History of Student Loans

The federal government began guaranteeing student loans provided by banks and non-profit lenders in 1965, creating the program that is now called the Federal Family Education Loan (FFEL) program. The first federal student loans, however, provided under the National Defense Education Act of 1958, were direct loans capitalized with U.S. Treasury funds, following a recommendation of economist Milton Friedman. But when Congress wanted to expand on that start, budget rules made the guarantee approach seem more attractive.

Under then-prevailing budget rules, a direct loan would have to show up in the budget as a total loss in the year it was made, even though most of it would be paid back with interest in future years. In contrast, a guaranteed loan, which placed the full faith and credit of the United States behind a private bank loan, would appear to have no up front budget cost at all — because the government’s payments for defaults and interest subsidies would not occur until later years. This raised concerns among economists, who worried that the government was making financial commitments without accounting for the ultimate costs.

In 1990, economists got what they wanted. With President George H.W. Bush’s signature on the Federal Credit Reform Act (which was included in a larger budget reconciliation bill, the Omnibus Reconciliation Act of 1990), all government loan programs—whether guarantees of commercial loans, or loans made directly from a federal agency—would have to account for their full long-term expenses and income. Every loan program would have an estimated “subsidy cost.”

The subsidy cost is the amount of money that needs to be set aside when the loan is made in order to cover the costs to the government over the life of the loan. According to the Government Accountability Office, the old approach “distorted costs and did not recognize the economic reality of the transactions,” while the new approach “provides transparency regarding the government’s total estimated subsidy costs rather than recognizing these costs sporadically on a cash basis over several years as payments are made and receipts are collected.” More information on student loan budget rules is provided here.

This more rational approach to budgeting changed the nature of policy discussions on Capitol Hill. Student loan programs were among the first to be affected.

Prompted by an analysis from the Bush administration indicating that direct loans would be less costly and simpler to administer than guaranteed loans, Congress created a direct lending pilot program in 1992. In 1993, newly elected President Clinton proposed replacing the guarantee program with the direct approach as part of his deficit reduction plan. Estimates from all of the government’s budgeting and auditing agencies showed that direct lending would deliver the same loans to students at significantly lower cost to taxpayers.

As part of the 1993 budget agreement, Congress passed a budget reconciliation bill (the Omnibus Reconciliation Act of 1993) that would phase in direct lending, starting with colleges that volunteered to participate and giving the Secretary of Education the power, if necessary, to require colleges to switch until at least 60 percent of loans nationwide were direct. While the law called for direct lending to replace guaranteed loans, it was silent about what would happen beyond the 60-percent mark, since that was outside of the five-year window covered by the budget.

In 1994, the new Republicans leadership in Congress targeted direct lending for elimination. However, many college and university officials were dissatisfied with the guaranteed loan system and optimistic about the new alternative. Under the guarantee system, financial aid administrators had to deal with what the Government Accountability Office labeled a “complicated, cumbersome process,” disconnected from other federal aid and involving thousands of middlemen. Hundreds of institutions were already participating in the direct loan program, which operated in tandem with the other federal aid programs.

Ultimately, Congressional leaders stopped short of eliminating direct lending. Instead, they passed a law that prohibited the Department of Education from encouraging or requiring colleges to switch to the direct loan program. In theory, this maximized choice: schools could choose to participate in one program or the other. In practice, those profiting from the guarantee system could use their substantial resources to lure or retain colleges and universities, while the direct loan program was not allowed to make its own case. Not surprisingly, campus participation in the drect loan program declined.

In 2003, a team of investigative reporters at U.S. News and World Report looked into what was causing some colleges to switch back to the guarantee program. Their front-page story found that much like old-time political ward bosses, the student loan industry “used money and favors, along with their friends in Congress and the Department of Education, to get what they wanted.”

By 2007, new volume in the direct loan program had reached the lowest share of total federal student loan volume since it began in the 1990s. This trend, however, reversed in 2008. Widespread credit market disruptions in 2008 and 2009 threatened the ability of many private lenders to make loans under the federal guaranteed student loan program, and numerous private lenders discontinued participation in the program. In response, schools that previously participated in the guarantee program switched to the direct loan program, and direct loan program volume, as share of total loan volume, began to increase in 2008.

Legislative responses to credit market turmoil also dramatically changed the structure and operations of the FFEL program. Congress and President George W. Bush enacted a temporary program in May 2008 to allow the U.S. Department of Education to buy guaranteed loans made by private lenders. The proceeds from the loans would be used to originate new student loans. The temporary program, the Ensuring Continued Access to Student Loans Act (ECASLA), marks a major historical change in the guaranteed loan program, as it provides federal capital to private lenders making student loans. In this regard, the guaranteed program now shares more characteristics with the direct loan program.

Finally, President Barack Obama proposed in his fiscal year 2010 budget request to Congress a full elimination of the FFEL program. He argued that subsidies paid to private lenders under the program were unnecessary and that cost savings could be achieved if all federal student loans were made through the direct loan program.

In 2010, Congress passed and the President signed into law a bill that eliminated the FFEL program for all new loans made as of July 1, 2010. All federal student loans have been made under the Direct Loan program as of that date. The Congressional Budget Office estimated that the elimination of the FFEL program under the law would generate $68.7 billion in savings over the next ten years. These savings were used to increase funding for the Pell Grant program.

Under then-prevailing budget rules, a direct loan would have to show up in the budget as a total loss in the year it was made, even though most of it would be paid back with interest in future years. In contrast, a guaranteed loan, which placed the full faith and credit of the United States behind a private bank loan, would appear to have no up front budget cost at all — because the government’s payments for defaults and interest subsidies would not occur until later years. This raised concerns among economists, who worried that the government was making financial commitments without accounting for the ultimate costs.

In 1990, economists got what they wanted. With President George H.W. Bush’s signature on the Federal Credit Reform Act (which was included in a larger budget reconciliation bill, the Omnibus Reconciliation Act of 1990), all government loan programs—whether guarantees of commercial loans, or loans made directly from a federal agency—would have to account for their full long-term expenses and income. Every loan program would have an estimated “subsidy cost.”

The subsidy cost is the amount of money that needs to be set aside when the loan is made in order to cover the costs to the government over the life of the loan. According to the Government Accountability Office, the old approach “distorted costs and did not recognize the economic reality of the transactions,” while the new approach “provides transparency regarding the government’s total estimated subsidy costs rather than recognizing these costs sporadically on a cash basis over several years as payments are made and receipts are collected.” More information on student loan budget rules is provided here.

This more rational approach to budgeting changed the nature of policy discussions on Capitol Hill. Student loan programs were among the first to be affected.

Prompted by an analysis from the Bush administration indicating that direct loans would be less costly and simpler to administer than guaranteed loans, Congress created a direct lending pilot program in 1992. In 1993, newly elected President Clinton proposed replacing the guarantee program with the direct approach as part of his deficit reduction plan. Estimates from all of the government’s budgeting and auditing agencies showed that direct lending would deliver the same loans to students at significantly lower cost to taxpayers.

As part of the 1993 budget agreement, Congress passed a budget reconciliation bill (the Omnibus Reconciliation Act of 1993) that would phase in direct lending, starting with colleges that volunteered to participate and giving the Secretary of Education the power, if necessary, to require colleges to switch until at least 60 percent of loans nationwide were direct. While the law called for direct lending to replace guaranteed loans, it was silent about what would happen beyond the 60-percent mark, since that was outside of the five-year window covered by the budget.