portfolio of Federal Direct loans, so the department’s loan-servicing directives to its stable of subcontracted loan administrators are incontrovertible. 

Nevertheless, there is good value in rehashing past sins—even in showcase hearings such as Senator Warren’s—provided we learn from them. 

According to the same notes to the ED’s balance sheet, the department’s Federal Direct loan portfolio now exceeds $1.2 trillion and is funded by an equivalent value of U.S. Treasury borrowings. As such, one might rightly view this program as self-liquidating because every dollar received from student loan borrowers could be used to pay down a corresponding value of debt. But that would only be true if the program were in run-off or liquidation mode, in which no new loans are made. 

Clearly, this is not the case, because the rate of newly originated loans surpasses the amortization of those that are currently in repayment. (Roughly half of all Federal Direct loan payment are deferred because the borrowers are still in school.) Therefore, U.S. Treasury borrowings to finance this program are accretive to the burgeoning federal deficit. 

Therein lies the rub and a potentially irresistible political opportunity, too: What if the ED were to divest its portfolio of student loans and reduce the federal deficit with the proceeds? Well, two things stand in the way: The IBR plans that extend durations and loan forgiveness under that and the PSLF program. 

The solution, therefore, is to restructure the entire portfolio of Federal Direct loans before divestiture so that payment durations mimic that which is currently available under its IBR plans. Roughly half of all loans that are currently in repayment are either delinquent, in default, in forbearance or have already been restructured under IBR. Why continue to deal on a piecemeal basis with what is obviously an improperly structured program at its outset? 

And because the government provides this unsecured (uncollateralized) financing to consumer-learners without regard for creditworthiness or prepayment penalty, it should also shield subsequent owners of the loans against losses due to loan default, prepayment or forgiveness. 

At that point, payment performance for the aggregate student loan portfolio should stabilize, the need for administrative intervention should therefore subside, and investors will know what to expect and when to expect it.

Mitchell D. Weiss
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