If you have an account at Community State Bank, Union Grove, Wis., and your son or daughter needs a college loan, they only have to phone the bank to start the ball rolling.

"Since we already know their families, we don't even ask for their Social Security number -- we just mail them the first set of forms they'll need," says lending officer Beth Quaderer, stressing that student lending is a service -- not a money-maker -- for most community banks.

Burdened by increasingly complex regulations and hurt by a dwindling allowance for servicing expenses, some small banks are bailing out of student lending. Those that remain in the program believe they have to offer the service -- or they've developed a profitable niche.

New Entrant

The niche banks are in competition with the big banks, like Citibank and Chase Manhattan, which totally dominate the $20 billion market. However, starting July 1, they will also be competing with the Department of Education, which -- by pitching direct student loans to 2,100 of the nation's colleges and trade schools -- hopes to control 40% of the market as of next July.

"We thought about leaving the program when Congress passed direct lending, but we still see a need in our community," says Ms. Quaderer. She adds that Community's $718,000 student lending portfolio is breaking even, and that she is "hearing many community bankers say they'll stay with the program, even though it isn't profitable, because it's an important part of their service package."

Principal Guaranteed

Launched in 1972 as the Guaranteed Student Loan Program -- and renamed in 1992 as the Federal Family Education Loan Assistance Program -- the system enables bankers to make unsecured loans to students and guarantee the principal through one of the 42 guarantors. In addition, the bankers are in certain circumstances paid a special allowance that helps defray their administrative costs and shield them from interest rate risk.

Over the years, however, the program has become quite complex -- partly in response to the stories of massive fraud at some of the schools. This has led to a proliferation of paperwork -- not to a new audit requirement -- that has driven up administrative expenses to the point where many bankers are bailing out.

"If we could make any money at all in student lending, we'd still be in it," says Bob Muth, president and CEO of Ohio's Andover Bank. Like other former student lenders, Andover, which holds $125 million in assets, now serves as an intermediary -- supplying students with forms for loan requests, then passing them on to a willing lender.

Direct Lending

To eliminate the crushing complexities -- and try to save taxpayers billions of dollars -- Congress in 1993 passed legislation enabling the department to lend directly to students through the schools they will attend. The Student Loan Reform Act of 1993 requires the agency to set up a direct lending program, and supplies enough money for the department to provide up to 5% of all student loans issued to student for the school year starting this fall.

In the direct program lending year that starts July 1, however, the department will be backed up with enough money to pursue 40% of all lending business. Leo Cornfeld, a deputy assistant secretary of the department, is guiding the development of direct lending.

Brimming with optimism, Mr. Cornfeld, who ran the department's office of financial assistance for the Carter administration, says direct lending is the only solution to the problems in the guaranteed lending program because, he says, the system is beyond repair.

Thus, he concludes, "if we don't eventually handle 100% of guaranteed student lending, then the direct student lending program will be a failure."

Decision in Fifth Year

After the fifth program year, when the department will be empowered to pursue up to 60% of all student lending, Congress will decide whether or not to hand over all student lending to the department -- as direct lending supporters originally wanted.

Opponents of direct lending don't believe that it will work for many reasons, and they express frustration that the government is allowing the problems in the existing program to fester.

"What you have is regulatory neglect," says John E. Dean, a partner in the Washington law firm of Clohan & Dean. "The department is investing its assets in the direct program and not paying much attention to the original program because they're planning to scrap it."

Mr. Dean, a special counsel to the Consumer Bankers Association in the knockdown, drag-out fight against direct lending, says the existing program should be allowed to remain in place and properly administered, in the event that direct lending does not work out.

Element of Customer Service

Despite the dwindling profit margins for banks remaining in guaranteed lending, some small banks, like Wisconsin's Community, will remain student lenders as long as possible.

"Back when direct lending was a big issue legislatively, we heard a lot of bankers said they really offer this program as part of their customer service, even if it wasn't making them money," says Ms. Quaderer.

Kawika Dagvio, a government relations specialist for the American Bankers Association, says "it's awfully hard for community banks to turn away a lot of these kids. If you're the president of the bank, and your dad lent this kid's granddad the money to buy his farm, you'll put this kid in the loan regardless of its costs, and you'll be sure to treat him well -- or you'll refer him to another bank that you're sure will treat him or her as well as you would."

Special Allowance

Because administrative expenses for student lending are greater than for most other loans -- in part because the borrower is often out of the area during and after his or her education -- bankers rely on a special allowance to help them defray those expenses.

But Congress has been rolling back the allowance -- originally set at 3.5 percentage points over the 90-day Treasury bill rate. Also intended to shield bankers against interest rate risk, the subsidy has been whittled down to 2.5%. "Banks have dropped out of the program every time they've brought the subsidy down," Mr. Dagvio says.

Despite the shrinkage of the subsidy and its paperwork burdens, Union Bank and Trust Co., Lincoln, Neb., has turned student lending into a profitable niche. In fact, with student loans representing a third of its $368 million in assets, Union Bank is the top student lender among community banks.

Profitable Program

Ken Backmeyer, Union's senior vice president, says his bank has been in guaranteed student lending since since the program started, and says, thanks to the efficiencies the bank has developed, its lending is profitable.

He, too, worries that the department is neglecting the guarantee program. "I'm not trying to present them as the enemy, but one of my fears is that they will divert money from the existing program to help increase their marketing for direct lending."

In its marketing effort, the department is stressing that students in direct lending will have five repayment options, and will not have to repay multiple guarantors -- as sometimes happens when the loans are sold into the secondary market. In addition, the department will point out that schools will have the loan money in hand just three days after an application is processed.

Success in Oklahoma

Mr. Backmeyer says the department's marketing efforts might lead the bank to step up its purchases of student loan portfolios. "We've always been open to it, but it might be a strategy for us down the road."

Another small bank that has been a profitable student lender is Stillwater National Bank, Stillwater, Okla. The bank, which holds $393 million in assets, last year disbursed $55 million in student loans.

"We have a large number of banks in the state, but we decided [student lending] was a niche we wanted back in 1982," says Ms. Sinclair. "We put together a marketing plan, and we're sticking to it. We're building our relationships with the schools, and we try to be available to help the students."

Ms. Sinclair feels that the marketing for direct lending eventually will trim Stillwater's portfolio by 20% to 25%. She adds, however, that the bank is hopeful that the losses will be offset by new student business.

Targeted Marketing

Some bankers say the department's marketing effort might be doing more harm than good, and that the marketing should target states or cities with the most student lending problems -- like fraud and default.

In North Dakota, says John Hoeven, president and CEO of the state-owned, $1 billion-asset Bank of North Dakota, "the banks, schools, and students feel well served by the existing system. But, with the department marketing direct lending, and imposing all sorts of burdensome regulations, it adversely affects states without real problems, because it drives out banks, drives up costs, and as the department takes over, consumers will suffer."

Fly-by-Night Trade Schools

That's because opponents of direct lending believe that the department will not offer the same level of service as a bank. Indeed, says Community's Ms. Quaderer, "if the government takes over student lending [completely], we feel it will add -- not diminish -- taxpayer expense. You'll have fraud, and possible misappropriation of funds."

The program already has been reeling from fraud -- almost all of it at fly-by-night trade schools -- but Mr. Cornfeld says "gate-keeping" will be much more vigilant than it was in the past because the department will demand financial statement before any loans are issued through any schools, and step up training among its inspectors.

He also dismisses suggestions that bankers would be more attentive to their lending than the department. "If there's one group in the country that gets a bum rap, it's federal workers," Mr. Cornfeld says.

Bankers hoping that direct lending will not deliver the annual $1 billion savings -- by eliminating the special allowances to banks -- are pinning their hopes on the accounting performed by the Congressional Budget Office.

Says Mr. Dean, "We believe very strongly that the savings promised will not be yielded because the estimate does not take into account the servicing costs that the government will have to pay after the loans go into repayment."

Stillwater's Ms. Sinclair is skeptical that the department will be able to handle the massive program.

"Last year, we put aside money for special assessments that were imposed by Congress, and we still haven't paid them because the department hasn't figured out how to collect them. I think you'll all see the bureaucratic snags one expects."

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