Uncle Sam as banker

High-school senior Anna Blackwell, 18, of Fort Worth, Texas, enjoys playing the piano and drums. This fall she plans to study marketing at Abilene Christian University. Like millions of other seniors, she's been sifting through available student aid; she hopes for a combination of grants, scholarships, and loans to combat the first year's bill of $18,600. She just applied for federal aid. "The grants are great, because, yeah-it's free money," she laughs. Government loans? "Great interest rates and lots of payment options."

Not all students get those same payment options. Some pay more for exactly the same government loans Miss Blackwell wants, depending on whether their school participates in the Federal Family Education Loan Program (FFELP) or the Direct Loan Program (DLP). FFELP students borrow government-backed loans from private vendors that tweak and discount loans to win customers. Vendors can pay part of the origination fee or offer annual interest rebates and short-term interest-free deals. DLP students, however, borrow directly from the government where terms are decreed by federal statute.

FFELP currently controls 70 percent of the multibillion-dollar government student-loan volume, while DLP handles the other 30 percent. That ratio has stood for years, according to Stephanie Babyak of the U.S. Department of Education. Big commercial banks that hold the majority of the student-loan business claim that improved customer service as well as price discounting account for the popularity of the privately run program. "Vendors are tripping over each other to make the program easy for school-based financial aid administrators to administer," said John Dean, special counsel to the Consumer Bank Association.

That's not always been the case. In the early 1990s before the advent of direct lending, colleges were often frustrated with programs and services offered by big private banks. In 1993 President Clinton promised to save both the government and students money and time by eliminating bank "middlemen" through a program of direct borrowing from the government. Advocates hailed the direct-loan program as one-stop shopping for students and colleges. Threatened with the loss of the lucrative student-loan business, big banks were forced to provide better service. "It proved to be a wake-up call to the lenders," said Mr. Dean.

The government began making the direct loans during the 1994-95 academic year, attracting mostly large state schools overwhelmed with sheer student volume (they now account for 65 percent of DLP loans) and small not-for-profit career and trade schools that were scared that FFELP lenders would cut them off because of their students' high default rates.

But despite the Clinton administration's optimistic predictions seven years ago, students are not saving money or time by borrowing directly from the government. Nor is direct lending saving taxpayers' money. According to a 1999 report by the education department's inspector general, it is no cheaper for the government to offer a direct loan than it is to subsidize private lenders. When interest rates are high, the report said, the government pays more to make DLP loans than it receives back from borrowers repaying DLP loans. Officials from the department disputed the findings.

Some schools still prefer to deal directly with the government, but others are returning to the private-loan program. Indiana University (IU)?one of DLP's 10 largest participants-plans to switch back to FFELP in the 2004-05 academic year. The switch could affect more than $100 million in student loans. Administrators said the change isn't based on DSL dissatisfaction, but on a desire to save money as IU converts to a single system for student loans for all its campuses. Currently only two IU campuses use DLP. The rest prefer FFELP. IU Medical School, for instance, prefers FFELP because banks offer special deals to medical students needing loans.

Politicians continue to see the value in pledging more money to help students pay the soaring cost of higher education. Last January, lawmakers voted to fix federally backed student loans at 6.8 percent beginning in 2006, with the government subsidizing lenders when financial conditions force market rates above that level. "We need to make sure that students continue to have access to higher education through an affordable student-loan program built on a public-private partnership" said Sen. Tim Johnson (D-S.D.), who proposed the bill. Congress is likely to reauthorize student-aid programs in 2004. In the meantime, President Bush's 2003 Education Department budget proposal wants to expand available student financial aid to $54.9 billion, excluding the consolidation of existing student loans-an increase of $2.8 billion over 2002.