Student Lending and the Land of Oz

Most of us are familiar with the story of the Wizard of Oz, particularly the part where Dorothy and her fellow travelers are instructed to put on green shaded glasses before entering the Emerald City.  There are several parallels between that fictional exercise and the federal budget process when it comes to student lending, none of which are good for taxpayers or borrowers.

Putting on green colored glasses is a good idea for anyone reading the Congressional Budget Office’s baseline numbers for student lending programs, released on February 6th.  Once again the numbers appear to support the idea that direct lending is a great deal for everyone.  According to CBO, the federal government stands to make $37 billion on loans it originates this year, which show up in the CBO estimates as positive cash flow in fiscal year 2013.  Newcomers to the issue may be shocked to see the government taking credit for $37 billion in positive cash flows when in reality, the Department of Education will spend nearly $106 billion borrowed from the federal Treasury to make new loans during fiscal year 2013 that in most cases will take more than a decade (or two) to be repaid.   

How is it possible for the government to make a 35 percent return on $106 billion in new loans in one year?  That’s a result of the Oz-like green glasses required to be worn by federal budget staff when writing these types of estimates.  The Federal Credit Reform Act (FCRA) requires federal budget writers to account for credit programs (with the exception of TARP) using a net-present value accounting, making large assumptions about future asset behavior and then writing all of the cash flow activity into a single fiscal year of the federal budget.  Basically, if you were to compile your entire credit history and cram it into a single budget year, what would it look like? For ten-year estimates, like the one CBO just released, that exercise is repeated ten times with increasingly volatile assumptions about future cash flows, interest rates, and repayment rates, among other variables, impacting the projections. 

A casual observer would be justifiably suspicious that estimates made using these assumptions could ever be accurate.  A key problem with the FCRA style of accounting is that it’s never accurately reflected the costs of federal student loan programs.  Not once.  Estimates have been off every year, and when the direct loan program misses estimates, the Treasury has to borrow money to make up the difference.  Sure, some error in long term budgeting is expected.  But FCRA isn’t even the best option out there, yet trillions of dollars in current and future student loan obligations are being made based on a flawed system of accounting – one that the CBO admits is inferior to alternative methods of accounting for federal credit programs.

Considering the errors in FCRA estimates and the required treatment of cash flows, it should be clear why the direct loan program is contributing hundreds of billions of dollars to the deficit.  Even though FCRA assumes the money will come back at some point in the future, the reality is that the debt issued to students will sit on the federal books, financed and refinanced through new Treasury bond issuances, until the full amount is repaid (or forgiven or discharged).  So even though the federal budget shows a positive cash flow of $37 billion over the life of all loans originated in fiscal year 2013, the $106 billion in new debt required to finance these loans will sit on the books for a decade or more, waiting to be paid off.  And next year’s cohort of loans will add more debt to the total, as will the next year’s cohort, and the next, and the next, as long as the direct loan program continues to operate.  Over the next ten years, it adds up to more than a trillion dollars in outstanding debt.

Ready to head back to Kansas?  Hold onto those green glasses.

The black box used to produce CBO’s estimates is difficult to decipher.  In published estimates, CBO refers to a ‘matrix of different zero coupon bonds’ (aka Treasury bonds) to calculate the government’s risk when making loans.   Even less clear is how the program appears more profitable this year as it did in last year’s estimates, despite some substantial changes in policy.

Last year, CBO estimated an average subsidy rate across all direct loans of -30.5 percent, and an estimated subsidy rate of -32.4 percent for loans made in fiscal year 2013.  Fast forward to this year’s estimates, and the CBO now assumes a total subsidy rate across all loan programs of -36.4 percent, a noted improvement from last year’s estimate.  That’s difficult to explain, considering:

• The interest rate environment has deteriorated slightly, making Treasury capital more costly to obtain;
• The number of students in default is rising;
• The number of students in deferment and forbearance has grown rapidly over the past year; and
• The Administration substantially expanded the very costly income-based repayment program, with changes impacting loans in 2013 and forward.

Sure, a couple of changes to the program might have helped improve the government’s subsidy rate on direct loans, like eliminating the 6-month grace period after graduation, but on balance it’s very difficult to see why the picture for direct lending is prettier this year than it was last year. 

Perhaps it’s the green eyeshades CBO is handing out to policymakers, hoping you’ll pay no attention to the $2 trillion hole behind the curtain.