Loan auctions not the safest bet

As Congress, the White House and the Department of Education moves towards reforming the student loan industry, a few changes are taking place.

One of the changes that will be partially implemented on July 1, 2009 is an auction system in the Federal Family Educational Loan program.

The National Association of Student Financial Aid Administrators released a report last month on "Evaluating Student Loan Auctions," just as President George W. Bush signed the College Cost Reduction and Access Act, which contains the auction system.

Besides dealing with the corruption within the industry, the Department of Education must ensure that the FFEL program is both saving the taxpayer dollars and not overburdening borrowers. Loan auctions are considered as one way to accomplish this.

"Beginning in July 2009, all guaranteed loans made to parents on behalf of students for whom they have not previously borrowed would be made by lenders who won the rights to make those loans through competitive auction," claims a 2007 cost estimate from the Congressional Budget Office. This system was designed with the intent to "inject market capitalism" into the program.

"Two winning lenders in each state who bid the smallest add-ons to the three month commercial paper (CP) rate used to calculate special allowance payments would have the right to make loans for two years. At the end of that two-year period, the auction of the right would be repeated," states the estimate.

Though, by all appearances, the auction system seems practical, the NASFAA report asserts, "The current auction system has been implemented based on several faulty assumptions."

These assumptions include an effort to drive down competition through subsidy rates, and having taxpayers save money by allowing lenders to compete for the right to originate loans. Loan auctions would not be affected because many do not qualify for the benefits anyway.

The Parent PLUS loan auctions will provide a good indication of what loan auctions will be like for all FFEL loans, further indicating market consolidation may occur on a limited basis, even though the market is already dominated by a few large lenders.

While the support for the auction system is rooted in the hopes that competition and capitalism will be brought into the current system, there is a strong possibility that this new system will create an environment for a potential oligopoly.

A 2001 U.S. General Accounting Office report, "Alternative Market Mechanisms for the Student Loan Program," argues that the diversity of lenders might decline. The report states that while there is the possibility of the auction system reducing federal FFEL program costs, "Their ability to realize this potential depends on whether there is sufficient competition in bidding."

When the competition is lacking, the big lenders will force out the small lenders and the system will fail. The system could only work well when there is an equal ability to raise cash for bids, which is not the case in this arrangement.

The NASFAA report points out that, "According to Department of Education figures, of the 20 large student loan originators in 2006, 12 are also the top 20 student loan holders. In other words, of the 20 largest loan providers competing for the loan volume, 12 also have the largest loan portfolios."

This is imperative, since large lenders have acknowledged that the presence of smaller providers, particularly nonprofits, forces loan costs down for borrowers.

Overall, the report concludes that the auction system in the FFEL program will not yield the expected consequences and will result in market consolidation.

The report urges the government to "work with loan providers, stakeholders and other non-partisan analysts to adjust subsidization level on a more frequent basis than has been done in the past."