The Private Sector Isn’t Always Cheaper/Better (Student Loan Edition)

It’s become such an article of faith that the private sector is better than the government at doing just about everything that those who want the government to take a more active role here and there are put on the defensive.

But the using the private sector to promote public goals can be more costly than having the government act on its own behalf. Robert Reich tells us in “The Real Scandal of Student Loans” tells us that it costs taxpayers $7 extra per every $100 borrowed to have private parties provide government subsidized student loans versus having the feds lend directly.

In case that number didn’t sink in, we are talking about 7% more in expenses. It’s as if taxpayers were paying a 7% origination fee on behalf of students to banks. To give a frame or reference, 7% fees and debt products generally don’t inhabit the same universe. In the heyday of junk bonds (the 1980s) when investment banking fees were higher, a junk bond new issue would carry a fee of, say, 3 1/2%. You only see numbers like 7% associated with equity deals (and even then the riskier initial public offerings, not seasoned issuers).

Of course, one can argue that we are discussing retail loans, not big institutional deals, so the cost per transaction has to be higher. Fine. I challenge you to name a retail banking product that has anything within hailing distance of a 7% fee. The only comparable is payday loans (which are worse if you annualize their charges) and they are a controversial product that some (this writer included) consider to be predatory lending. (Credit card late fees can also be of that magnitude, but they are not an upfront charge applicable to all).

Why is it so costly? Reich doesn’t say, but I imagine a significant contributor is our fragmented banking system. Banks are eager to capture customers young, and a student loan is one way to establish a relationship. So it’s a safe bet that most of America’s 9000 banks offer student loans. And Reich points to the other culprit: with lobbyists pushing the program, costs are not at issue.

To Reich:

The emerging scandal over student loans – and finiancial aid administrators that have cozy relationships with lenders – is only the tip of a scandalous iceberg.

Consider: The Federal government subsidizes college loans in two different ways, giving colleges and universities the option of which way to go.

The first way is for the federal government to lend students the money directly. Students get a good deal because the government, being the government, can raise funds at a lower interest rate than can banks or other private lenders. The alternative is for the federal government to subsidize student loans indirectly by guaranteeing banks and other private lenders that if a student doesn’t repay the loan, the government will. The government also gives banks and private lenders additional subsidies to ensure they get a profitable return on any student loan they make.

Obviously, this second alternative is a great deal for the banks and other lenders. Hey, a guaranteed return on a no-risk loan! But it’s a lousy deal for American taxpayers. According to a study by the Center for American Progress, taxpayers pay about $7 more for every $100 lent by the private lenders than they do on direct government loans.

That amounts to billions of taxpayer dollars each year. Billions that could be saved if the direct loan program was the only program. Billions of savings that could be put, for example, into Pell Grants for needy students.

So here’s the multi-billion-dollar question. Why does the federal government continue to provide colleges and universities the option of going with the more expensive program when the government can offer direct loans more cheaply? Why is it that some fifteen years after the direct student loan program was first established, more than three-quarters of student loans still come through the more expensive system?

Let me hazard a guess. Because the banks and other private lenders have enormous political clout in Washington. They also have clout within colleges and universities.

This is the real scandal of student loans, and it’s got to stop. There’s no good reason for the federal government to waste taxpayer money by subsidizing banks and other private lenders when government direct loans are cheaper.

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