Subsidy Costs for Direct vs. Guaranteed Student Loans

July 27, 2009

Today CBO released a letter that contains an estimate of the change in federal costs, adjusted for the cost of market risk, that might result from enactment of the Presidents proposal to prohibit new federal guarantees of student loans and to replace those guarantees with direct loans made by the Department of Education. The Federal Family Education Loan Program provides federal guarantees for loans made to students by private lenders and is the predominant source of loans for higher education; CBO projects that, under current law, guaranteed loans will account for 70 percent of all new direct and guaranteed student loans made over the next 10 years. Under the Presidents proposal, the Department of Education, through the William D. Ford Direct Loan Program, would provide federal support for student loans only by lending money directly to students.

In its cost estimate last week for the Student Aid and Fiscal Responsibility Act of 2009, as approved by the House Committee on Education and Labor, which would incorporate the Presidents proposal, CBO estimated that replacing new guarantees of student loans with direct lending would yield gross savings in federal direct (or mandatory) spending of about $87 billion over the 20102019 period. (Mandatory spending is governed by existing provisions of law and does not require future appropriations.) About $7 billion of those savings would represent a reduction in the administrative costs of the guaranteed loan program, which are recorded in the budget as mandatory spending. In contrast, most of the administrative costs for the direct loan program are funded in appropriation bills and recorded as discretionary spending. Thus, of the $87 billion reduction in direct spending, roughly $7 billion would be offset by an increase in future appropriations for administrative costs, for an estimated net reduction in federal costs from the Presidents proposal of about $80 billion over the 20102019 period.

Those estimates follow the standard loan-valuation procedure called for in the Federal Credit Reform Act of 1990 (FCRA). The law specifies that the cost of federal loans and loan guarantees be estimated as the net present value of the federal governments cash flows, using the Treasurys borrowing rates to discount those flows; that calculation does not include administrative costs, which are recorded in the budget year by year on a cash basis (that is, undiscounted). The FCRA methodology, however, does not include the cost to the government stemming from the risk that defaults will exceed the estimated rate, especially at times of market stress. CBO found that, after accounting for the cost of such risk, the proposal to replace new guaranteed loans with direct loans would lead to estimated savings of about $47 billion over the 20102019 periodabout $33 billion less than CBOs estimate under the standard credit reform treatment.