WASHINGTON — Bankers have survived competition from the government’s direct education loan program, but they complain that a looming federal mandate to cut interest rates — again — on private sector loans may drive them out of student lending entirely.

In 1998, in changes to the Higher Education Act, Congress determined that the method for calculating the maximum interest rate that private lenders may charge on government-guaranteed loans would be revised starting Oct. 1, 2003. Industry experts estimate that the change could cost banks $1 billion per year.

Bankers vowed last week at a conference sponsored by the Consumer Bankers Association that their top legislative priority would be persuading lawmakers and the Bush administration to change the law and let them charge the current rates.

“Lenders want to stay in the business,” said Mary L. Polsley, Bank One Corp.’s student loan product manager, “but truly, there is no more room for cuts.”

Ms. Polsley, a senior vice president, said that if the new rate structure goes through, many students will not be able to get student loans. The government’s direct lending program “could not take on all the business from lenders that quickly,” she said.

But getting federal officials to comply will be an uphill battle.

First, the solution would involve revamping a complex formula, and Capitol Hill veterans stressed that the industry must propose an alternative rate structure well before the 2003 deadline and start educating legislators right away.

“It is a difficult argument to make to people,” said Sally Stroup, a staff member on the House Committee on Education and the Workforce. “I am the first to admit this is not going to be an easy sell.”

Second, the political landscape will only get rockier. Democrats, typically fierce defenders of the direct government loan program, will have more votes in the House and Senate next year to scuttle legislation. And partisan rancor may be high in the initial months after the contested presidential election.

“It is going to be hard to get something like this noticed in the short term,” said Joe Belew, the president of the Consumer Bankers. “I am sure there will be some that want to continue the partisan wars. It will be a difficult atmosphere to work in initially.”

Mr. Belew said successful banking legislation always relies on bipartisan support. Interest rates on student loans “could be perceived as more of an education issue, and that is a more politically charged atmosphere,” he said.

Bankers, Sallie Mae, and student loan trade associations may have hurt their cause with Democrats by filing a lawsuit Nov. 3 to stop the Education Department from cutting the direct loan program’s origination fee and interest rates on consolidated loans. The plaintiffs complained that the cuts make it more difficult for banks to compete against Uncle Sam for student loans, and that they violate the Higher Education Act.

Education loans are still a major business for banks, which made about two-thirds of the $33.7 billion of student loans guaranteed by Uncle Sam in fiscal year 1999, the most recent year for which data are available.

But because of market forces and legal changes, lender yield on student loans — interest plus federal subsidies — has fallen consistently, from 8.47% in 1986 to 7.4% in 1999.

In 1998 lawmakers lowered the ceiling interest rates on student loans and simultaneously reduced the subsidies by 30 basis points.

Last year a law was enacted that changed the formula for calculating the maximum interest rate. Instead of basing the calculation on short-term Treasury securities, Congress switched to three-month commercial paper plus 1.74% for students still in school and 2.34% for loans in repayment. The industry wanted to use commercial paper — which is less volatile — as the basis, because it was expected to lead to more stable interest rates.

That was only a temporary fix. If the 1998 law is not changed, loans originated on and after Oct. 1, 2003, will have an interest rate based on a blend of 10- and 20-year Treasury notes plus 1%, regardless of the student’s educational status. That is expected to cut into bankers’ profits even further.

The decline in earnings alone would exceed 57% for loans in repayment. The new formula would lower the interest rate — using current rates on long-term Treasury notes — to 6.32%, a $1 billion loss annually industrywide, predicted Mark J. Weadick, director of the investment banking division at Citigroup Inc.’s Salomon Smith Barney.

Put another way, the new formula for calculating the interest rate could result in a cut of 70 or 80 basis points for banks, said P. Gregory Stringer, senior vice president of education finance at National City Corp. in Cleveland, speaking at the Consumer Bankers conference. “I wonder how many of us in this room can absorb that kind of reduction and remain in this business.”

The dwindling federal debt complicates matters, because some Treasury bonds are being eliminated as debt is paid off. Even if the new interest rate structure remains, there might be a dwindling supply of 10- and 20-year Treasury notes on which to base the variable loan rates. “We are going to have to find a new index for the student loan program,” Mr. Weadick said.

Bankers at the conference are still developing a plan for revising the student loan rate structure, but the solution could involving tying interest rates to shorter-term London interbank offered rates, which include one-, three-, and six-month as well as one-year rates for dollar deposits in the London market. However, legislators may be reluctant to use Libor because international banks set them.

Mary Bushman, FleetBoston Financial Corp.’s vice president for public policy and corporate communications, said she would be open to keeping the interest rate formula where it is now or to changing the base on which it is calculated to Libor.

Ms. Bushman declined to say whether FleetBoston would stop providing guaranteed student loans if the rate structure is not changed.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.