Seeking to preserve a profitable niche, industry officials are asking lawmakers to repeal a law that could force banks out of the student loan business.
As of July 1, banks will have to peg interest rates on newly originated student loans to 10-year Treasury bonds instead of 3-month notes. The change is expected to cost the industry more than $260 million a year, increase the amount of interest rate risk lenders must bear, and eliminate the market for student loan securities.
"I am not certain we'll be making student loans if this takes effect," said Jon A. Veenis, president of Norwest Student Loan Center, Sioux Falls, S.D.
The problems stem from a 1993 law that created the government's direct student loan program. The provision pegging rates to 10-year Treasuries was included to reduce the cost of the direct loan program, but it was worded so broadly that it also applies to loans made by private-sector banks.
It requires lenders as of July 1 to set the rate on new student loans 100 basis points above the rate on the 10-year Treasury bill. The new rate will be 145 basis points lower than the current rate, which is calculated by adding 310 basis points to the price of a 91-day Treasury note.
Lenders have known of this problem for four years. But rather than working to repeal this particular provision, they have been trying to correct it by eliminating the direct loan program outright.
"Getting rid of the direct loan program would have taken care of this problem, but unfortunately that didn't happen," said Consumer Bankers Association president Joe Belew.
"For a while, we were far too passive on this," an industry source added.
Attention now is focused on eliminating the interest rate provision. Led by Sallie Mae, lobbyists are telling lawmakers that banks will abandon the program if changes are not made.
"Student loans will simply become unprofitable for private lenders under this formula," said Mary F. Bushman, a lobbyist with AFSA Data Corp., Fleet Financial Group's student loan unit.
Repealing the measure will not be easy.
As the law stands, seven million students a year will pay less for their loans. In addition, if the private lenders are forced from the market, business would increase for the direct loan program-a pet project of the Clinton administration.
"Part of problem is political-you have this perception that it is the lenders versus the students," Mr. Belew said. "On top of that, it is difficult to get anyone's attention focused on this because it is so arcane."
To overcome opposition, lenders have been floating a compromise that would peg rates to a different index such as Libor or commercial paper. Lenders also are offering to accept a decrease in government subsidies.
The subsidies exist because the government caps student loan rates at 8.25%. To prevent banks from taking losses when rates rise above this threshold, the Department of Education makes up the difference each quarter between 8.25% and the rate calculated using the government's formula.
Details on the compromise are still sketchy, and lenders declined to discuss the offer on the record. But Sallie Mae executive vice president Paul Carey said lawmakers cannot let this problem go unaddressed.
"There needs to be a resolution of this," Mr. Carey said. "There are other ways to price student loans that are efficient that would work just fine. The 10-year Treasury index just doesn't make sense to anybody."
Lenders said the formula that kicks in July 1 would yield about 125 basis points per loan, but their exposure to interest swings would rise dramatically because their portfolios would be loaded with long-term, fixed-rate debt.
The risk could be mitigated with derivatives, but the cost of these complex hedges would erase already thin profits. One estimate by the Congressional Research Service said these instruments would cost up to 120 basis points, leaving banks with 5 basis points in profit to cover all other costs.
The index in the 1993 law "can result in a greater likelihood that the program will become unprofitable at certain points in the business cycle," CRS said in a July report. "The result could be a shutdown of the guarantee delivery system."
Mr. Carey said the market for student loan securities will die if a compromise is not reached. The problem: Investors will receive a return based on a long-term investment, even though they are holding a short-term instrument. This mismatch in price and term makes the product very risky because the return is extremely sensitive to changes in interest rates.
Also, Mr. Carey questioned why lawmakers want to mess with a proven product. "We issue over $100 billion of debt tied to the current index," he said. "We all know we can raise capital tied to the 91-day T-bill. No one has ever funded off this new index."
