Last week, the Republican majority in the House of Representatives passed H.R. 1911, the Smarter Solutions for Students Act.
Unfortunately, it’s neither smart, nor a solution.
The legislation pegs all Stafford Direct Student Loan rates (subsidized and unsubsidized) to the 10-year Treasury note, adjusted annually, plus 2.5% to cover administrative costs. Borrowers who qualify for subsidized loans would pay no interest while they are still in school and all loans have an 8.5% lifetime interest rate cap. (PLUS and parent loans would be similarly indexed, plus 4.5%).
In a Washington Times op-ed, Representatives John Kline (R-Minn.) and Virginia Foxx (R-N.C.) rationalize their legislation two ways: First, because fixed-rate loans create problems when “lower rates become available in the market”; second, because “politicians don’t have the know-how to pick static interest rates that will work for borrowers and fund student-loan programs.”
Reps. Kline and Foxx also respond to those who argue for perpetuating the status quo by insisting that extending the current arrangement would cost “roughly $8 billion,” even though Congressional Budget Office data suggest otherwise.
As unlikely as the Smarter Solutions Act is to find itself under Obama’s pen in its present form, the concept of indexing student loan interest rates is not new. In fact, Reps. Kline and Foxx make reference to the administration’s recent budget proposal, which also calls for market-based loan pricing.
However, the way each of these schemes is structured, student-borrowers will still end up paying more than they should.
As I explained previously, the starting point for pricing all financing transactions is the half-life. For example, a loan that is to be fully paid off in equal monthly installments over the course of a 5-year term would have a 2.5-year half-life, and one that spans 10 years (such as for Stafford loans) would have a 5-year half-life.
That half-life is then matched against comparable points on the yield curve — whether the curve depicts a Treasury note or Libor rates — before adjusting for the lender’s own creditworthiness. (In the case of federal government, the yield curve for Treasury notes is that starting point.) Afterward, additional premiums are tacked on to cover administrative (including loan servicing) and credit (delinquency, default-related risk) costs, which is presumably what the Kline-Foxx bill intends.
However, there are at least two flaws in the legislators’ thinking.
First, apart from the error of linking a 10-year government-backed financing to the yield of a comparable-term Treasury note, the fact that this legislation provides for annual adjustments tosses the entire concept of half-life-based pricing out the window. Given that structural twist, any lender would rightly fund these loans at the very low-cost end of the yield curve.
For example, according to the Treasury Department’s online resource center, the 10-year Treasury note currently yields 2.02%, the 5-year yields 0.91% and the 1-year yields 0.12%. Under the Smarter Solutions Act, Stafford loans would then be priced at 4.52% even though its real cost is 0.12% instead of 2.02%. That translates into a 4.40% upcharge versus the 2.5% premium Kline-Foxx represents to be the case.
We’re not talking about small potatoes here.
If the difference between the yields of the 1-year and 10-year Treasury notes were to remain constant over time, that 4.40% premium would result in a 23.7% present-day profit. In other words, for every dollar loaned out under this arrangement, the feds would earn a little less than a quarter, or $25.1 billion on the $106 billion the CBO currently projects will be funded in 2013.
As for Representatives Kline’s and Foxx’s other assertions, I agree that politicians — or anyone else, for that matter — don’t have the ability to accurately project market rates. But to suggest that managing fixed-rate loans is more burdensome than it is for floating-rate transactions is absurd, as any lender who has administered variable-rate loans can attest.
On the other hand, market-based pricing does indeed make sense — but not because consumers will complain when rates fall below a fixed-rate price. Rather, dynamic pricing is appropriate because the government’s own borrowing rates aren’t set in stone.
Even Sen. Elizabeth Warren (D-Mass.) misses the mark with the bill that she introduced the week before.
It proposes to peg student loan interest to the federal funds rate, which represents the price banks pay one another to borrow funds overnight. Other than for a populist argument to charge students the same rates the banks pay, that concept also fails to properly align loan durations. And it neglects to incorporate a spread to cover the administrative and credit costs the government incurs to operate this program.
Look, pricing is very important, but let’s first decide on the primary objective for this enterprise: Is the government in the student loan business to make money, lose money or just to cover its costs? Only then will we be able to devise a methodology that’s fair, enduring and in the best interest of our children.
This is an Op/Ed contribution to Credit.com and does not necessarily reflect the views of the company.