E8-14820. Federal Family Education Loan Program (FFELP)

AGENCY:

Department of Education, Department of the Treasury, Office of Management and Budget.

ACTION:

Notice of terms and conditions of purchase of loans under the Ensuring Continued Access to Student Loans Act of 2008.

SUMMARY:

Under section 459A of the Higher Education Act of 1965, as amended (“HEA”), as enacted within the Ensuring Continued Access to Student Loans Act of 2008 (Pub. L. 110-227), the Department of Education (“Department”) has the authority to purchase, or enter into forward commitments to purchase, Federal Family Education Loan Program (“FFELP”) loans made under sections 428 (subsidized Stafford loans), 428B (PLUS loans), or 428H (unsubsidized Stafford loans) of the HEA, on such terms as the Secretary of Education (“Secretary”), the Secretary of the Treasury, and the Director of the Office of Management and Budget (collectively, “Secretaries and Director”) jointly determine are “in the best interest of the United States” and “shall not result in any net cost to the Federal Government (including the cost of servicing the loans purchased).”

This notice (a) establishes the terms and conditions that will govern the loan purchases made under section 459A of the HEA, (b) outlines the methodology and factors that have been considered in evaluating the price at which the Department will purchase loans made under section 428, 428B, or 428H of the HEA, and (c) describes how the use of those factors and methodology will ensure that the loan purchases do not result in any net cost to the Federal Government. The Secretaries and Director concur in the publication of this notice and have jointly determined that the programs described in this notice are in the best interest of the United States and shall not result in any net cost to the Federal Government (including the cost of servicing the loans purchased).

DATES:

Effective Date: The terms and conditions governing the Loan Purchase Commitment Program and the terms and conditions governing the Loan Participation Purchase Program are effective July 1, 2008.

FOR FURTHER INFORMATION CONTACT:

Kristie Hansen, U.S. Department of Education, Office of Federal Student Aid, Union Center Plaza, 830 First Street, NE., Room 113F1, Washington, DC 20202. Telephone: [phone] or by e-mail: [e-mail].

If you use a telecommunications device for the deaf (TDD), call the Federal Relay Service (FRS), toll free, at 1-800-877-8339.

Individuals with disabilities can obtain this document in an alternative format (e.g., Braille, large print, audiotape, or computer diskette) on request to the contact person listed under FOR FURTHER INFORMATION CONTACT.

SUPPLEMENTARY INFORMATION:

Introduction

The purchasing of loans is intended to encourage eligible FFELP lenders to provide students and parents access to Stafford and PLUS loans for the 2008-2009 academic year. To accomplish this objective, the Department is offering lenders the opportunity to participate in a Loan Purchase Commitment Program (“Purchase Program”) and a Loan Participation Purchase Program (“Participation Program”) (collectively, “Programs”).

Under the Loan Purchase Commitment Program, the Department may purchase eligible loans that are held by eligible lenders. To participate in the Purchase Program, each eligible lender must enter into a Master Loan Sale Agreement with the Department and deliver to the Department or its agent the fully executed master promissory note (or all electronic records evidencing the same) evidencing each eligible loan that the eligible lender wishes to sell to the Department and any and all other documents and computerized records relating to such eligible loans.

Under the Loan Participation Purchase Program, the Department may purchase participation interests in eligible loans that are held by an eligible lender acting as a sponsor under a Master Participation Agreement. To participate in the Participation Program, each sponsor must enter into a Master Participation Agreement with the Department and a third-party custodian acceptable to the Department and must have provided appropriate notice to the Department of the intent to participate in the Loan Purchase Commitment Program.^[1]

Terms and Conditions

Pursuant to section 459A of the HEA, the Secretaries and Director establish the terms and conditions that will govern the Loan Purchase Commitment Program (“Loan Purchase Commitment Program Terms and Conditions,” attached as Appendix B to this notice) and the terms and conditions that will govern the Loan Participation Purchase Program (“Loan Participation Purchase Program Terms and Conditions,” attached as Appendix C to this notice). The Loan Purchase Commitment Program Terms and Conditions and the Loan Participation Purchase Program Terms and Conditions are collectively referred to as the “Terms and Conditions.” (The Notice of Intent to Participate, referenced in the Terms and Conditions, is attached as Appendix D to this notice.)

Outline of Methodology and Factors in Determining Prices

In accordance with Public Law 110-227, the goal in structuring the Purchase Program and the Participation Program described in this notice is to maximize student loan availability while ensuring loan purchases result in no net costs to the Federal Government. These programs will offer temporary liquidity to FFELP lenders at prices that will encourage their continued participation in the FFELP. This notice responds, in particular, to the requirement in section 459A of the HEA for an outline of the methodology and factors considered in evaluating the price at which loans may be purchased, and describes how the use of such methodology and consideration of such factors will ensure that no net cost to the Federal Government results from the loan purchases under these programs.

Servicing and Financing Costs. In determining the prices described in this notice, the Secretary and the Secretary of the Treasury analyzed the costs incurred in making FFELP loans by large and small lenders, for-profit and not-for-profit lenders, and national and regional lenders based on publicly available data and consultations with a number of lenders and financial market analysts. This analysis examined lender returns in the context of loan servicing and financing expenses associated with obtaining funding to pay program costs and finance actual loan disbursements.

• The rate of lender returns on FFELP loans in the in-school and grace periods are effectively set by section 438 of the HEA at the commercial paper (CP) rate plus 1.19 percent or CP plus 119 basis points for for-profit lenders (a basis point equals one one-hundredth of a percent). 20 U.S.C. 1087-1(b)(2)(I)(ii) and (b)(2)(I)(vi)(I)(bb). For eligible not-for-profit holders, the HEA provides a return of CP plus 134 basis points. 20 U.S.C. 1087-1(b)(2)(I)(ii) and (b)(2)(I)(vi)(II)(bb). (These return levels reflect the net of borrower interest payments and Federal interest subsidies.) Returns are different for PLUS loans, which make up a relatively small portion of overall FFELP volume. These PLUS return levels were reflected in the cost neutrality calculations but, for simplicity, are not detailed in this notice.
• Lenders reported that loan servicing costs generally average between 30 basis points and 60 basis points per dollar loaned, with larger, more efficient lenders typically averaging closer to 30 basis points and small or not-for-profit lenders averaging closer to 60 basis points. Lenders pay the Department a 1 percent fee on each loan they make. 20 U.S.C. 1087-1(d)(2)(B). In addition, lenders must repay excess interest payments as required by section 438 of the HEA. 20 U.S.C. 1087-1(b)(2)(v). Because the student borrowers of most loans subject to the Purchase Program and the Participation Program will be in school and not making payments on their loans during the 2008-2009 academic year, lenders may need to obtain funding to make these statutorily-required payments to the Department. Financing costs (i.e., interest expenses incurred to obtain capital from deposits or from private capital markets) typically total 15 basis points for every dollar loaned.
• Subtracting estimated servicing and financing costs from the lender return levels established in the HEA leaves lenders with estimated pre-tax returns of CP plus 44-74 basis points for for-profit lenders and CP plus 59-89 basis points for lenders that are eligible not-for-profit holders. Lenders finance loan disbursements from these returns. If lenders sell participation interests in their loans under the Participation Program, they are charged CP plus 50 basis points, leaving a net pre-tax return of −6 basis points to 24 basis points for for-profit lenders. If lenders can obtain private financing at a lower interest rate, their net pre-tax return would be higher.

Based on this background information, the Secretaries and Director determined that setting the price paid by lenders on a participation interest in a loan at the principal of that loan and the commercial paper rate plus 50 basis points would offer most lenders sufficient opportunity to continue their participation in the FFELP. Setting a higher price risks limiting participation to only the largest lenders, while offering a lower price would be overly generous, especially for those same large lenders.

Origination and Deconversion Costs. In addition to servicing and financing costs, lenders incur administrative costs to originate loans and remove or “deconvert” loans from their servicing systems. In determining the proper price to reimburse lenders for these costs, the Department and the Department of the Treasury analyzed information from lenders and servicers.

The Department and the Department of the Treasury consulted with lenders, who provided them with their estimated origination and deconversion costs. Larger, more efficient lenders indicated that their origination costs ranged between $20-$30 per loan while these costs for smaller lenders were $75 per loan. Lenders indicated that their estimated deconversion costs (i.e. the costs resulting from the process of taking a loan from one lender's servicing system and transferring it to another servicing system) ranged from $20-$50 per loan.

To ensure the Participation Program is open to more than just the largest lenders, the Secretaries and Director used these estimates to establish a flat $75 fee paid on each loan sold to the Department to cover all servicing, origination, and deconversion costs. This assumes the lower end of the origination cost range and the higher end of the deconversion costs range.

Pricing structures on many private servicing contracts tend to have costs that differ greatly for different services, with high origination costs and relatively low deconversion costs, or at times, the converse. Notwithstanding these differences, the Secretaries and Director are reasonably certain that the $75 fee accounts for these variations while ensuring adequate participation in the Participation Program.

Analysis of Cost Neutrality

The cost-neutrality analysis used credit subsidy cost estimation procedures established under the Federal Credit Reform Act of 1990 (Pub. L. 101-508) and OMB Circular A-11. These procedures entail performing various analyses, projecting cash flows to and from the Government, and discounting those cash flows to the point of disbursement; the analysis also used the Credit Subsidy Calculator (“OMB calculator”), developed by the Office of Management and Budget to estimate credit subsidy costs for all Federal credit programs, as the discounting tool.^[2] The results of the analysis were subsidy rates that reflect the Federal costs associated with a loan; these costs are expressed as a percentage of the credit extended by the loan. For example, a subsidy rate of 10.0 percent indicates a Federal cost of $10 on a $100 loan.

The metric to determine cost neutrality was that costs under the new Programs should not exceed costs expected under the FFELP had the loan purchase authority in section 459A of the HEA not been enacted. Thus all costs were compared to estimates in the 2009 President's Budget for the FFELP, after adjustments were made for enacted legislation (other than the loan purchase authority provided by Pub. L. 110-227), including administrative costs.

Student loan cost estimates were developed to assess the Federal cost incurred for loans financed for students in five categories: Students attending proprietary schools, students attending two-year schools, freshmen/sophomores at four-year schools, juniors/seniors at four-year schools, and students in graduate programs. Risk categories have separate assumptions based on historical patterns—for example, the likelihood of default or the likelihood of statutory deferments or discharge benefits—of borrowers in each category. The analysis also considered risk factors that are particular to the new programs, such as the likelihood that lenders involved in loan participation agreements file for bankruptcy protection.

This discussion outlines the analysis of the new Purchase Program and Participation Program with respect to the following critical aspects affecting the Federal cost:

○ Administrative costs;

○ Borrower behavior;

○ Lender behavior; and

○ Various risk factors.

Administrative Costs. Under the Federal Credit Reform Act, Federal administrative costs are not included in credit subsidy cost calculations. However, to capture the full cost of the Purchase Program and Participation Program, section 459A of the HEA requires the determination of cost neutrality to include total costs, including Federal administrative costs that are subject to appropriation, and thus administrative costs were estimated and included in the cost-neutrality analysis. Administrative cash flows primarily involve servicing costs associated with loans purchased by the Department. These costs extend for up to 40 years, because servicing must continue until the last loan is paid in full. Administrative costs also include start-up costs to enhance the Department's systems to accommodate the purchase of participation interests and any put FFELP loans. Other start-up costs include legal and technical advisory contracts and changes to Department accounting, reporting, and program compliance systems and processes.

For the new programs, the Secretaries and Director estimated that start-up costs would be $15.7 million and servicing costs would vary, according to the amount of volume in the program. Estimates for start-up costs were derived from conversations with the Department's existing service contract providers, while servicing cost estimates were derived from costs currently incurred with the Department's Federal Direct Loan servicing contract.

Borrower Behavior. Given the base FFELP serves as the foundation of the new programs, and the characteristics of the base program are unchanged, there is no reason to believe that the Purchase Program and Participation Program outlined in this notice will affect borrower behavior. Thus, this cost analysis uses the same borrower behavior assumptions as were used in preparing the 2009 President's Budget to gauge the effect on program costs of borrower-based activities such as loan repayment, use of statutory benefits such as deferments and loan discharges, and default rates and timing. These assumptions are based on a wide range of data sources, including the National Student Loan Data System, the Department's operational and financial systems, and a group of surveys conducted by the National Center for Education Statistics such as the 2004 National Postsecondary Student Aid Survey, the 1994 National Education Longitudinal Study, and the 1996 Beginning Postsecondary Student Survey.

Lender Behavior. A key factor in assessing whether the Purchase Program and Participation Program would operate in a cost-neutral manner was lender behavior: Specifically, how many lenders would participate in each program and how many loans would they eventually choose to sell to the Department. The Secretaries and Director considered alternative scenarios of market conditions and lender behavior to determine whether each program could be considered cost-neutral.

In one scenario, the Secretaries and Director assumed that market conditions would not improve and that FFELP lenders would put or sell participation interests to the Department in 100 percent of all FFELP loans made for the 2008-09 academic year. At the end of the participation period, FFELP lenders would also put 50 percent of those loans to the Department. The Secretaries and Director assumed that the loan volume would be $65 billion and that the total portfolio would be similar to the expected 2008-2009 school year of student loans under the FFELP before enactment of the loan purchase authority in Public Law 110-227.^[3] Further, the loans purchased at the end of the participation period would be representative of the total loan volume. Under this scenario, we determined that costs for both the Purchase Program and the Participation Program were less expensive to the Government than for the baseline subsidy costs for FFELP loans costs for the FFELP baseline in this period. (Please see Table 2, located in Appendix A, for a summary of the analysis for this scenario, which also includes the risk factors discussed in this notice.)

The Secretaries and Director also considered other scenarios. In those scenarios, the Secretaries and Director sorted the expected FFELP volume under the Purchase Program and Participation Program into three categories: Loans made by lenders and sold to the Department; loans made by lenders on which the lenders first sold participation interests to the Department and then, on September 30, 2009, sold the loans themselves to the Department; and loans made by lenders on which participation interests were sold to the Department but then redeemed by the lender, for a cash payment, eliminating the Department's participation interest. In general, the Secretaries and Director derived volume allocations under particular scenarios by making assumptions about near-term market conditions, likely lender behavior based on type of lending institution and operational capability, and projecting lender demand for any particular option under those conditions.

One of these scenarios, considered to be one of the most costly to the Government, would be that market conditions improve significantly over the next year, and that lenders sell a greater proportion of higher cost loans to the Government (in a process often termed “cherry-picking”). A Congressional Budget Office analysis, and other analyses, of the FFELP portfolio have found that certain loans are more profitable for FFELP lenders than others. In particular, borrowers with small balances provide relatively little margin income relative to the fixed costs lenders face to service those loans. Some borrowers, including those that attended schools with higher than average default rates, are more likely to become delinquent and, consequently, present higher expected default costs, and greater losses of margin income due to default.

The Terms and Conditions seek to reduce the impact of these risk factors. For example, program guidelines requiring lenders to sell all 2008-09 Stafford loans held for a specific borrower, combined with the administrative complexity and expense of identifying and deconverting only less profitable loans, make it less likely that lenders will choose to sell only poorly-performing loans to the Department.

Nevertheless, if financial markets improve to the point where lenders can finance most loans privately, they might still sell those least profitable loans to the Department. In this situation, borrowers with very low balances will present relatively high servicing costs to the Department per dollar of outstanding balance.

Under the scenario described in the preceding paragraph, the analysis estimates 4 percent of FFELP volume ($65 billion in the 2008-2009 academic year) will be loans made by lenders and sold to the Department; 32 percent of volume ($21 billion) would be loans for which participation interests, and then the loans themselves, would be sold to the Department; and 32 percent ($21 billion) would be loans for which participation interests were sold, but then redeemed.^[4] Cost estimates assuming these volume allocations and risk adjustments for this scenario still compared favorably with the costs for the base FFELP. (Please see Table 3, located in Appendix A, for a summary of the analysis for this scenario and the risk factors discussed in the following sections.)

It should also be noted that, in addition to the examples discussed herein that represent certain abnormal market and lender behavior conditions, all other alternatives under which the Purchase Program and Participation Program were analyzed were less expensive than base FFELP costs.

Risk Factors. Analyzing whether the Purchase Program and Participation Program would operate in a cost-neutral manner requires that projected costs account for the presence of various risks and cost factors that must be assumed since the programs will not operate entirely like the base FFELP, nor without operational risk. In addition to cherry-picking, the Secretaries' and Director's estimates included adjustments for four other factors: that lenders involved in loan participation agreements file for bankruptcy protection (“bankruptcy remoteness”); that lenders redeem their participation agreements early, reducing Federal earnings from the participation interests acquired (“interest adjustments”); that unforeseen problems undermine the Department's ability to effectively oversee and administer the Purchase Program and Participation Program (“operational risk”); and that some of the loans purchased by the Department would be those where the Department would otherwise reject a claim under the FFELP program (“claim rejects”).

The Terms and Conditions for each program seek to reduce the impact of these risk factors. None of these factors is likely to lead to significant additional Federal costs. For example, the requirement that lenders sell participation interests that total at least $50 million will limit involvement to large financial institutions that, in general, are financially stable and not likely to proceed to bankruptcy. Additionally, upon filing for bankruptcy, the yield owed by the lender to the Department increases from principal of that loan and the commercial paper rate plus 50 basis points, to principal of that loan and the commercial paper rate plus 300 basis points.

However, to ensure estimates reflect a conservative assessment of possible Federal costs, the Secretaries and Director added cost adjustments to incorporate each risk factor in all of the scenarios noted in the preceding paragraphs. The adjustments were based on an assessment of private-sector behavior and program data as follows:

• Bankruptcy remoteness. The Government might face legal risks if a lender declares bankruptcy while holding rights to loans under the participation agreement. The Secretaries and Director believe that the structure to be utilized under the Participation Program offers sufficient bankruptcy protection, in that legal title of these participated loans will be placed in a custodial facility, and that the participation agreement vests the Government with a valid security interest under the Uniform Commercial Code. Nonetheless, a bankruptcy court might tie up control of the loans until the claims of other creditors are settled. This risk is more present if markets remain distressed during the next one to two years as the likelihood of bankruptcy is higher; however, the risk never goes to zero entirely. For the scenario in Table 2 below (where the market conditions do not improve), the analysis assumes an increase in cost of 15 basis points. For the scenario in Table 3, where market conditions do improve, the analysis assumes an increase in cost of 5 basis points. Assumptions are based on an estimated one-year default rate of lenders and potential recoveries on default.
• Interest adjustments. If financial market conditions significantly improve between now and the end of September 2009, lenders that took advantage of the participation agreements might opt to buy their loans out early and finance them privately through more favorable rates. While this outcome is highly desirable from a policy perspective, it would deprive the Department of some of the margin income it might expect from the participation agreement under a scenario where lenders opt to maintain their loans in the participation agreements until the last possible moment. The cost neutrality analysis below assumes a 20 basis point increase in the cost for interest that the Department does not realize, based on the expected placement of FFELP loans in the participation interest program, and the difference between the commercial paper rate plus 50 basis points lenders must pay the Department and the cost of Government borrowing.
• Operational risk. Operational risk is in general a major concern in all credit activities in both the public and private sectors, and has been a major focus in recent efforts to overhaul bank regulations. (Operational risk is limited in this analysis to that related to funding and management of the participation or loan purchase agreements.) In the new Purchase Program and Participation Program, operational risk might result from imperfect controls of ineligible lending, servicing errors, technology failures, and the risk of fraud. While the Department has made every effort to mitigate operational risk, the emergency nature and accelerated implementation timeframe for these Programs make operational risk more of a concern than in established Department programs. For the low risk scenario, the analysis below assumes a 10 basis point increase in cost, reflecting risks other than credit or market risk, as banks are currently required to finance on average about eight percent of their assets with capital. For the high scenario, we raised the factor related to operational risk by 70 basis points to equal a total of 0.80 percent. We estimated this worst-case scenario using survey data from bank regulators implementing an overhaul of bank regulations. The largest United States banking organizations will be subject to a new system of capital requirements which includes an explicit charge for operational risk. Under that regulation banks must develop models generating a probability distribution of losses for operational risk, and hold capital equal to the 99.9th percentile of that estimated probability distribution. Banks were surveyed to measure the anticipated impact of the regulation. Using the best available models of operational risk, the banks reported that operational risk would account for roughly ten percent of their required capital. As banks currently finance on average about eight percent of their assets with capital, worst-case scenario operational risk losses can thus be estimated at about one percent of total assets. Also, while we do not believe that this program has, or necessarily will, face such a level of operational risk, we developed the high scenario to ensure that the program is cost neutral, even under extreme and unlikely circumstances.
• Claim rejects. This risk factor takes into account the costs associated with the purchase of loans that would not typically qualify for the federal guarantee in the FFEL program due to improper origination or servicing. The 6 basis point increase in cost is based on a historical rejected claim rate of 1 percent of volume, and assumes that these loans would have higher loss rates than the average portfolio.

Cost estimates reflecting these factors, for each of the market condition and lender behavior scenarios discussed elsewhere in this notice, were calculated and included, as illustrated in Tables 2 and 3. As those analyses show, even with these risk adjustments, the estimated costs of the loans included in the Purchase Program and Participation Program remained lower than those for standard FFELP loans.

Conclusion. After taking into account alternative market and lender behavior scenarios and appropriate risk factors, the Secretaries and Director determine that the Purchase Program and Participation Program are in the best interest of the United States and will result in no net cost to the Federal Government (including the cost of servicing the loans purchased).

Applicable Program Regulations: 34 CFR part 682.

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Note:

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(Catalog of Federal Domestic Assistance Number 84.032 Federal Family Education Loan Program)

Program Authority: 20 U.S.C. 1087i-1.

Dated: June 25, 2008.

Margaret Spellings,

Secretary of Education.

Dated: June 25, 2008.

Henry M. Paulson, Jr.,

Secretary of the Treasury.

Dated: June 25, 2008.

Jim Nussle,

Director, Office of Management and Budget.

Footnotes

1.  Lenders that qualify as “eligible not-for-profit holders” for a higher special allowance rate may sell participation interests in their loans under this program without loss of eligibility for that rate. An entity qualifies for that rate only if the entity is the “sole beneficial owner of such loan.” 20 U.S.C. 1085(p)(2)(C). Courts treat a participation interest in a loan as a beneficial ownership of a loan. The Department becomes a beneficial owner of a loan in which it purchases a participation interest, and the lender then holds a junior beneficial ownership interest. In light of other statutory provisions and the congressional intent they evidence, the Department interprets the HEA to disqualify an otherwise-eligible not-for-profit holder only if a for-profit entity acquires beneficial ownership of a loan. See 20 U.S.C. 1085(p)(2)(B), (E), (3).

2.  The OMB calculator takes projected future cash flows from the Department's student loan cost estimation model and produces discounted subsidy rates reflecting the net present value of all future Federal costs associated with loans made in a given fiscal year. Values are calculated using a “basket of zeros” methodology under which each cash flow is discounted using the interest rate of a zero-coupon Treasury bond with the same maturity as that cash flow. To ensure comparability across various Federal credit programs, this methodology is incorporated into the calculator and used government-wide to develop estimates of the Federal costs of credit programs.

3.  This loan volume assumption is the full FFELP non-consolidation estimate for the 2008-2009 academic year (as presented in the 2009 President's Budget) and is adjusted to include increases to unsubsidized Stafford Loan limits provided for in Pub. L. 110-227.

4.  The loan volume assumption in this scenario was developed through conversations with a variety of lending institutions. Depository lending institutions indicated that they would use their own capital to originate new student loans rather than take advantage of the participation agreement structure. Non-depository institutions indicated they would use participation agreements. For the top 100 lenders in FY 2007, which together accounted for over 80 percent of FFELP non-consolidation volume, 33 percent of volume was originated by depository institutions and 67 percent by non-depository institutions. (Figures for non-depository institutions include loans made by depository institutions acting as eligible lender trustees.)

Lenders currently have $50 billion in warehouses and substantial additional loans securitized in rollover accounts that will require long-term refinancing. These inventory stocks may provide lenders with an incentive to put loans. Representatives of depository institutions indicated they may increase volume to ensure students have access to loans, but may not want to maintain this additional volume on their books.

In consideration of these factors, estimates assumed all 2008-2009 FFELP non-consolidation loan volume originated by depository institutions over the level originated for 2007-2008 and 50 percent of 2008-2009 loans originated by non-depository institutions and included in the Loan Participation Purchase Program will be put. Estimates further assumed that all loans of $1,000 or less would be put first, with the balance up to the total amount put made up of loans of over $1,000.