oversight

Guaranteed Student Loans: Profits of Secondary Market Lenders Vary Widely

Published by the Government Accountability Office on 1990-09-28.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

      .
                     United   States   General   Accounting   Office
                     Briefing Report to Congressional
&A0                  Requesters



September   1990
                     GUAIZANTEED
                     STUDENT LOANS.
                     Profits of Secondary
                     Market Lenders Vary
                     Widely




                                                                       $
 GAO/HRD-!IO-13OBR
                                                                       8
GAO
        United States
        General Accounting  Office
        Washington, D.C. 20548

        Human Resources     Division

        B-235076

        September 28, 1990

        The Honorable Edward M. Kennedy
        Chairman, Committee on Labor
          and Human Resources
        United States Senate

        The Honorable Augustus F. Hawkins
        Chairman, Committee on Education
          and Labor
        House of Representatives

        The federal government subsidizes higher education loans to students.
        In fiscal year 1988, federal interest subsidies for Stafford student loans
        (formerly Guaranteed Student loans) were about $22 billion. Lenders,
        such as banks, savings and loan associations, and credit unions, make
        below-market rate loans (generally 8 percent) to students and bill the
        federal government for the interest subsidies.

        In 1986, when the Congress reduced the federal subsidy rate by 0.25
        percent for most new loans, lenders warned that resulting profit reduc-
        tions would make the guaranteed loans unattractive investments. To
        provide a better basis for determining the appropriate subsidy rate on
        student loans, you requested us to determine

      . the lenders’ rates of return or profitability          on Stafford loans in their
        portfolios,
      . the reasons for varying levels of profitability among institutions that
        hold such loans, and
      . the effect of the 1986 subsidy reductions on these lenders’ profitability.

        As agreed with your offices, our report focuses on the activities of
        lenders that purchase Stafford loans in the “secondary market.” These
        lenders purchase the loans from originating lenders (those that made the
        loans), thereby providing them money to make new loans. Originating
        lenders’ portfolios may contain many kinds of loans-such as home
        mortgages, auto loans, and credit card receivables. In contrast, many
        lenders in the secondary market either deal almost exclusively with stu-
        dent loans or separately account for their student loan activities. While
        secondary market lenders may not be representative of originating
        lenders, they are more likely to maintain the financial data we needed to
         determine the profitability of their student loan business.




         Page 1                        GAO/I-lRD9O-13oBR   Profitability   of Guaranteed   Student   Loans
    8235076




    We judgmentally selected 10 institutions that are major loan holders in
    the three main kinds of secondary markets for student loans:

l   Commercial banks-Chase Manhattan Bank and Wachovia Bank and
    Trust Company.
l   The federally chartered secondary market-the Student Loan Mar-
    keting Association, known as Sallie Mae.
l   State-level agencies or institutions- the California, Colorado, Indiana,
    Nebraska, Pennsylvania, and Virginia agencies, and’& New England
    Education Loan Marketing Corporation (Nellie Mae), which serves four
    New England states.

    The banks and Sallie Mae are for-profit institutions; the state institu-
    tions are not.’ Information that lenders reported to the Department of
    Education indicates that these 10 institutions held (1) about 34 percent
    of all Stafford loans outstanding at the end of fiscal year 1988 and (2)
    made about 71 percent of all secondary market purchases of Stafford
    loans during the year.

    The Congress has changed the level of interest subsidies paid to lenders
    several times since the inception of guaranteed student loan programs in
    1965. Effective October 1, 1980, the subsidy for lenders using financing
    for which interest is taxable was set at the difference between the
    interest rate paid by students-generally    8 percent-and a rate 3.5 per-
    cent above the yield on 91-day Treasury bills. Subsidy levels for Staf-
    ford loans financed from tax-exempt sources on or after that date were
    set at one-half of the subsidy for taxable financed loans, provided total
    interest paid to lenders was at least 9.5 percent.

    In 1986, the Gramm-Rudman-Hollings budget sequester temporarily
    reduced the subsidy rate factor for new loans made between March 1
    and September 30, 1986, from 3.5 to 3.1 percent. The reduction applied
    to the first four quarterly subsidy payments for each loan. Subse-
    quently, the Higher Education Amendments of 1986 set the subsidy rate
    factor at 3.25 percent for new loans made after November 15, 1986,
    with funds obtained from taxable sources. Subsidies for loans purchased
    with tax-exempt funds were not affected by either of the 1986 revisions.



    1Although some of the institutions we reviewed are nonprofit entities and do not earn “profits” as
    such, we use the term “profitability” of student loans as the difference between income earned on the
    loan portfolios and the costs associated with financing and servicing the loans, the costs of operating
    the agency, and applicable taxes.



    Page 2                              GAO/HRD!Kk130BR      Profitability   of Guaranteed   Student   Loans
                 B235076




                 We analyzed records obtained from the Department and the 10 institu-
                 tions for the four fiscal years 1985-88, and interviewed Department and
                 lending institution representatives and other knowledgeable parties. We
                 conducted our work between January 1988 and February 1990 in accor-
                 dance with generally accepted government auditing standards. A more
                 detailed description of our methodology is in appendix I.


                 Annual after-tax rates of return varied considerably during fiscal years
Results of Our   1985-88 among and within the institutions we reviewed. Sallie Mae, the
Analysis         two commercial banks, and the Indiana agency were profitable during
                 each of the 4 years. Five other secondary market lenders experienced
                 losses in at least one year during the period.” The Pennsylvania agency
                 had losses in all four fiscal years, while the other four lenders had
                 annual rates of return ranging from a profit of 1.24 percent of their out-
                 standing Stafford loan portfolios to a loss of 3.31 percent. (See pp. 21-
                 25.)

                 In 1988, secondary market lenders’ net rates of return varied within a
                 range of 4.26 percentage points of outstanding loans. Profit variations
                 were due primarily to differences in the lenders’ financing, servicing,
                 operating, and other costs, which varied within a range of 3.86 per-
                 centage points. In contrast, gross revenues as a percentage of out-
                 standing loans varied by only 1.35 percentage points. The 1986 subsidy
                 reductions have had little effect on lenders’ revenues to date.

                 The variations in profitability among lenders indicate that revenue and
                 cost information does not provide a sufficient basis for determining
                 appropriate subsidy levels. In fact, profitability by itself is not the only
                 determinant of lender participation. The loan portfolios of all but 1 of
                 the 10 institutions increased over the 4-year period, including the hold-
                 ings of 4 agencies that were unprofitable in at least one of the years.
                 These not-for-profit agencies were established for such purposes as
                 serving as a secondary market for all lenders in their service areas by
                 purchasing all loans offered without regard to risk or potential
                 profitability.




                 2Colorado provided cost information, but did not provide other information needed to compute
                 profitability.



                 Page 3                           GAO/HRD9O-13OBR       Profitability   of Guaranteed   Student   Loams
                          B-235076




Cost Variations           The institutions’ financing costs, principally interest, accounted for
Significantly Affected    about 76 percent of total costs in 1988. Costs as a percentage of out-
                          standing loans varied within 1.34 percentage points. The factors
Profitability             affecting their financing costs included the timing, maturity, and mix of
                          taxable and tax-exempt financing, and the mix of fixed and variable
                          rate financing.

                          Costs unrelated to financing-servicing,    operating, and other costs-
                          varied by 3.71 percentage points in fiscal year 1988. These costs were
                          lowest for Sallie Mae (1.42 percent) and highest for the California
                          agency (5.13 percent). The higher costs at several institutions were due
                          in part to unique events or circumstances. For example, California’s
                          1988 costs included a provision for future losses on delinquent loans of
                          3.34 percent-the   agency may incur significant losses if the Department
                          of Education or the state guaranty agency3 determines that certain of its
                          delinquent loans were not properly serviced and refuses to pay default
                          claims. The Colorado agency’s 3.58-percent rate was caused in part by
                          expenses related to its transition from in-house servicing of loans to a
                          contract arrangement.


Interest Subsidy          The 1986 reductions had little, if any, effect on the institutions’ profit-
                          ability, primarily because they applied to only a small portion of their
Variations Had Little     1988 outstanding loans. The Gramm-Rudman-Hollings budget sequester
Effect on Profitability   reduction in the subsidy rate was temporary and applied only to new
                          loans made between March 1 and September 30, 1986. The reduction to
                          3.25 percent required by the Higher Education Amendments of 1986
                          applies only to loans made after November 15, 1986, and financed with
                          taxable funds. On average, these changes applied to about 18 percent of
                          the Stafford loans held by the 10 institutions at the end of fiscal year
                          1988.

                          We estimate that the maximum reduction in overall profitability for any
                          institution was 0.1 percent of outstanding loans in 1988. The reductions
                          had no effect on the Colorado and Pennsylvania agencies, which relied
                          entirely on tax-exempt financing during the year. However, for some
                          institutions in some years, the reductions could be significant. For
                          example, the reduction for one agency was 0.1 percent of outstanding
                          loans compared to its rate of return for that year of 0.29 percent.


                          3Borrowers’ interest and loan principal payments are guaranteed by guaranty agencies, which are in
                          turn insured by the Department.



                          Page 4                           GAO/HRD90130BR        Profitability   of Guaran teed Student   Loans
                                   F&235076




                                   The 1986 subsidy reduction of 0.25 percent can be expected to reduce
                                   revenues more in the future as (1) loans subject to the lower subsidy
                                   rate make up more of the taxable funded portions of portfolios and (2)
                                   state limits on the use of tax-exempt debt cause state agencies to rely
                                   more on taxable borrowing. However, the effect of the subsidy reduc-
                                   tion on the institutions’ profitability will likely continue to be minor
                                   compared with the effect of variations in financing, servicing, and other
                                   costs. (See p. 28.)


    Loans Financed With Tax-       Agencies that use tax-exempt funds to purchase Stafford loans at times
    Exempt Funds Can Earn          earn higher interest revenues than do lenders using taxable funds to
                                   finance their loan portfolios because:
    More RevenueThan Other
.   Loans                      l   The 1986 reduction of 0.25 percent in the subsidy rate factor did not
                                   apply to student loans made or purchased with tax-exempt funds, which
                                   continue to receive subsidies at the pre-1986 level. At the end of fiscal
                                   year 1988, such loans accounted for about 55 percent of the Stafford
                                   loan portfolios of all seven state secondary market institutions studied.
                               l   The Higher Education Act provides loans purchased with tax-exempt
                                   funds a minimum rate of return of 9.5 percent. In periods of relatively
                                   low interest rates, lenders receive higher rates of interest on these loans
                                   than on loans made or purchased with taxable funds that are not pro-
                                   tected by an interest rate floor. For example, during fiscal year 1986 the
                                   gross return on tax-exempt financed loans remained at the floor of 9.5
                                   percent, while the return on taxable financed loans to first-time bor-
                                   rowers ranged from 8.75 to 10.88 percent. (See p. 26.)

                                   Eliminating the 9.5-percent revenue floor and reducing the subsidy rate
                                   factor on tax-exempt financed loans to 3.25 percent would be consistent
                                   with the treatment of loans financed with taxable funds and would
                                   reduce federal interest subsidies. However, such actions would reduce
                                   revenues of state-level agencies, which included the least profitable
                                   institutions in our study.


                                   The Department of Education and 9 of the 10 secondary market lenders
    Agency Comments                we reviewed provided written comments on a draft of this report. The
                                   Department and several of the institutions provided technical com-
                                   ments, which we incorporated where appropriate. Several lenders also
                                   noted that the institutions vary widely in their operations and profit-
                                   ability, and some advised us that their costs have increased since the



                                   Page 5                   GAO/HRMO-13OBR   Profitability   of Guaranteed   Student   Loans
Et-235076




completion of our study. Our evaluation of their comments begins on
page 36. Their comments appear in appendixes III through XII.


We are sending copies of this briefing report to the Department of Edu-
cation, other congressional committees, and other interested parties.
Should you wish to discuss its contents, please call me on (202) 275-
1793. Major contributors to this report are listed in appendix XIII.




Franklin Frazier
Director, Education
   and Employment Issues




Page 6                   GAO/HBD-B@13OBR   lbfltability   of Guaranteed   Student   Loana
.




    Page 7   GAO/HRDWMOBB   Profitability   of GuaranteesI   Student   bona
    Contents


    Letter                                                                                                        1

    Profitability of                                                                                            12
    Stafford Student       Objectives
                           Scope and Methodology
                                                                                                                12
                                                                                                                13
    Loans Held by          The 10 Institutions’ Loan Holdings Have Increased                                    20
    Secondary Markets      Profitability Varied Widely Among Secondary Market                                   21
                                Lenders
    Varied Widely          Revenues Were Similar                                                                25
                           Costs Varied                                                                         29
                           Conclusions                                                                          35
                           Agency Comments and Our Evaluation                                                   36
.
    Appendix I                                                                                                  38
    Methodology            Data Collection
                           Data Validation
                                                                                                                39
                                                                                                                39
                           Data Limitations                                                                     40

    Appendix II                                                                                                 43
    Data Supporting
    Figures
    Appendix III                                                                                                50
    Comments From the
    Department of
    Education
    Appendix IV
    Comments From Sallie
    Mae
    Appendix V
    Comments From Chase
    Manhattan


                           Page 8                 GAO/HRDSl%13OBR   Profitability   of Guaranteed   Student   Loans
                            Content.3




    Appendix VI
    Comments From
    Wachovia
    Appendix VII                                                                                     .58
    Comments From the
    California Agency
    Appendix VIII                                                                                    59
    Comments From the
.   Indiana Agency
    Appendix IX                                                                                      60
    Comments From the
    Nebraska Agency
    Appendix X
    Comments From Nellie
    Mae
    Appendix XI
    Comments From the
    Colorado Agency
    Appendix XII
    Comments From the
    Pennsylvania Agency
    Appendix XIII
    Major Contributors to
    This Briefing Report



                            Page 9      GAO/HRD9@13OBR   Profitability   of Guaranteed   Student   Loam
          Contents




Tables    Table 1: Stafford Loan Holdings Generally Increased                                       21
              Despite Unprofitable Operations (Fiscal Years 1986-
                88)
          Table II. 1: Ten Institutions’ Loan Holdings Doubled                                      43
               (Fiscal Years 1985-88) (Data for Fig. 6)
          Table 11.2:Nine Institutions’ Profitability Varied Widely                                 43
               (Fiscal Year 1988) (Data for Fig. 7)
          Table 11.3:For-Profit Institutions Were Consistently                                      44
               Profitable (Fiscal Years 1985-88) (Data for Fig. 8)
          Table 11.4:Not-for-Profit Agencies’ Returns Varied (1988)                                 44
               (Data for Fig. 9)
          Table 11.5:State Governmental Agencies’ Returns Varied,                                   45
               but Each Has Had Losses (Fiscal Years 1985-88)
              (Data for Fig. 10)
          Table 11.6:Institutions’ 1988 Gross Revenues Were Similar                                 45
              (Data for Fig. 11)
          Table 11.7:9.5-Percent Interest Revenue Floor Increased                                   46
              Returns on Tax-Exempt Financed Loans (Data for
              Fig. 12)
          Table 11.8:Loans Subject to Reduced Subsidies Are                                         47
              Increasing (Fiscal Years 1987-88) (Data for Fig. 13)
          Table 11.9:Costs Varied Among 10 Lenders (Fiscal Year                                     47
               1988) (Data for Fig. 14)
          Table II. 10: Tax-Exempt and Taxable Borrowing Costs                                      48
              Were Similar (Fiscal Years 1985-88) (Data for Fig.
               15)
          Table II. 11: Proportion of Loans Purchased With Tax-                                     48
              Exempt Funds Has Declined (Fiscal Years 1985-88)
              (Data for Fig. 16)
          Table II. 12: Servicing and Operating Costs Varied (Fiscal                                48
              Year 1988) (Data for Fig. 17)
          Table II. 13: Taxes Reduced Federal and Commercial                                        49
              Lenders’ Profitability (Fiscal Year 1988) (Data for
              Fig. 18)

Figures   Figure     1: Objectives                                                                  13
          Figure     2: Methodology                                                                 14
          Figure     3: Reviewed 10 Secondary Markets                                               15
          Figure     4: State Agencies Reviewed                                                     17
          Figure     5: How Profitability Is Calculated                                             18




          Page 10                     GAO/HRlMO-13OBR   Profltabiity   of Guaranteed   Student   L.oans
Contents




Figure 6: Ten Institutions’ Loan Holdings Doubled (Fiscal                            20
     Years 1985-88)
Figure 7: Nine Institutions’ Profitability Varied Widely in                          22
     1988
Figure 8: For-Profit Institutions Were Consistently                                  23
     Profitable (Fiscal Years 1985-88)
Figure 9: Not-For-Profit Agencies’ Returns Varied (Fiscal                            24
     Years 1985-88)
Figure 10: State Governmental Agencies’ Returns Varied,                              25
     but Each Has Had Losses (Fiscal Years 1985-88)
Figure 11: Institutions’ 1988 Gross Revenues Were Similar                            26
Figure 12: 9.5-Percent Interest Revenue Floor Increased                              27
     Returns on Tax-Exempt Financed Loans (Fiscal Years
     1985-88)
Figure 13: Loans Subject to Reduced Subsidies Increased                               29
     (Fiscal Years 1987-88)
Figure 14: Costs Varied Among 10 Lenders (1988)                                       30
Figure 15: Tax-Exempt and Taxable Financing Costs Were                                32
     Similar (Fiscal Years 1985-88)
Figure 16: Proportion of Loans Financed With Tax-                                     33
     Exempt Funds Has Declined (Fiscal Years 1985-88)
Figure 17: Servicing, Operating, and Other Costs Varied in                            34
     Fiscal Year 1988
Figure 18: Taxes Reduced Federal and Commercial                                       35
     Lenders’ Profitability in Fiscal Year 1988




 Page 11                 GAO/HRD9@13OBR   Proiitability   of Guaranteed   Student   Loans
Profitability of Stafford Student Loans Held by
SecondaryMarkets Varied Widely

                The costs of federal interest subsidies for guaranteed student loans rose
Objectives      from $1.3 billion in fiscal year 1980 to $3.3 billion in fiscal year 1985. In
                1986, the Congress reduced the interest subsidy rate by 0.25 percent for
                most new loans. At that time, some lenders indicated that the reduction
                would make student loans unattractive. To assess the profits lenders
                were making on these loans and to provide a basis for assessing the ade-
                quacy of federal interest subsidies, the House Committee on Education
                and Labor and the Senate Committee on Labor and Human Resources
                asked us to determine (1) the profitability of Stafford loan portfolios
                held by major secondary market institutions receiving federal interest
                subsidies on these loans, (2) the reasons for variations in the profit-
                ability of these portfolios, and (3) the effect of the 1986 reduction in the
                interest subsidy rate on their profitability. (See fig. 1.)

                After discussions in early 1988 with the committees, we focused our
                efforts on the profitability of Stafford loan portfolios of those lenders
                that make up the secondary market for student loans, that is, financial
                institutions that purchase Stafford loans from banks, savings and loan
                associations, credit unions, and other financial institutions that make
                loans to students. In contrast to the originating lenders, whose portfolios
                may contain many kinds of loans-such as home mortgages, auto loans,
                and credit card receivables-many       lenders in the secondary market
                either deal almost exclusively with student loans or separately account
                for their student loan activities.




                Page 12                   GAO/HRD-SO-130BR   Profitabihy   of Guaranteed   Student   Loans
                            Profitability of Stafford Student Loans Held
                            by Secondary Markets Varied Widely




    Fiaure 1


           GAO Objectives


               l   Determine profitability of
                   student loans
.              l   Examine variations
               l   Determine effect on profits of
                   1986 interest subsidy
                   reduction




                             At the beginning of our review, we held a conference with secondary
    Scopeand                 market officials and others knowledgeable in student loan finance as we
    Methodology              developed our review methodology. We also contracted with an expert
                             on government-sponsored enterprises to identify and describe the legal
                             and institutional factors that affect the three major kinds of institutions
                             that make up the secondary market for Stafford loans-commercial
                             banks, state agencies, and the federally chartered Student Loan Mar-
                             keting Association (Sallie Mae)-and their reasons for participating in
                             the secondary market for student loans. (See fig. 2.)




                             Page 13                         GAO/HRD90-130BR   Profitability   of Guaranteed   Student   Loans
                             Profitability of Stafford Student Loana Held
                             by Secondary Markets Varied Widely




    Figure 2


           GAS Methodology


               l   Held conference with major
                   loan purchasers to discuss
                   review approach
.

               l   Used consultant to identify and
                   assess factors affecting
                   competitiveness among
                   purchasers

               l   Analyzed financial activities of
                   10 major purchasers


                             We focused on the activities of 10 judgmentally selected Stafford loan
                             secondary market institutions that were major loan holders during fiscal
                             years 1985-88. At the end of fiscal year 1988, secondary market institu-
                             tions held about two-thirds of all Stafford loans. The 10 we analyzed
                             held about $13.5 billion, or one-third of all Stafford loans, and made
                             about 71 percent of all reported secondary market purchases during
                             fiscal year 1988. (See fig. 3.)




                             Page 14                         GAO/HRD-9lX13OBR   Pmfitmbtkity   of Guuanteed   Student   Loans
                               Profitability of Stafford Student Loans Held
                               by Secondary Markets Varied Widely




    Figure 3


           GACI Reviewed IO Secondary
                Markets

               l   Sallie Mae

               0 Commercial banks
.                *Chase Manhattan
                 l Wachovia
               l   State agencies
                   lDesignated not-for-profit
                    (CA, IN, NE, Nellie Mae)
                   @Government agencies
                    (CO, PA, VA)

                               They represent the three major kinds of secondary market institutions:

                           . The federally chartered Student Loan Marketing Association (Sallie
                             Mae) is a stockholder-owned, for-profit corporation, established by the
                             Congress as a national secondary market for federally guaranteed stu-
                             dent loans. With a portfolio of about $9.4 billion of Stafford loans at the
                             end of fiscal year 1988, Sallie Mae is by far the largest holder of these
                             loans,
                           l Commercial banks are stockholder-owned, for-profit lending institu-
                             tions. We selected two banks that, in addition to purchasing Stafford




                               Page 16                         GAO/HRD90-13OBB   Profitability   of Guaran teed Student   Loana
    Profitability of Stafford Student Loam Held
    by Secondary Markets Varied Widely




    loans, were also major originators of such loans. Chase Manhattan Bank’
    and Wachovia Bank and Trust Company together held $1.1 billion of
    Stafford loans at the end of fiscal year 1988.
l   State agencies are either governmental or not-for-profit agencies. They
    purchase student loans from private lenders, often for resident-bor-
    rowers of the states in which they were established. A principal feature
    that differentiates them from other secondary lenders is that they may
    use tax-exempt financing to purchase Stafford loans. We selected seven
    state agencies to provide a cross-section of the different types of state
    secondary markets. Three of these are private, not-for-profit agencies
    that serve single states (California, Indiana, and Nebraska); one is a pri-
    vate, not-for-profit agency that serves Massachusetts, New Hampshire,
    Connecticut, and Rhode Island (New England Education Loan Marketing
    Corporation, or Nellie Mae); and three are state governmental agencies
    that serve single states (Colorado, Pennsylvania, and Virginia). (See fig.
    4.)

    To determine Stafford loan profitability for the 10 institutions in each of
    the four years during the 1985-88 period, we analyzed their Stafford
    loan costs and revenues expressed as a percentage of the average bal-
    ance of their outstanding Stafford loan portfolio for each year.2
    Although the seven state agencies do not generate “profits” as such, we
    use the terms “profit” and “loss” to refer to each of the 10 institutions’
    net rates of return on Stafford loans (net income or loss as a percentage
    of the average balance of outstanding Stafford loans).




    1We excluded from our analysis Stafford loans held by Chase Lincoln First Bank and Chase Man-
    hattan, St. Thomas.

    2Colorado provided cost data, but did not provide other data needed to compute profitability.



    Page 16                           GAO/HRD9@13OBR         Profitability   of Guaranteed   Student   Loans
                                    Profitability of Stafford Student Lonna Held
                                    by Secondary Markets Varied Widely




Figure 4: State Agencies Reviewed




                                       W[      Not-for-profit Agencies
                                               GowmmsntalA~s
                                       m




                                    Page 17                              GAO/HRMU%13OBR   Profitability   of Guaranteed   Student   Loans
                          Profitability of Stafford Student Loans Held
                          by Secondary Markets Varied Widely




    Figure 5


           GAO How Profitability Is Calculated


                Gross revenues
                Less costs:
.               @Costof funds
                *Servicing costs
                @Operating costs
                aTaxes, where applicable

                Equals profitability, or net rate
                of return


                          Revenues to lenders, whether they make loans or purchase them in the
                          secondary market, consist mostly of interest paid by students and
                          interest subsidies paid by the Department of Education. Borrowers
                          interest and loan principal payments are guaranteed by 1 of 59 state or
                          nonprofit guaranty agencies, which are in turn insured by the Depart-
                          ment. The federal interest subsidies include (1) students’ interest while
                          they are in school and during grace and deferment periods after they
                          leave and (2) an additional subsidy, referred to as a special allowance




                          Page 18                         GAO/HRD!M%13OBR   Profitabiity   of Gnaran teed Student   Loans
        Profitability of Stafford Student Loans Held
        by Secondary Markets Varied Widely




        payment, throughout the life of the loan that is intended to give lenders
        a near-market interest rate.3

        Secondary market lenders incur costs to borrow the funds to purchase
        and service loans and to pay operating and other expenses.

l Costs of funds include lenders’ interest expenses and other costs of
  issuing debt, such as letters of credit, underwriting, and bond attorneys’
  fees.
. Servicing costs include the costs of billing, collecting, and accounting for
  loan payments; encouraging borrowers to make scheduled payments;
  and filing claims with the guaranty agency when students default. Some
  lenders service their own loans, while others contract for the servicing
  of all or a portion of their portfolios.
l Operating and other costs include administrative costs and provisions
  for loan losses.

        To calculate profits for Sallie Mae and the two commercial banks, we
        also deducted taxes from revenues. To facilitate comparisons among
        agencies, we included in our analyses only revenues and costs directly
        associated with the Stafford loans held by each. We excluded, for
        example:

    9 Arbitrage revenues that state agencies earned by issuing tax-exempt
      securities and temporarily investing portions of the proceeds in higher
      yielding investments until they purchase student loans.
    l Revenues that Wachovia and the Colorado, Indiana, and Pennsylvania
      agencies, or their affiliates, received for servicing loans held by other
      lenders.
    l Revenues that Sallie Mae earned from sales of letters of credit and loans
      it made to facilitate other lenders’ student loan programs.

        In addition, some of the 10 institutions failed to provide all of the data
        we requested. A complete description of our methodology, including
        data limitations, is in appendix I.




        3The interest rate students pay has been 8 percent on loans to first-time borrowers since 1983. For
        students borrowing Stafford loans for the first time after June 1988, interest will increase to 10
        percent after the fourth year of repayment. The special allowance is paid quarterly and, for taxable
        faced    loans, is the difference between the borrower’s interest rate and the average bond
        equivalent rate on 9lday T~asury bills plus 3.26 percent.



         Page 19                          GAO/HRD9@199BR         Profitability   of Guaran teed Student   Loans
                                            Profitability of StatTord Student Loans Held
                                            by Secondary Markets Varied Widely




                                            The 10 institutions we reviewed were among the 40 largest holders of
The 10 Institutions’                        guaranteed student loans at the end of fiscal year 1988.4 As shown in
Loan Holdings Have                          figure 6, their outstanding Stafford loans rose from $7.4 billion at the
Increased                                   end of fiscal year 1985 (22 percent of all outstanding loans) to $13.5
                                            billion at the end of fiscal year 1988 (34 percent). Sallie Mae was by far
                                            the largest holder. Its $5.1 billion student loan portfolio at the end of
                                            fiscal year 1985 increased to about $9.4 billion at the end of fiscal year
                                            1988. Four other institutions reviewed were among the 10 largest
                                            holders of guaranteed student loans at the end of fiscal year 1988-
                                            Nellie Mae, Chase Manhattan, and the Nebraska and California agencies.


Figure 6: Ten Institutions’ Loan Holdings
Doubled (Fiscal Years 1985-88)              14     Dofm   in BHlions
                                            13




                                             4
                                             3
                                             2
                                             1
                                             0 \
                                                           W-B
                                                   1985         1988      1987   1988
                                                   End of F-1      Year

                                                            State Agencies
                                                            cbfnmerdal BenILs
                                                            Sallie Mae

                                            Note: Excludes many of the Pennsylvania agency’s Stafford loans (for example, $340 million for 1988)
                                            that-while  federally insured-were  ineligible for federal interest subsidies pnnclpally because the bor-
                                            rowers’ incomes exceeded federal maximums.




                                            4At that time, about $40 billion of the $45 billion of outstanding     guaranteed student loam were Staf-
                                            ford loans.




                                            Page 20                              GAO/ERB!I@12OBR        Profitability   of Guaran teed Student   Loans
                                            Profitability of Stafford Student Loana Held
                                            by Secondary Markets Varied Widely




                                            As discussed in more detail below, net rates of return varied widely
                                            among nine institutions during the 4-year period. However, profitability
                                            was apparently not the only factor influencing lenders’ continued partic-
                                            ipation in the program. As shown in table 1, of the five agencies that
                                            reported losses in at least one year during the period, four increased
                                            their loan portfolios substantially while one reduced its portfolio
                                            slightly. Each of the lenders that had losses are not-for-profit or state
                                            agencies generally established for purposes other than making profits.
                                            Some of the reasons for which these lenders were created include (1) to
                                            serve all lenders and borrowers in their service areas regardless of the
                                            costs and risks of certain kinds of loans and (2) to purchase loans that
                                            lenders have difficulty selling to for-profit secondary market
                                            institutions.

    Table 1: Stafford Loan Holdings
.
    Generally Increased Despite                                                                                                      Loan holdings
    Unprofitable Operations (Fiscal Years                                                               Years                              change
    1986-88)                                Institution                                                 unprofitablea                    (percent)
                                            Sallie Mae                                                  None                                       82
                                            Chase Manhattan                                             None                                       11
                                            Wachovia                                                    None                                      135
                                            California                                                  1988b                                     196
                                            Indiana                                                     None                                        48
                                            Nebraska                                                    1985                                      230
                                            Nellie Mae                                                  1985-86                                   258
                                            Pennsvlvania                                                198588                                    408
                                            Virainia                                                    1987-88                                    -8
                                            Talifornia and Chase Manhattan data are for calendar years
                                            bNo data on profitability for fiscal years 1985 and 1966.



                                            The variations in profitability among the institutions were more often a
    Profitability Varied                    result of differences in costs than in revenues. In 1988,s for example, net
    Widely Among                            rates of return varied within a 4.26~percentage-point range, from a
    Secondary Market                        3.31-percent loss to a 0.95~percent profit. (See fig. 7.) However, gross
                                            revenues as a percentage of outstanding loans varied by only 1.35 per-
    Lenders                                 centage points (9.03 to 10.38 percent). Costs as a percentage of out-
                                            standing loans varied over a broader, 3.34~percentage-point range (9.00
                                            to 12.34 percent).


                                            ‘The California agency and Chase Manhattan data are for calendar year 1988. All other data are for
                                            the fiscal year ending September 30,1988.



                                            Page 21                             GAO/‘HFKL9&13OBR        Profitability   of Guaran teed Student   Loans
                                               Profitability of Stafford Student Loans Held
                                               by Secondary Markets Varied Widely




Figure 7: Nine Institutions’   Profitability
Varied Widely in 1988
                                               Nef Rate of Rafurn (Percent)




                                               -4




                                               Note. Data not avallable for the Colorado agency

                                               Among profitable lenders in 1988, Sallie Mae had the highest profit
                                               (about 0.95 percent after taxes) and Chase Manhattan had the lowest
                                               (0.18 percent). During that year, three of the nine agencies (California,
                                               Pennsylvania, and Virginia) had negative net rates of return (losses of
                                               3.31, 0.40, and 0.18 percent, respectively).


For-Profit Secondary                           Sallie Mae, Chase Manhattan, and Wachovia were consistently profitable
                                               over the 4-year period, with Sallie Mae’s rates of return being the
Market Lenders Were                            highest and Chase Manhattan’s the lowest. (See fig. 8.) According to
Consistently Profitable                        officials at Chase, profits on the bank’s Stafford loan portfolio were
                                               lower because of additional investments made in equipment and staff in
                                               anticipation of substantial increases in the size of its student loan opera-
                                               tion. Stafford loans made up relatively small portions of the two com-
                                               mercial banks’ assets-about 0.88 percent at Chase Manhattan and
                                               about 1.48 percent at Wachovia as of the end of fiscal year 1988. In
                                               contrast, student loans were a major portion of total assets for Sallie
                                               Mae and most of the state agencies.



                                               Page 22                           GAO/HRD-90-13OBR   Profitability   of Guaranteed   Student   Loans
                                                 Profitability of Stafford Student Loans Held
                                                 by Secondary Markets Varied Widely




Figure 8: For-Profit Institutions Were
Consistently Profitable (Fiscal Years 1985
                                                 Net Rate of Return (Percent)
88)
                                                  2.0




                                                 -1 .o

                                                 -1.5

                                                 -2.0

                                                    1985                            1966                          1987
                                                    Fiscal Year

                                                         -        Sallie Mae
                                                         -1-1     Chase Manhattan
                                                         m        Wachovia




State Not-for-Profit                             While Sallie Mae and the banks consistently earned a profit during the
                                                 4-year period, the four not-for-profit agencies’ net rates of return varied
Institutions’ Net Returns
TT--2 - -1
v ar1eu
                                                 considerably. Although all four had positive returns in 1987, two had
                                                 losses in earlier years (Nebraska in 1985 and Nellie Mae in 1985 and
                                                 1986), and California had a large loss in 1988. (See fig. 9.) According to
                                                 agency officials:

                                             l   The Nebraska agency’s 1.71-percent loss in fiscal year 1985 resulted tn
                                                 part from high interest costs for long-term fixed interest rate securities
                                                 that the agency had issued in prior years when interest rates were
                                                 higher. Nebraska lowered its cost of funds considerably, from 10.63 per-
                                                 cent in fiscal year 1985 to 7.73 percent in fiscal year 1986, by issuing
                                                 lower yield securities to replace earlier higher yield securities, thereby
                                                 improving its net rate of return in subsequent years.
                                             l   Nellie Mae’s losses in fiscal years 1985 and 1986 of 0.43 and 0.57 per-
                                                 cent, respectively, resulted in part because it did not receive special
                                                 allowance subsidy payments for some of its loans during these years.



                                                 Page 23                            GAO/IiRD9&130BR   Profltabllity      of Guaranteed   Student   Loana
                                         Profitability of Stafford Student Loana Held
                                         by Secondary Markets Varied Widely




                                         These loans were purchased with funds Nellie Mae raised by issuing tax-
                                         exempt securities before it obtained approval of its plan for using such
                                         funds to finance Stafford loans. The loans were therefore ineligible for
                                         special allowance payments until Nellie Mae received state approval.
                                       . The California agency incurred a 3.31-percent loss in calendar year 1988
                                         largely because it included in its costs a provision for future losses on
                                         delinquent loans of 3.34 percent. The agency may incur significant one-
                                         time losses if the Department of Education or the guaranty agency
                                         determines that certain delinquent loans were not appropriately ser-
                                         viced and therefore refuses to pay default claims.


Figure 9: Not-for-Profit Agencies’
Returns Varied (Fiscal Years 198588)
                                         Net Rate of Return (Percent)
                                         2




                                                                                                          --

                                                                     7  mmmmmmZ~OmOO*O*
                                                                                              *a---                           \\
                                                                                                                                   \




                                         -2


                                         -3


                                         -4


                                          1995                               1966                                1997                              1999
                                          Fiscal Year

                                                 -      California
                                                 -1-1   Indiana
                                                 m      Nebraska
                                                 nnnn   Nellie Mae

                                          Note: California agency data not avallable for fiscal years 1985 and 1986.




                                          Page 24                              GAO/HBDf@13OBR         ProfItability     of Guaranteed   Student   Loans
                                          Profitability of Stafford Student Loam Held
                                          by !?uxondary Markets Varied Widely




State Governmental                        The Virginia agency earned a profit in fiscal years 1985 and 1986, but
                                          incurred losses in 1987 and 1988. The Pennsylvania agency had losses in
Agencies Have Had Losses                  all four years. (See fig. 10.) The Colorado agency did not provide suffi-
                                          cient revenue data to determine its profitability during the 4-year
                                          period.

                                          Virginia’s losses were attributed to its high cost of funds-the highest
                                          reported of the 10 institutions in 1986, 1987, and 1988. A Virginia
                                          agency official explained that the agency had issued fixed rate tax-
                                          exempt bonds at a time when interest rates were higher. The Penn-
                                          sylvania agency, as was the case with Nellie Mae, lost potential revenue
                                          because it was initially not eligible to receive special allowance pay-
                                          ments. It began to receive the subsidy payments in January 1987, after
                                          its plan for the use of tax-exempt financing was approved.


Figure 10: State Governmental Agencies’
Returns Varied, but Each Has Had
                                          2   Net Rate of Return (Percent)
Losses (Fiscal Years 1985-88)




                                          1985                               1986
                                          Fiscal Year

                                                 -      Pennsylvania
                                                 -9-9   Virginia




RevenuesWere Similar                      nues as a percentage of outstanding loans varied in 1988 within a




                                           Page 26                             GAO/ERD9@13OBR   Profitability   of Guaranteed   Student   Loans
                                      Profitability of Stafford Student Loans Held
                                      by Secondary Markets Varied Widely




                                      1.35-percentage-point range-from                       9.03 to 10.38 percent of their Staf-
                                      ford loan portfolios6


Figure 11: Institutions’ 1988 Gross
Revenues Were Similar
                                      11       Gross Revenue   Rate (Percent)

                                      10

                                       9

                                       6

                                       7

                                      6

                                      5

                                      4

                                      3

                                      2

                                      1

                                      0
                                           5




                                      Note: Colorado agency data not available.


                                      Although the special allowance payment for tax-exempt financed loans
                                      is generally one-half of that for taxable-financed loans, loans financed
                                      with tax-exempt funds are guaranteed a gross interest revenue rate of
                                      at least 9.5 percent.’ When the Treasury bill rates to which subsidies are
                                      tied are relatively low- as was the case in recent years-the revenue
                                      rates on tax-exempt financed loans can approach, or even exceed, those
                                      on taxable financed loans. Figure 12 illustrates the effect of the 9.5-
                                      percent floor on lenders’ gross interest revenues for their tax-exempt
                                      funded loans during fiscal years 1985-88. The floor raised agencies’

                                      ‘Some of the variations in revenues resulted from the use of different reporting periods. Two agen-
                                      cies used the year ended December 31, and the others used September 30, 1988. Average Treasury
                                      bill rates in the quarter ending December 31, 1988, rose above earlier levels, thereby increasing
                                      annual interest subsidy revenues for the two agencies.

                                      ‘Stafford loans made or purchased with tax-exempt funds before the beginning of fiscal year 1981
                                      earn special allowance payments at the same rate as loans made or purchased with taxable funds.



                                      Page 26                                   GAO/HRNNl-13OBB   Profitability   of Guaranteed   Student   Loana
                                                                     Profitability of Stafford Student Loans Held
                                                                     by Secondary Marketa Varied Widely




                                                                     revenues on tax-exempt financed loans in periods of relatively low Trea-
                                                                     sury bill rates.



   Figure 12: g&percent             Interest Revenue Floor increased Returns on Tax-Exempt Financed Loans (Fiscal Years 1985-88)

f 11.0     Intenst Rata (Percent)




                                           1999                                        1999                            1967                                      1999
         Fiscal Year

           B           Interest rate paid (with 9.5-percent floor)
           -1-1        Interest rate had there been no floor

                                                                     Quarterly revenues of lenders who used tax-exempt financing were as
                                                                     much as 1.12 percent higher than they would have been without the
                                                                     interest rate floor in 13 of the 16 quarters during the 4-year period. For
                                                                     example, we estimate that in fiscal year 1988 the seven state agencies
                                                                     we reviewed received about $8 million more than they would have
                                                                     without a 9.5~percent interest revenue floor. For all agencies that use
                                                                     tax-exempt financing, we estimate that the provision increased revenues
                                                                     by about $19 million in that year. However, the institutions that bene-
                                                                     fited from the subsidy reduction exemptions included the least profit-
                                                                      able of the 10 we studied. Furthermore, in 7 of the 16 quarters,
                                                                     Treasury bill rates declined to the point that the 9.5~percent interest
                                                                      revenue floor provided the state agencies higher interest revenue for
                                                                      tax-exempt financed loans than for taxable financed loans, which have
                                                                      no minimum special allowance payment.




                                                                      Page 27                         GAO/HRD9@12OBB   Profltablllty   of Guaranteed   Student   Loana
                                  Profitability of Stafford Student Loans Held
                                  by Secondary Markets Varied Widely




Federal Cost Reduction            Two congressional changes were enacted in 1986 to reduce federal
                                  interest subsidy costs that resulted in slightly lower revenues for most
Initiatives Have Had Little       lenders. The first was temporary; the second remains in effect:
Effect on Lenders’
Revenuesto Date               l   The Gramm-Rudman-Hollings sequester reduced the interest subsidy
                                  rate factor used to calculate special allowance payments by 0.4 percent
                                  for loans made between March 1 and September 30,1986. This reduction
                                  remained in effect for four quarterly payments on each affected loan.
                              l   The Higher Education Amendments of 1986 reduced the interest subsidy
                                  rate factor for taxable financed loans made after November 15, 1986, by
                                  0.25 percent, from 3.5 to 3.25 percent. This provision applies for the life
                                  of these loans.

                                  Although the Gramm-Rudman-Hollings reduction applied to all Stafford
                                  loans, in practice it did not affect tax-exempt financed loans. The 91-day
                                  Treasury bill rates were low enough that these loans earned the min-
                                  imum 9.5-percent return provided for by law. In contrast, institutions
                                  that held taxable financed loans experienced reductions in revenue due
                                  to the sequester. Because of the short duration of the cut (it applied only
                                  to loans made during a 7-month period), as of September 30, 1986, this
                                  temporary subsidy rate reduction affected no more than 5.1 percent of
                                  any of the 10 agencies’ portfolios.

                                  The Higher Education Amendments excluded tax-exempt financed loans
                                  from the 0.25-percent reduction in the subsidy rate factor. Because
                                  many of the loans held by five state agencies, and all of the loans held
                                  by two agencies, were made or purchased with tax-exempt rather than
                                  taxable financing, the rate reduction had little, if any, effect on their
                                  gross revenues. Moreover, because the reduction applies only to loans
                                  made after November 15,1986, many of the taxable financed loans in
                                  their portfolios were unaffected as of the end of fiscal year 1988. As a
                                  result, none of the 10 agencies’ revenues decreased by the full 0.25 per-
                                  cent as of September 30,1988. Revenue reductions due to the revised
                                  3.25-percent subsidy rate factor ranged from zero for the Colorado and
                                  Pennsylvania agencies, which held only tax-exempt financed loans, to
                                  slightly more than 0.1 percent of the loan portfolio balance for Chase
                                  Manhattan Bank, which had almost half of its loans subject to the 3.25-
                                  percent rate factor. (See fig. 13.) Although Chase Manhattan’s O.l-per-
                                  cent revenue reduction is not as significant as the variations in its costs,
                                  it is significant when compared to its 1988 net rate of return before
                                  taxes of 0.29 percent.




                                  Page 28                         GAO/HRINML12OBR   Profitabiity   of Guaranteed   Student   Loans
                                             Profitability of Stafford Student L.oam Held
                                             by Secondary Markets Varied Widely




Figure 13: Loans Subject to Reduced
Subsidies Increased (Fiscal Years 1987-88)
                                             50   Percent of Outstanding Loans Subject   to Reduced   Subsidies




                                             Note: The Colorado and Pennsylvania agencies held only tax-exempt financed loans, which are not
                                             subject to the subsidy reduction.


                                             As the number of taxable financed loans subject to the reduced subsidy
                                             rate increases, the new rate will have a greater effect on lenders’ reve-
                                             nues. The rate cut, however, will continue to have no impact on lenders’
                                             Stafford loan portfolios financed with tax-exempt funds.


                                             As shown in figure 14, the 10 institutions’ 1988 costs (cost of funds;
Costs Varied                                 servicing, operating, and other costs; and applicable taxes) as a per-
                                             centage of their outstanding loans varied from 8.48 percent for Sallie
                                             Mae to 12.34 percent for the California agency, a range of 3.86 per-
                                             centage points. While the cost of funds was the 10 lenders’ largest cost
                                             element, it varied less as a percentage of outstanding loans than ser-
                                             vicing costs or operating and other costs.




                                             Page 29                            GAO,‘HRD90139BB           Profitability   of Guaran teed Student   Loans
                                   Profitability of Stafford Student Loans Held
                                   by Secondary Markets Varied Widely




                                   The cost of funds varied from 7.06 percent of outstanding loans for
                                   Sallie Mae to 8.40 percent for the Virginia agency-a range of 1.34 per-
                                   centage points. In contrast, servicing costs varied by 2.13 percentage
                                   points, ranging from 0.80 percent for Sallie Mae to 2.93 percent for the
                                   Colorado agency. Operating and other costs varied by 3.89 percentage
                                   points, ranging from 0.15 percent for Wachovia to 4.04 percent for the
                                   California agency.


Figure 14: Costs Varied Among 10
Lenders (1988)
                                   13   Costs as Percent       of Outstanding      Loans
                                                                            . . . . ..-
                                                                                                                 . . . .. ..-w




                                        [         Taxes

                                                  Servicing,     Operating,   and Other Costs

                                                  Costs of funds




Funding Cost Variations             Many factors influence the secondary market lenders’ cost of funds,
                                    including (1) the tax status of the securities issued, such as taxable or
                                    tax exempt; (2) the timing and terms of the debt issue-including       the
                                    interest rate in effect at the time of issue, whether the rate is variable or
                                    fixed, and the length of the repayment period; and (3) the costs of



                                    Page 30                                     GAO/HRD9@13OBR   Profitability    of Guaranteed   Student   Loans
Profitability of Stafford Student Loans Held
by Secondary Markets Varied Widely




issuing the debt and obtaining credit enhancements, such as letters of
credit. The interplay among these factors and the volatility of interest
rates make it difficult to analyze and isolate the reasons for funding cost
differences.

For example, while market interest rates on tax-exempt financing are
generally lower than on taxable financing, a secondary market agency
may incur higher average interest costs for its tax-exempt financed debt
than for its taxable debt. This could occur as market interest rates
declined, if it had issued long-maturity, fixed-rate, tax-exempt debt at
high market interest rates, while its taxable debt was shorter-maturity
and/or floating-rate. The Colorado and Pennsylvania agencies (which
relied exclusively on tax-exempt financing during the period) and the
Virginia agency (which used tax-exempt financing for almost two-thirds
of its loan portfolio) were among those with the highest costs of funds in
 1988.

In addition, for four of the five state agencies that had both taxable and
tax-exempt debt, the average cost of tax-exempt debt exceeded their
average cost of taxable debt in at least 1 of the 4 years for which we
collected data. One of the agencies had a higher average cost for its tax-
exempt debt in all 3 years that it held Stafford loans financed with both
taxable and tax-exempt debt. However, while the cost of tax-exempt
debt exceeded that of taxable debt for some institutions in some years,
overall the average cost of outstanding taxable debt exceeded the
average cost of tax-exempt debt outstanding in all 4 years. (See fig. 15.)




 Page 31                         GAO/HRD9@13OBR   Profitability   of Guaranteed   Student   L.oans
                                       Profitability of Stafford Student Lams Held
                                       by Secondary Markets Varied Widely




Figure 15: lax-Exempt and Taxable
Financing Costs Were Similar (Fiscal
                                       10.0     Average Cosl of Funds (Percorn Interest Rate)
Years 1985-88)




                                        7.5


                                        7.0


                                        6.5




                                          lM5                               1966                            1987                           1666
                                          Fiscal Year

                                                -        Taxable debt
                                                - - --   Tax-exempt debt



                                        However, the 1986 Tax Reform Act (P.L. 99-514) reduced the interest
                                       rate advantage of new tax-exempt borrowing and the availability of tax-
                                       exempt funds. The act amended the Internal Revenue Code to (1) reduce
                                       personal and corporate income tax rates, thereby lessening the tax
                                        advantage of investments yielding untaxed interest income, and (2) sub-
                                       ject tax-exempt student loan bonds to an alternative minimum tax that
                                        requires certain investors to pay income tax on their interest, notwith-
                                        standing the tax-exempt status of the bonds. For new taxable and tax-
                                       exempt debt, these changes tend to narrow the difference between
                                        interest rates.

                                       The 1986 Tax Reform Act also reduced the availability of tax-exempt
                                       funds by restricting, in stages, the amount of tax-exempt debt a state
                                       could issue each year. For calendar year 1988, this volume cap limit was
                                       $50 per capita, or $150 million for each state-whichever     was greater.
                                       For the six state agencies that provided data for all 4 years, the propor-
                                       tion of Stafford loan portfolios financed with tax-exempt borrowings
                                       declined from over 75 percent of outstanding loans at the end of fiscal
                                       year 1985 to less than 50 percent at the end of fiscal year 1988,
                                       although the dollar volume of tax-exempt loans rose over the period.



                                        Page 32                              GAO/IIRD~13OBR     Profitabi     ty of Guaranteed   Student   Loans
-
                                          Profltabllty of Stafford Student Loans Held
                                          by Secondary Markets Varied Widely




                                          (See fig. 16.) For example, an official at the Virginia agency told us it
                                          was unable to issue additional tax-exempt debt to purchase Stafford
                                          loans in 1987 and 1988 because the agency did not receive state
                                          approval for an allocation under the state’s volume cap for new tax-
                                          exempt bond issues.


Figure 16: Proportion of Loans Financed
With Tax-Exempt Funds Has Declined        Outstanding   Loans (Billions    of Dollars)
(Fiscal Years 1985438)
                                          2.0




                                                 1985          1966       1997
                                                 Fiscal Year


                                                 I      1 Financed with taxable debt
                                                        1

                                                            Financed with tax-exempt     debt




Servicing and Other Costs                 Nonfund costs, which include the cost of servicing and all other Stafford
                                          loan-related costs other than the cost of funds, varied somewhat among
Varied                                    the 10 institutions in fiscal year 1988 (see fig. 17). Sallie Mae, with the
                                          largest portfolio, had the lowest nonfund costs that year (1.42 percent
                                          of outstanding loans). However, there was no apparent connection
                                          between the size of the other institutions’ portfolios and their nonfund
                                          costs. Rather, differences in lenders’ servicing and operating costs
                                          reflect their operating policies and experiences. Among circumstances
                                          officials described to us to explain their nonfund costs were the
                                          following:




                                          Page 33                                    GAO/‘HRD9@13OBR   Profitability   of Gunran teed Student   Loam
                                             Profitability of Stafford Student Loans Held
                                             by Secondary Markets Varied Widely




                                         l Though the California agency reported relatively low servicing and
                                           operating costs, its fiscal year 1988 total nonfund costs exceeded the
                                           other nine institutions’ costs, reflecting a 3.34-percent provision for
                                           losses on delinquent loans. According to an agency official, some
                                           defaulted loans may not be reimbursed by the guaranty agency or the
                                           Department of Education if either determines that they were not prop-
                                           erly serviced.
                                         l The Colorado agency’s high fiscal year 1988 nonfund costs (3.58 percent
                                           of outstanding loans), according to an agency official, reflected expenses
                                           related to its transition from in-house to contracted servicing.
                                         9 The Pennsylvania agency reported high nonfund costs in all 4 years.
                                           The agency services loans for other lenders in addition to its own, and it
                                           used the proceeds from its loan-servicing operation to help subsidize
                                           loans to borrowers who do not qualify for federal subsidies under Staf-
                                           ford loans.
                                         l According to a bank official, Chase Manhattan’s relatively high nonfund
                                           costs (2.19 percent in fiscal year 1988) increased from previous years, in
                                           part due to additions to its staff and equipment in anticipation of
                                           expanding its student loan activities.


Figure 17: Servicing, Operating, and
Other Costs Varied-in Fiscal Year 1966
                                             5.5   Servicing       and Operating   Costs (Percent)

                                             5.0

                                             4.5

                                             4.0

                                             3.5

                                             3.0

                                             2.5
                                                               I         .




                                              Page 34                                    GAO/HRD90-130BR   Profitability   of Guaranteed   Student   Loans
                                           Profitability of Stafford Student Loans Held
                                           by Secondary Markets Varied Widely




    Taxes Substantially                     Unlike the seven state agencies, Sallie Mae and the two banks are sub-
                                           ject to income taxes. Sallie Mae pays federal corporate income taxes, but
    ReducedFor-Profit                      is exempt from state and local income taxes. The banks are subject to
    Lenders’ Returns                       both federal and state taxes. As shown in figure 18, the payment of
                                           taxes substantially reduced these three lenders’ net rates of return on
                                           Stafford student loans in fiscal year 1988.


    Figure 18: Taxes Reduced Federal and
    Commercial Lenders’ Profitability in   Return as a Percentage   of Outstanding    Loans
    Fiscal Year 1988
                                           1.6




.




                                           0.6




                                                  l-J      Applicable taxes
                                                           Net rate of return (after taxes)




    IConclusions
                                            1985-88 among the secondary market institutions that we reviewed. The
                                            variations resulted more often from variations in costs than from varia-
                                            tions in revenue.




                                            Page 36                                  GAO/HRD9@13OBR   Profitability   of Guaranteed   Student   Loam
                          Prof¶tability of Stafford Student Loans Held
                          by Secondary Markets Varied Widely




                          In addition, the 1986 subsidy reductions had little or no effect on
                          lenders’ revenues. For some lenders in some years, however, the reduc-
                          tions could be significant when compared to profits because profit mar-
                          gins were relatively narrow.

                          Four of these institutions consistently earned a profit on their Stafford
                          loans, including the two commercial lenders and Sallie Mae, all of which
                          are for-profit entities. The other lenders incurred losses in 1 or more
                          years. These lenders were not-for-profit or state agencies that entered
                          the secondary market for reasons other than making a profit.

                          The variations in profit levels, and the many reasons for them, indicate
                          that profitability measures do not, in themselves, provide a sound basis
                          for determining the appropriate special allowance factor.
.

                          The Department of Education and 9 of the 10 lending institutions we
    Agency Comments and   reviewed commented on a draft of this report. The Department had only
    Our Evaluation        a technical comment that we addressed in appendix II. Our evaluation of
                          the comments received from the institutions are summarized below.

                          1. Several institutions suggested we more clearly emphasize that the 10
                          participants in the study may have used different assumptions or
                          methods to allocate costs, and that 2 of the participants provided data
                          on a calendar year rather than a fiscal year basis.

                          While we requested comparable data from all institutions and identified
                          possible inconsistent assumptions or allocations of costs, we recognize
                          that differences among the lenders exist. We discuss data limitations in
                          appendix I.

                          2. Several lenders stated that their costs have increased since the com-
                          pletion of our review. According to these lenders, increases included
                          higher letter-of-credit costs and higher administrative costs attributed to
                          stricter enforcement of due diligence requirements. Lenders also stated
                          that their revenues had been adversely affected by (1) Treasury Depart-
                          ment regulations that reduced the benefits of using tax-exempt
                          financing and (2) lower special allowance payments, which are having a
                          greater impact on revenues each year.

                          We recognize that profit levels of some institutions may have changed
                          since our review. We state in the report that the impact of the reduction
                          in the special allowance rate should be greater for some agencies in


                          Page 36                         GAO/EIRB9@130BR   Profitability   of Guaranteed   Student   Loana
Profitability of Stafford Student Loans Held
by Secondary Markets Varied Widely




future years. Our analysis was limited to the 1985-88 period, and we did
not attempt to forecast any future changes in lenders’ operations. How-
ever, where appropriate, we have incorporated the lenders’ concerns in
the report.

3. Our original draft of this report contained a consultant’s paper that
discussed the legal and institutional factors affecting the secondary
market in guaranteed student loans. In their comments on the report,
some institutions suggested that the information from the paper was
valuable, while others disagreed with some of the information the paper
contained.

While we believe the paper provided a useful description of the charac-
teristics of the secondary market for student loans, we have deleted it
from our report because of the controversy it generated among the insti-
tutions and our concern that it would divert attention away from the
major focus of the report.

4. The two commercial banks were concerned about public disclosure of
the information they provided.

We discussed the issue with officials of the two banks and agreed to (1)
treat the detailed information that they provided, and which was not
included in our draft report, as proprietary, and (2) identify in our
report the institutions’ revenue, costs, and profitability analyses which
were included in our draft report.

5. Several lenders suggested revisions and technical changes to increase
the accuracy or clarity of the report. We made changes where
appropriate.




Page 37                         GAO/HRD-!40-130BR   Profitability   of Guaranteed   Student   Loans
Appendix I

Methodology


              Early in our review, we held a conference with participants and other
              knowledgeable parties in the student loan community, such as repre-
              sentatives from the Department of Education, the Congressional Budget
              Office, and secondary markets, to help us develop our study approach.
              We also contracted with an expert on government-sponsored enterprises
              to identify and describe the legal and institutional benefits, limitations,
              and other factors that influence the efficiency, competitiveness, and
              profitability of the three major kinds of secondary market institutions.

              As agreed in discussions with congressional staff, we focused our efforts
              on a group of major secondary markets, that is, financial institutions
              that purchase Stafford loans from originating lenders, such as banks,
              savings and loan associations, and credit unions. Because many sec-
              ondary markets deal primarily in student loans, we expected that they
              would be more likely than originating lenders to maintain financial data
              that could be used to determine the profitability of their Stafford loan
              portfolios.

              We focused our analysis on the student loan holdings of 10 major sec-
              ondary markets during fiscal years 1985-88. These 10 accounted for
              about one-third of all Stafford loan holdings at the end of fiscal year
              1988 and nearly three-fourths of all Stafford loan purchases lenders
              reported to the Department of Education for fiscal year 1988.

              The 10 institutions were judgmentally selected to represent the three
              basic kinds of entities: commercial banks, state agencies, and an institu-
              tion chartered by the federal government to provide a secondary market
              for student loans. As a basis for our sample selection, we used Depart-
              ment of Education data on dollar volume of Stafford loan holdings and
              purchases by secondary market institutions. Of the institutions
              selected-other than Sallie Mae, the dominant secondary market
              entity-two    were commercial banks. To provide a cross-section of the
              different kinds of state agencies, we selected four not-for-profit corpora-
              tions and three state governmental agencies. Six of the lo-the two
              banks, the three state governmental agencies, and one of the state not-
              for-profit institutions- originate as well as purchase loans. All 10 were
              among the top 40 holders of guaranteed student loans in fiscal year
               1988.

              We sent questionnaires to each of the 10 institutions requesting data for
              fiscal years 1985-88 regarding special allowance payments, revenues,
              and cost of funds and servicing, operating, and other costs not related to
              financing.


              Page 38                   GAO/HRD9@13OBR   Profitability   of Guaranteed   Student   Loans
                      Appendix I
                      Methodology




                      We mailed each of the 10 institutions three questionnaires:
Data Collection
                  . Special allowance payment questionnaire-requested,        by year, a break-
                    down of loan portfolio by the SAPfactor (3.5 percent, 3.25 percent, or
                    other) used to calculate special allowance payments.
                  . Cost of funds questionnaire-requested     distribution of fiscal year-end
                    loan balances by source of funding (taxable, tax-exempt, or other) and
                    the cost of funds for and rate of return on student loans. Additional
                    items on this questionnaire included letters of credit and their cost
                    purchase price of portfolios (whether at par or at a premium or dis-
                    count), and whether new borrowings were at fixed or floating interest
                    rates.
                  l Servicing and operating cost questionnaire-requested       loan-servicing
                    costs, operating costs, and other costs not related to the cost of funds;
                    proportions of portfolio serviced by the institution or contracted out;
                    and comments, including a description of efforts to constrain these
                    costs.

                      We requested cost and revenue data as a percentage of portfolio rather
                      than in terms of dollar volume. In those cases where we determined
                      from talking to responsible officials that they had based their cost and/
                      or revenue percentages on some other measure of portfolio, we asked
                      them to recalculate using average daily loan balance.

                      We tabulated data received in response to these questionnaires and used
                      the data to calculate rates of profitability and to assess the relative
                      importance of various factors to explain variations in profitability.
                      Though we use the terms “profitability,”      “profit,” and “loss” in dis-
                      cussing net returns of all these institutions, we recognize that state agen-
                      cies’ activities do not generate profits as such.

                      To calculate net rates of return, or “profits,” we aggregated the cost of
                      funds, servicing, operating, and other costs (all as percentages of loan
                      balances) and then deducted the sum of these costs from interest rev-
                      enue (made up of borrowers’ interest plus federal special allowance pay-
                      ments). Where applicable-that      is, for the two banks and Sallie Mae-
                      we deducted taxes to obtain their net rate of return after taxes.


                      We checked data validity principally by examining the internal consis-
Data Validation       tency of data provided; the consistency of those data within the context




                      Page 39                  GAO/HRIHK%13OBR   Profitability   of Guaranteed   Student   Loans
                   Appendix I
                   Methodology




                   of relevant laws and regulations; and, to a limited extent, the consis-
                   tency of questionnaire data with data reported to the Department of
                   Education, such as institutions’ annual reports and financial statements,
                   For example, we checked the volume of an institution’s loans subject to
                   the reduced special allowance payment against outstanding loans
                   funded with taxable loans. Because the reduction did not apply to loans
                   from tax-exempt funds, any excess of 3.25-percent special allowance
                   payment loans over taxable funded loans suggested an error in one of
                   the totals. We also calculated a range of possible rates of return (interest
                   revenue) based on formulas specified by law and compared these ranges
                   with rates of return the institutions reported.

                   We interviewed Department of Education officials and financial officials
                   at the secondary market institutions to confirm our interpretations of
                   the regulations. We reviewed reports by the Department, the Congres-
                   sional Budget Office, and the Congressional Research Service, as well as
                   other literature relating to student loan finance.

                   When we had obtained corrected data or explanations of apparent
                   inconsistencies, we sent review copies of our compiled and derivative
                   data to financial or executive officers at each of the 10 institutions,
                   requesting that they make any needed changes.

                   Nine of the 10 institutions sent confirmation of the data. Some of these
                   included additional revisions. California sent us additional financial
                   data on which to base the requested data but asked us to perform the
                   calculations. To do so, we allocated operating costs and the cost of funds
                   between taxable and tax-exempt funds in the same proportion that the
                   agency allocated outstanding debt.

                   We conducted our work between January 1988 and February 1990 in
                   accordance with generally accepted government auditing standards.


Data Limitations   certain data limitations remain.


Data Validity      Except where our data analysis revealed inconsistencies, we did not
                   attempt to verify or validate the data institutions provided us.




                   Page 40                   GAO/HRIh9@13OBR   Profitability   of Guaran teed Student   Loana
                            Appendix I
                            Methodology




Imprecision Due to Use of   Some data represent estimates rather than exact values. For example,
                            Virginia’s agency cautioned that some of its data are estimates and that
Estimates                   because of the use of average balances, its data should not be construed
                            as exact. As another example, the California data are estimates based on
                            that agency’s guaranteed student loan portfolio; the agency does not
                            maintain separate cost data on its Stafford loan holdings.


Fiscal Year Variations      We requested data for fiscal years ending September 30. However, only
                            2 of the 10 entities operate on the federal fiscal year. Of the eight that
                            operate on other fiscal years, all but two provided cost and revenue esti-
                            mates based on the federal fiscal year.

                            Of the two entities that did not provide data based on the federal fiscal
                            year, one pointed out that because of year-end adjustments, conversion
                            to a September 30 fiscal year would result in distorted data. As noted on
                            affected figures, those two institutions’ data are by calendar year. They
                            are therefore not directly comparable to the other institutions’ data,
                            particularly when interest rates for the calendar year differ substan-
                            tially from rates for the fiscal year.

                            Moreover, we do not know how the institutions that converted their
                            data for us handled year-end adjustments in completing our question-
                            naires. One of the six that converted their data commented that the con-
                            version probably entailed some sacrifice of precision.


Trend Data                  To present a cross-section of the agencies represented, summary data
                            and charts representing trends in cost of taxable and tax-exempt funds
                            over time were developed using simple averages of the agencies’ costs.
                            Because they are not weighted by loan volume, they do not reflect the
                            aggregate costs of the 10 institutions’ portfolios financed with taxable
                            funds as compared with those financed with tax-exempt funds.

                            Further, because we included institutions’ data as available, averages do
                            not represent the same number of institutions in each year. One agency
                            was unable to separate guaranteed Stafford loan costs from costs of
                            other student loan programs and was unable to provide cost of funds
                            data for 2 of the 4 years. Another was unable to separate out guaran-
                            teed Stafford loan revenue for any of the years.




                            Page 41                  GAO/HRD-W13OBR   Profitability   of Gum-an teed Student   Loans
                            Appendix I
                            Methodology




Differences in Operations   Because of variations in the 10 institutions’ operations, costs do not
                            always reflect the same cost elements. In figure 14, for example, ser-
                            vicing costs may reflect in-house servicing, contracted servicing, or a
                            mix of the two.


Differences in Accounting   In addition to differing in their operations, lenders differed in their
                            methods of accounting for costs. For example, we asked institutions to
Practices                   include in their cost of funds all costs incident to obtaining funds. Debt
                            issuance costs institutions told us they had included in the cost of funds
                            varied somewhat, and we did not attempt to eliminate those variations.
                            Nor did we attempt to adjust institutions’ cost of funds for variations in
                            their accounting practices with respect to some cost elements-pre-
                            miums paid on loan purchases, for example.

                            We recognize that, since the completion of our review, the financial con-
                            dition of the institutions could have changed. For example, since 1988
                            the institutions’ borrowing costs have likely increased. Also, costs may
                            have increased due to stricter loan servicing requirements imposed by
                            the Department.




                            Page 42                  GAO/HRDfWl2OBR   Profitability   of Guaranteed   Student   Loans
    Appendix II

    Data Supporting Figures


    Table 11.1:Ten Institutions’ Loan Holdings
    Doubled (Fiscal Years 198588) (Data for       Dollars    in bullions
    Fig. 6)
                                                                                                 Outstanding amount of Stafford loans
                                                                                                                     Seven state
                                                  Fiscal year                            Sallie Mae    Two banks      institutions                         Total
                                                  1985                                        $5.144            $0.871                 $1.423             $7.438
                                                  1986                                         6.271             0.854                  1.753              8.878
                                                  1987                                         7.419             1.095                  2.449             10.963
                                                  1988                                         9.357             1.068                  3.054             13.479
                                                  Note: Thus table does not rnclude a major portion of Pennsylvanra’s guaranteed student loans. We
                                                  excluded loans to students not eltgible for federal interest subsidles (about $8.2 mrllron, $22.1 mrllton,
                                                  $71 5 mrllron. and $340.2 million at the end of fiscal years 198588, respectively). Accordtng to an agency
                                                  offrcral, these loans were made to students who were ineligrble for federal interest subsrdtes because,
                                                  for example, their incomes exceeded federal limrts. Nonetheless, according to this official, thetr loans
                                                  are guaranteed lust as other Stafford loans by federally supported guaranty agencies. We also excluded
                                                  from our analysis about $7.1 million of loans eligible for federal interest subsidies that Pennsylvania
                                                  purchased wrth taxable funds the last day of fiscal year 1988 because the agency did not provide data
.                                                 for these loans.


    Table 11.2:Nine Institutions’ Profitability
    Varied Widely (Fiscal Year 1988) (Data for                                                                                   Net rate of return in 1988
    Fig. 7)                                       Lender@                                                                        as a percent of poftfoliob
                                                  Sallie Mae                                                                                                0.95
                                                  ChaseC                                                                                                     0.18
                                                  Wachovta                                                                                                   0.34
                                                  CaliforniaC                                                                                              -3 31
                                                  Indiana                                                                                                   0.92
                                                  Nebraska                                                                                                   0 26
                                                  Nellie Mae                                                                                                 0 34
                                                  Pennsvlvania                                                                                             -0.40
                                                  Virainia                                                                                                 -0.18
                                                  ?nsufficient   data were available to calculate Colorado’s rate of return

                                                  bNet rates of return were calculated after taxes, if applicable.

                                                  CCalrfornra and Chase data are for calendar year 1968; other data are for the fiscal year endrng Sep-
                                                  tember 30. 1988.




                                                  Page 43                               GAO/HRD-W13OBR          Profitability   of Guaranteed   Student    Loans
                                                 Appendix ll
                                                 Data Supporting    Figures




    Table 11.3:For-Profit Institutions Were
    Consistently Profitable (Fiscal Years 1985                                        Net rate of return as a percent of portfolio
    88)(Data for Fig. 8)                                                           After taxes                          Before taxes
                                                 Yeap                   Sallie Maeb WachoviaC Chased           Sallie Mae Wachovia                        Chase
                                                 1985                           0 96         064      0.29            1.78         126                      0.57
                                                 1986                             083           0.46       0.29                 1.53            0.90        0 57
                                                 1987                             0.88          0.42       0.23                 1.50            0.77        0.43
                                                 1988                             0.95          0.34       0.18                 1.47            0 56        n 79

                                                 ‘Chase data are for calendar years; other data are for fiscal years ending September 30

                                                 bUnlrke the other rnstrtutrons reviewed. Sallre Mae included In Its figures adjustments for expected
                                                 increases In servicing costs as loans mature. These adjustments were 0 22. 0 18, 0 11, and 0 14 percent
                                                 In fiscal years 1965-88, respectrvely These adlustments were treated as deferred Income rn Sallre Mae’s
                                                 financral reports and as addrtrons to costs In the figures Sallre Mae provided to GAO. The figures pro-
                                                 vrded by Sallie Mae indicate that taxes as a percentage of net rncome were about 46, 46, 41, and 35
                                                 percent In fiscal years 198586, respectrvely. Due to such items as tax-exempt rncome and tax benefits
.                                                In lease transactrons, Sallie Mae’s effective tax rates (taxes as a percentage of net Income from all
                                                 sources) for all operatrons were 36.9, 350, 31 0, and 27.4 percent in calendar years 198568, respec-
                                                 trvely. Unlrke the banks, Sallte Mae IS exempt from state and local taxes.

                                                 CWachovra’s student loan operations were subject to state as well as federal Income tax Wachovra
                                                 reported that its taxes as a percentage of net Income were about 49, 49, 45, and 40 percent tn fiscal
                                                 years 1985-68, respectrvely Due to Income from tax-exempt secuntres, Investment tax credrts, etc
                                                 Wachovra’s effective tax rates for all operations were lower-for example, about 22 percent in calendar
                                                 year 1986.
                                                 dChase was subject to federal and stnte corporate income tax The data Chase provrded rndrcate that
                                                 taxes as a percentage of net income were about 49, 49, 47, and 38 percent in fiscal years 1965-88,
                                                 respectrvely Due to losses from other operatrons (Income from tax-exempt Investments, etc ), Chase’s
                                                 effective tax rate (total provision for taxes as a percentage of net income before taxes) was lower-for
                                                 example about 20 percent in calendar year 1988.


    Table 11.4:Not-for-Profit Agencies’
    Returns Varied (1988)(Data for Fig.9)                                                         Rate of return as a percent of portfolio
                                                 Yeap                                     Californiab         Indiana     Nebraska       Nellie Mae
                                                 1985                                                 c               0.46             -1.71              -043
                                                 1986                                                  c              0.68               0.28             -057
                                                 1987                                             1.24                0.65               0.22               0.31
                                                 1988                                           -3.31                 0.92               0.26               0.34
                                                 %alrfornra data are for calendar years 1967 and 1988 The other agencies provided data for fiscal years
                                                 ending September 30
                                                 bCalrfornra’s agency did not provide sufficient data to calculate net rates of return in fiscal years 1985
                                                 and 1986
                                                 ‘Not available




                                                 Page 44                             GAO/HRD90-130BR         Profitability   of Guaranteed      Student    Loans
                                               Appendix II
                                               Data Supporting    Figures




    Table 11.5:State Governmental Agencies’
    Returns Varied, but Each Has Had                                                               Rate of return as a percent of portfolio
    Losses (Fiscal Years 1985-88)              Fiscal year                                              Pennsylvania                      Virginia
    (Data for Fig. 10)
                                               1985                                                                   -2 04                               0 70
                                               1986                                                                   -371                                0 11
                                               1987                                                                   -1 71                          -0 24
                                               1988                                                                   -0.40                          -0     18

                                               Note Colorado’s agency provided insufficient data to calculate profrts.


    Table 11.6:Institutions’ 1966 Gross
    Revenues Were Similar (Data for Fig. 11)   Lender                                                            Revenue as a Dercent of oottfolioa
                                               Sallie Mae                                                                                             9.95
                                               Chaseb                                                                                                1038
                                               Wachowa                                                                                                9 66
                                               Californiab                                                                                            9 03
.                                              Indiana                                                                                                9 60
                                               Nebraska                                                                                               9 83
                                               Nellie Mae                                                                                             9 ss
                                               Pennsylvania                                                                                           9 47
                                               Virgmia                                                                                                9 79
                                               %hase and Cakfornia data are for calendar year 1988; other data are for the fiscal year endlng Sep-
                                               tember 30, 1988
                                               bChase’s revenue was highest, at least In part, according to a bank official, because its data were for
                                               calendar year, not fiscal year, 1988 and Interest rates were higher in the fourth quarter of calendar year
                                               1988 (the quarter following the end of fiscal year 1988). California also reported revenue for the calendar
                                               year, but its revenue was nevertheless the lowest, at least In part, according to the agency’s treasurer,
                                               because it did not receive interest subsidies for many of its loans as a result of servrcrng problems
                                               Except for Chase, Sallie Mae had the highest revenue (9.95 percent) and California had the lowest
                                               (9 03) Thus, revenue varied within a 0 92.percentage-point     range




                                               Page 45                             GAO/HRDSO-13OBR         Profitability   of Guaranteed   Student   Loans
                                         Appendix II
                                         Data Supporting    Figures




Table 11.7:OS-Percent Interest Revenue
Floor Increased Returns on Tax-Exempt                                                                         Interest rate
Financed Loans* (Data for Fig. 1.2)                                                                                     Interest calculated
                                                                                                 Interest paid with     without g&percent
                                         Fiscal year/quarter                                      9Spercent floor                       floor
                                         1985

                                         1                                                                         10.36                      1036
                                         2                                                                          9 98                       9.98
                                         3                                                                          9.64                       964
                                         4                                                                          9.50                       942
                                                                                                                                                 -
                                         1988
                                         1                                                                         9.50                        944
                                         2                                                                         9.50                        9 21
                                         3                                                                         9.50                        8.69
                                         4                                                                         9- 50
                                                                                                                      -_                       838
                                         1987
                                         1                                                                         9 50                        8.51
                                         2                                                                         9.50                        8.60
                                         3                                                                         9.50                        871
                                         4                                                                         9.50                        8.89
                                         1988
                                         1                                                                         9.50                        8.84
                                         2                                                                         9.50                        872
                                         3                                                                         9.50                        0.97
                                         A                                                                         9 !=a                       937
                                         aTotal interest lenders received from borrowers and the Department of Education on loans to first-time
                                         borrowers (all &percent loans) financed with tax-exempt funds.




                                         Page 46                            GAO/HRD9&13oBR         Profitability    of Guaranteed   Student   Loam
                                                Appendix II
                                                Dab SUPPOW         Fieures




Table 11.8:Loans Subject to Reduced
Subsidies Are Increasing (Ftscal Years          Percent of portfolio subject to 3.25-percent special allowance promion
1987-88) (Data for Fig. 13)
                                                                                                                               End of fiscal years
                                                Lender                                                                       1987           -______ 1988
                                                Sallie Mae                                                                         3             -.____~    20
                                                Chase                                                                             33                        46
                                                Wachovla                                                                           5                        28
                                                Californiaa                                                                       25          -____         25
                                                Indiana”                                                                           3                         6
                                                Nebraskaa                                                                          1                        39
                                                Nellie Maea                                                                        0                        11
                                                Coloradoa,b                                                                        0                         0
                                                Pennsylvanlaa,c                                                                    0              ___-       0
                                                VirginIaa                                                                          3                         9
                                                %tate agency.
                                                bColorado had only tax-exempt financed loans, which were not subject to the subsidy reductton

                                                ‘Except for taxable financed loans purchased on the last day of fiscal year 1988 that were not Included
                                                In any of Pennsylvanra’s data, all of the agency’s loans were financed from tax-exempt sources and thus
                                                were not subject to the reduction.


Table 11.9:Costs Varied Among 10
Lenders (Fiscal Year 1988) (Data for Fig. 14)                                            Costs as a percent of portfolio in 1988
                                                                                                         Operating
                                                                             cost of      Servicing      and other       Lender
                                                Lender                        funds           costs          costs        taxes*                         Total
                                                Sallie Mae                      7.06                0.80                   0.62        0.52               9.00
                                                Chaseb                          7.96                1.29                   0.90        0.11              10.20
                                                Wachovia                        7.30                1.65                   0.15        0.22               9.32
                                                Californiab                     7.21                1.09                   4.04        0.00              12.34
                                                Indiana                         7.16                1.03                   0.49        0.00               8.88
                                                Nebraska                        7.51                1.50                   0.56        0.00               9.57
                                                Nellie Mae                      7.31                1.12                   0.92        0.00               9.35
                                                Colorado                        7.93                2.93                   0.65        0 00              11.51
                                                Pennsylvania                    7.52                1.68                   0.67        0.00               9.87
                                                Viraima                         8.40                1.05                   0.52        0.00               9.97
                                                aApplicable only to Sallie Mae and the two banks.
                                                bChase and California data are for calendar year 1988: other data are for the fiscal year ending Sep-
                                                tember 30, 1988.




                                                Page 47                            GAO/IiRDMI-13OBR        Profitability      of Guaranteed    Student   Loans
                                                Appendix II
                                                Data Supporting     Figures




    Table 11.10:Tax-Exempt and Taxable
    Borrowing Costs Were Similar (Fiscal        Average borrowrng costs (figures are in percent)
    Years 1985-88) (Data for Fig. 15)
                                                Year                                                                Taxable                        Tax exempt
                                                1985                                                                          9 22                        9 14
                                                1986
                                                __~.-                                                                         7.77                            7 62
                                                1987                                                                          7 29                            7 08
                                                1988                                                                          7.86                            7 09
                                                Note Data shown are unwerghted averages for state agencies that reported the cost of both taxable
                                                and tax-exempt debt at some trme dunng the fiscal year 198588 period. The averages represent drf-
                                                ferent numbers of agencies In drfferent fiscal years. three In fiscal year 1985, four in fiscal year 1986: five
                                                In 1987 and 1988. Virglnia was not included In the fiscal year 1985 averages because it had no taxable
                                                financed loans In that year Californra was not included In the fiscal year 1985 and 1986 averages
                                                because It drd not provrde data on the costs of its tax-exempt and taxable debt In those years. Colorado
                                                and Pennsylvania were not Included in any of the averages because they reported no taxable financed
                                                debt during the fiscal year 198588 period. Chase and California data are for calendar years, other data
                                                are for the fiscal year endrng September 30, 1988

.
    Table II.1 1: Proportion of Loans
    Purchased With Tax-Exempt Funds Has         Dollars in millions
    Declined (Fiscal Years 1985-88) (Data for                                                              Loan holdings
    Fig. 16)                                                          Loan holdings                          from taxable
                                                                          from tax-           Percent      debt and other              Percent
                                                Fiscal vear            exemot debt             of total          sources                of total    Total loans*
                                                1985                               $843              80                   $216               20           $1,059
                                                1986                                736              60                     482              40            1,217b
                                                1987                                815              53                     710              47              1 ,525b
                                                1988                                967              49                   1,008              51              1.975
                                                Note: Data shown are totals for SIX state agencres that provided data for all 4 years
                                                %um of the columns does not equal the total due to rounding.
                                                bData for the end of fiscal years 1986 and 1987 Include about $4 mrllron of loans In Indiana’s portfolio
                                                financed from nerther tax-exempt nor taxable debt.


    Table 11.12:Servicing and Operating
    Costs Varied (Fiscal Year 1988) (Data for   Lender                                                                        Cost as a percent of portfolio*
    Fig. 17)                                                                                                                                                  1 42
                                                Sallie Mae
                                                Chase                                                                                                         2 19
                                                Wachovia                                                                                                      1 80
                                                California                                                                                                    5.13
                                                Indiana                                                                                                       1 52
                                                Nebraska                                                                                                      2.06
                                                Nellie Mae                                                                                                    2.04
                                                Colorado                                                                                                      3.58
                                                Pennsylvania                                                                                                  2 35
                                                Virninia                                                                                                      1 57

                                                %hase and Calrfornia data are for calendar year 1988; other data are for the fiscal year ending Sep-
                                                tember 30, 1988.




                                                Page 48                               GAO/I3RDSO-13OBB        Profitability       of Guaranteed    Student   Loans
                                            Appendix II
                                            Data Supporting   Figmes




Table 11.13:Taxes Reduced Federal and
Commercial Lenders’ Profitability (Fiscal                                          Profits as a percent of portfolios
Year 1988) (Data for Fig. 18)                                                                   Applicable        Net rate of return after
                                            Lender             Rate of return before taxes            taxes                         taxes
                                            Sallie Mae                                    1 47               0.52                              0.95
                                            Chase                                         0.29               0.1 1                             0.18
                                            Wachovla                                      0.56               0.22                              0.34
                                            Thase data are for calendar year 1988; other data are for the fiscal year ending September 30, 1988.




                                            Page 49                           GAO/HRD9@19OBB         Profitability   of Guaran teed Student   Loans
Amendix     III

CommentsFrom the Department of Education



                                                UNITEDSTATESDEPARTMENTOFEDUCATION
                                   OFFICEOF     THE   ASSKTANT   SECRETARY    FOR   POSTSECONDARY       EDUCA     rlON




                        Mr. Franklin      Frazier
                        Director,     Education      and Employment    Issues
                        United    States   General     Accounting   Office
                        Human Resources       Division
                        Washington,      DC 20540
                        Dear Mr.     Frazier:
                        Thank    you for    the   opportunity      to review   GAO draft      report,
                        "Guaranteed   Student Loans:      Secondary   Market Lenders' Profits     Vary
                        Widely"   GAO/HRD 90-130,    dated July 19, 1990.
                        The Department     offers    the following               technical            comments           to be taken
                        into consideration        when preparing               the final            report.

Now on pp. 47 and 27.                                                        12. u
                        Calculations          for    fiscal     year     1987,    quarters     1, 2, and 3 for
                        interest      calculated        without    9.5 percent     floor    in effect    are correct
                        if you consider          each quarter       alone.     However, it does not represent
                        the true       effect       depicted     in the report.            The illustration        has
                        totally      ignored       the fact       that     most new loans        made during       the
                        sequester       were made during           the last      3 months (July,         August,   and
                        September).
                        If you     have any questions,    please   contact                          Valerie        Hurry      of   the
                        Division     of Quality Assurance    on 708-9453.
                                                                                                     Sincerely,



                                                                                                     Leonard        L. Haynes 111(




                          Page50                                  GAO/HRIMO-13OBRProf'itabilityofGuaranteedStudentLoans
Appendix IV

CommentsFrom Sallie Mae



                               STUDENT LOAN MARKETING ASSOClATlON
                               1050 Thomas Jefferson Street NW
                               Washington   0 c 20007
                               202-298-2600




                                                                                     September      4, 1990

                              HAND DELIVERED
                              Mr.   Franklin    Frazier
                              Director,      Education    and Employment    Issues
                              United    States    General   Accounting   Office
                              441 G Street,       N.W., Room 6739
                              Washington,      DC 20548
                              Dear Mr.      Frazier:
                                    Thank you for the opportunity                  to comment on the                  General
                              Accounting  Office's  draft report                 "Guaranteed    Student               Loans:
                              Secondary  Market Lenders'  Profits                 Vary Widely".
                                      We endorse         the Report's        conclusion        that the variation            in
                              profitability           among the secondary           markets       examined     is largely
                              attributable          to their      respective       abilities       to efficiently          manage
                              the cost of servicing               student     loans and to effectively                contain
                              their      general      operating       costs.     In our view, the report                reaches    an
                              important         conclusion      in its findings            that the least        significant
                              variation         in costs among the secondary                  markets   studied       is their
                              cost of funds,           which as is pointed            out in the Report is by far the
                              largest        cost element       for all secondary             markets.      According        to the
Now on p. 29.                 Report        (Page 33), the variation             as to costs of funds is "less                  as a
                              percent        of outstanding         loans than all other cost elements
                              (servicing,         operating       and other non-fund             costs)   combined".


Material deleted, see p. 37




                                         Page 51                             GAO/HRD-90-13OBR         Profitability      of Guaranteed   Student Loans
            Appendix N
            Comments From Sallie Mae




    Mr.  Franklin    Frazier
    Page Two
    September     4, 1990




            While the Report attempts                   to assess the impact on lender
    profitability            of Congressionally             mandated reductions                in the special
    allowance        formula,        it does not go far enough in addressing                             the long
    term impact of such reductions.                         Specifically,           we think        GAO should
    have attempted             to isolate        the effect        of the 1986 Gramm-Rudman-
    Hollings       sequestration            order     (which reduced the special                    allowance
.   rate to T-Bill             plus 3.0) on the loans actually                      affected        by that
    order.        This could have been accomplished                         by: 1) isolating             that
    segment of each lender's                   loan    holdings       that was affected              by the
    sequester        order:       2) applying        the proportional             costs associated             with
    each loan holder's               portfolio       to that segment:             and 3) by reducing
    each loan holder's               income on that segment of loans by the relative
    amount of the decrease                  in special        allowance        payments attributable
    to the Gramm-Rudman-Hollings                     sequester        order.        Similarly,          GAO could
    have examined            the future        effects     on profitability              of those loans
    originated         since November 16, 1986, the date the special                                 allowance
    rate was reduced by 25 basis points                           under the Higher Education
    Amendments of 1986.                 Since loans subject               to the reduction              will
    eventually         dominate        a lender's       holdings,         such an analysis              would
    have helped          the Congress to better                 understand        the full        effect      of
    long-term        reductions         in special        allowances.            Even now, because over
    $40 billion          of GSLP loans have been made since                         the enactment            of the
    1986 Amendments,              the effect        on lenders'         portfolios        and their
    overall       profitability           is much more dramatic                than would be true from
    an analysis          which failed          to look beyond fiscal                1988.        This short
    sighted       approach        has seriously         reduced the value of the Report.
            As Sallie       Mae has previously          stated       in correspondence           and
    conversation         with your office,         we believe          that GAO must acknowledge
    that secondary          markets     are not a wholly           suitable      proxy for the
    universe       of guaranteed        student     loan lenders.            While the number of
    secondary        markets    serving     the GSL program have remained                   relatively
    constant       over the past several           years,      there has been a steady
    decline      in the number of lenders              originating         loans under the GSLP.
    This indicates          that the overall          health     of the program and the
    effect     of program revisions,             such as reductions            in the level          of
    special      allowance      payments received           by program        participants,          may
    not be adequately           evaluated       by analyses        that concentrate
    exclusively        on the secondary          markets.        We strongly         urge that some




             Page 52                                 GAO/HRD9@13OBR            Profitability   of Guaranteed     Student   Loans
                                            Appendix     N
                                            Comments     From        Sallie   Mae




                                      Mr. Franklin    Frazier
                                      Page Three
                                      September    4. 1990

                                      mention     of the limitations                associated        with the study's
                                      concentration     on secondary                markets      be   added to the Report
                                      introduction.
                                                Lastly,      we think     the Report does not give adequate                 weight     to
                                      the significant            uncertainties       regarding      integrity      of the data being
                                      reported.           We suggest      that the items listed            in Appendix       II under
                                      the heading          "Data Limitations"          be summarized         and brought       forward    as
                                      part of the introduction                 to the Report and the accompanying
                                      summary.          These limitations         which include        concerns      regarding      data
                                      validity,         the use of inconsistent            fiscal     years,    limited     trend data
                                      and variations           in the accounting         practices       of those organizations
                                      providing         data to GAO, are significant               enough that they should be
                                      brought       directly      to the reader's        attention.
l   Material   deleted,   see p. 37




                                                                                         Sincerely,



                                                                                                                            u
                                                                                         Lawrence A. Hough
                                                                                         President  and
                                                                                         Chief Executive Officer
                                      Enclosure
                                      cc:    Mr.   Jay       Eglin




                                             Page 53                                  GAO/HRWlO-130BR       Profitability       of Guaranteed   Student   Loans
    Appendix V                                                                                                               -
    comments From ChaseManhattan




                 QlcHAsE
                 =                                 August    20,   1990


                 Mr. Franklin       Frazier
                 Director,      Education    and Employment    Issues
                 United    States    General   Accounting   Office
                 441 G. Street       Northwest
                 Washington,      D.C. 20540
.                Lear    hr.   Frazier:
                                                  Re:    Proposed Report to Congress                on
                                                         Student  Loan Profitability
                 This letter      is in response        to your    July   19,     1990 letter       to
                 Charles   Christiana.
                 While Chase Education    Finance supports   the aforementioned      study,
                 we note that the limited      number of commercial  bank participants
                 weakens any conclusions     that may be drawn from the study.
                 In Chase Education         Finance's    data collection         package,   the data
                 were predicated        on certain    assumptions        and estimates.       Since
                 there were no standard          assumptions      utilized      by the participants
                 it is probable       that the variances        cited      with respect   to gross
                 income yields,       funding    and operating        costs may, in part,        be due
                 to different      assumptions      and allocation         methodologies    within
                 each institution.          As a result,     comparability        of the results
                 might be questionable.
                 Chase Education        Finance has an even more basic concern.                  We
                 oppose the dissemination            of the study in its present             form and
                 object    to any release       of our confidential           or vroorietarv
                 information.       Chase Education         Finance's      intention     in completing
                 the data collection         forms was to provide            data for consolidation
                 with other    institutions.           Moreover,    identification         of Chase is
                 not, in our opinion,          a critical      element     of the study and
                 therefore    anonymity      should be afforded         to us.
                 In addition,      since this      study may be subject        to release      under
                 the Freedom of Information            Act, Chase    Education     Finance
                 respectfully      requests    that all commercial        and financial        data of
                 Chase and its participation            in the study not be disclosed.                 It
                 is our understanding        that information        which contains        proprietary
                 and confidential       data is not subject        to public     disclosure        under
                 the Freedom of Information            Act or under the GAO's regulatory
                 policies.      It is our opinion         that the data provided         is
                 proprietary      and confidential        and should not be made available
                 publicly.




                        Page 54                         GAO/HRl%SQ130BB         Profitability   of Guaranteed   Student   Loans
       Appendix V
       Comments Prom Chase Manhattan




    Mr. Franklin     Frazier
    Page two
    August 17,     1990


    Chase Education       Finance    appreciates       the opportunity       to review
    the draft     and communicate       its position.        In view of Chase's
    objections,      I assume you will        consolidate      the financial      data and
    not release      Chase's   data separately.           If that   is not the case, I
    am available      to discuss     these issues with you in greater
    detail.      Please feel     free to call      me at (813) 881-8080.


                                        Sincerely
                                                  1 i - ',     .
                                          \


                                        Stephen T. Iovino
.                                       President
    STI/sah




         Page 65                         GAO/HRD43@13OBR     Profitabiity   of Guaran teed Student   Loans
Appendix VI                                                                                                                              -
CommentsFrom Wachovia



                                                                                              Wachowa
                                                                                   Wachcwia   Bank & TrustCompany.N.A.
                                                                                                           PO.Box xl!39
                                                                                              WmstanSalem. NC271503099
              August         L5,   1990




              Mr. Franklin    Frazier
              Director,    Education    and Employment Issues
              United States     General   Accounting  Office
              441 G Street,     N. W.
              Washington,    DC 20548

                 Re:     Proposed         Report   to Congress   on Student       Loan Profitability

              Dear     Mr.     Frazier:

                      This letter   is in response   to your July               19, 1990 letter  to
              Kay Triplett.       We appreciate   the opportunity               to comment on the draft
              report.

                      We support   the study of lender   profitability         by the General   Accounting
              Office.     Although    your survey was limited       as far as cormnercial     banks are
              concerned,     your conclusions    show the declining       profitability    of student
              loan assets      to an after-tax   margin which is not very attractive.

                     We cooperated       in completing      the "data collection          instruments"   citing
              the fact that our data input was based on certain                     estimates      and
              assumptions.         Some of the volatility         in costs cited       in your study is likely
              due to variances        among respondents        in estimating      yields,      funding costs and
              other    cost allocations.        We question      any conclusion        one might draw
              regarding      absolute    profit  levels     with such a small sample size.             Assuming
              respondents      used the same assumptions            and estimates      for each year's     data,
              one could draw some conclusion             regarding     trend absent a conclusion          about
              absolute     levels.

                    We assume that your report           may be subject    to release   under                the Freedom
              of Information      Act.   We respectfully      request   that Wachovia data                   and
              Wachovia's     cooperation   in your study be granted          anonymity.

                      We understand        that commercial             and financial       information     which contains
              privileged      and confidential            information        is subject       to exception     from
              release    under the Freedom of Information                      Act.    We deem estimated         yields,
              internal    estimates        of funding        costs,       and servicing       and other    cost estimates
              to be valuable         proprietary       information.            This information        is not available
              from other      sources.         Product      profitability         estimates      may be a valuable
              resource     internally,        but should not be available                  for external     publication.
              Page 8 of the draft            report    illustrates          a plan of wide distribution             absent
              any request       under the Freedom of Information                     Act.




                       Page 56                               GAO/HRD-SO-13OBR          Profitability    of Guaranteed        Student   Loans
          Appendix    VI
          Comments        From   Wachovia




Mr. Franklin          Frazier
Washington,          DC                                2                        August      15,   1990


           we must  protest    the publication        of the         draft  report  in its         current
form       and request    that GAO carefully         control         copies   of the draft         report.

            Wachovia's      intention     in completing    the data collection    forms was to
provide        data which would be aggregated             with other respondents.      We do not
believe        that    release      of the identity     of Wachovia Bank b Trust     is necessary
for       the purposes        of your study.

       Thank you for             allowing   us to state         our position.       I would be happy          to
discuss    our position              with you and can      be    reached at     919-770-4554.

                                                 Sincerely,



                                                 Richard   B. Roberts
                                                 Executive   Vice  President




           Page 67                               GAO/HRB!3@13OBR            Profitability     of Guaranteed        Student   Loans
    Appendix VII

    CommentsFrom the CaliformiaAgency




                   CALIFORNIA                   STLJDENT     L~A~FINANCE                          CORPORATION



                      August     17,     1990


                      Mr.   Franklin    Frazier
                      Director,      Education  and Employment Issues
                      United States General Accounting        Office
                      Human Resources Division
                      Washington,      D.C. 20548
.
                      Dear Mr. Frazier:
                      Thank you for including          California       Student Loan Finance Corporation
                       (CSLFC) in the General Accounting                   Office's     study regarding       the
                      profitability         of student   loans to secondary market lenders.                We at
                      CSLFC view our participation                 in the study as an opportunity               to
                      assist the General Accounting             Office     in educating      Congress relative
                      to the numerous influencing                 factors      relating     to our secondary
                      market's      profitability      over the last several            years.
                      We have reviewed the draft               report you sent to us in its entirety.
                      Clearly,      it is extremely         thorough and very informative.             However,
                      we could not find where inherent                  risk    in the guaranteed        student
                      loan program is explicitly               discussed.      An example of this risk is
                      where legislated             change to the program retroactively                  changed
                      servicing       requirements       for loans which were originated           or purchased
                      in previous        years.       When this occurred,         it created      an immediate
                      profitability         risk,    a risk     which was not a reality          nor perceived
                      to exist      when the affected           loans were originated        or subsequently
                      purchased.         This type of retroactive            change significantly       altered
                      profitability          levels     for    lenders    and holders       of student       loan
                      portfolios.
                      Please let me know if you or your staff       have any questions     or
                      comments.    Again, thank you for allowing us to participate   in this
                      vitally   important  study.
                      Sincerely!.,
                                 .4




                      SK/th




                               Page 58                       GAO/HRJMO-18OBR      Profitability     of Guaranteed   Student   Loans
Appendix   VIII
CommentsFrom the Indiana Agency




                                           Aeguct     24,   1990



                                           Mr. Joaaph J. Eglln,     Jr.
                  251 Nwr(h MMis streat    Aaaistant   Director
                  Suita 1000               Human Resources Division
                  Indianapolis. IN 46204   General Accounting    Office
                  317-237-2000             Washington,    D.C.  20548

                                           Dear Mr. Eglin:

                                           Thank you for          the draft      report   entitled   “Guaranteed    Student
                                           Loans Secondary          Market    Lenders Profits      Vary Widely.”      I have
                                           reviewed      the report        in detail        and I believe        it   fairly
                                           rrpresents      information       provided     to the General         Accounting
                                           Office     by our organization.              I cannot coeaaent regarding         the
                                           accuracy of the information           in regard to other organizations.

                                           It      is  important        to note, as a matter of update,                    that costs of
                                           operatiowa         have increased             substantially          since those periods
                                           covered      by the report              and now represent          1.74X of outstanding
                                           student       loan     assets.          This increase       in cost of operations              is
                                           largely     attributable          to the imposition         of very prescriptive              due
                                           diligence        requirements          of questionable        value in the collection
                                           of loans.        We continue         to believe      that greater         efficiencies        can
                                           be realized          in costs of operations               while enhancing collection
                  SfKPbKN 1. CLINTON       effectiveness          if      the level of regulatory             direction        is tied to
                     PfWdWU                delinquency         and defsult            rates.      Through this approach,              those
                                           organiaations          who are ineffective                in their      collections       would
                                           recciva      increased         regulatory      oversight       and those organizations
                                           which kavc proven themselves                  capable in collection              of education
                                           loaad       wwuld         be      permitted       to retain          that      effectiveness
                                           unftc$ered       by prescriptive          due diligence         requirements.

                                           We appreciate    the opportunity   to be involved in the study.
                                           ?leese call me if you have any questions about my comments.




                  Indiana
                  Secondary
                  Market
                  lot EdocahonLoans. Ino




                                                               QAo~fB13BBit                ProRtabiUty       of Gaurmteed         Student      Loans
    Appendix IX

    CommentsFrom the NebraskaAgency



                                       !YEBHELP
                                       Nebraska llighcr Education Loan Program, lnc
                                       IiOil “0” Slreef PO Buu lll505
                                       Lmcoln, SE 68501-2505




                                       August     22, 1990

                                       Mr. Franklin Frazier
                                       Director,   Education and Employment     Issues
                                       United State General Accounting    Office
                                       Washington,    DC 20548

                                        Dear    Mr. Frazier:
.
                                           Thank yell for the opp,xtunity   to comment on the draft of the GAO’s repori on t!:c
                                       profitability of guaranteed  student loans held by secondary markets.  As we understand
                                       them, the objectives of the report as directed by the House Committee  on Education   and
                                       Labor and the Senate Committee       on Labor and Human Resources were to determine:

                                        l   the profitability of student loans held by major secondary markets,
                                        l   the reason for the variations    in profitabihty,   and
                                        .   the effect of the 1986 reduction     in the interest subsidy rate on profitability.

                                           It would be difficult   for people not directly involved in the student loan industry to
                                       comprehend     the difficult nature of this undertaking,   and we applaud your efforts.    Thr
                                       Nebraska Higher Education         Loan Program, Inc. (NEBHELP)      has several concerns about
                                       the report, however, which we will address in this letter. Our concerns include the scope
                                       of the report, major changes that have occurred since the period covered in the report
                                       that make the information        in the report obsolete, and the impact of the Student Loan
                                       Marketing   Association’s    (Sallie Mae) inclusion in this report.

                                       Scope

                                           The scope of the report and the large number of variations               in the agencies and d:lta
                                       studied preclude making any general conclusions             related to the objectives of the report.
    Now on   p.    36.                 To illustrate,     in the first paragraph     on page 41 of the conclusion        you state. “the I’JSh
                                       subsidy reduction        had little or no effect on lenders’ revenues.”       The discussion on pasts
    Now on   pp.    28-29.             30 - 32 and the data in Table III.8 in Appendix              III suggest, however, that the subsidy
                                       reduction     may not have efiected lenders’ revenues because secondary                markets did not
                                       have significant      loan volume in their portfolios    subject to the reduced subsidies. A more
                                       accurate conclusion        based on the information     you provide would be. “The effect uf the
                                        1986 subsidy reductions cannot be determined          at this time since the subsidy reduction has
                                       yet to be passed from originating          lenders to secondary markets.”         We agree with your
    Now on   p.    36.                 conclusion     in the final paragraph of the conclusion on page 41: “The variations             in profit
                                       levels. and the many reasons for them indicate that profitability                 measures do not. in
                                       themselves,      provide    a sound basis for determining         the appropriate    special allowance
                                       factor.”


                                       Dated    Information

                                            The data used to generate     the analysis and draw conclusions      in this report   was collected




                             Page 60                                 GA0/HRD60430BR             Profitability    of Guaranteed        Student      Loans
   Appendix IX
   Comments From the Nebraska                  Agency




Page 2, Franklin      Frazier,   August   22, 1990

from fiscal years 1985       through 1988. A number of significant        events and changes have
occurred in the student        loan industry since 1988 and increased the costs associated with
acquiring, owning, and       servicing loans. These events and changes include the UES failure,
changes in regulations,      and most recently, the financial difficulty of the Higher Educational
Assistance  Foundation        (HEAF).    the nation’s largest student loan guarantor.

    UES failure

    The UES incident has created a dramatically         different     cost of funds structure.  Due
to both real and perceived    risks, credit providers,    particularly    the Japanese banks, have
made a wholesale exit from the student loan industry since 1988. As funds become less
available, they become more costly. The fact that letter of credit fees have increased 30%
- 40% since July, 1988 is proof of that statement.     The resulting increased cost of obtaining
credit facility has narrowed    the aiready slim margins of many secondary              markets and
increased the need for maintaining      the existing special allowance rate.

   Regulation     changes

    Arbitrage      regulations     issued by the Treasury Department        since fiscal year 1988 remove
many of the benefits of utilizing tax exempt financing                  as vehicle for financing       student
loans.     As discussed in the report, many state agencies and not-for-profit                      secondary
markets have utilized tax exempt financing as the major source of financing student loan
purchases.       Typically,    state agencies and not-for-profit      secondary markets have accepted
lower rates of return to fulfill the mandate of providing               access and service to areas that
for-profit     lenders do not serve. The arbitrage earnings have allowed state agencies and
not-for-profit       secondary        markets  to subsidize     otherwise     unprofitable     student     loan
operations       and provide additional       services and access to students.         As the full extent of
arbitrage restrictions        is realized the possibility exists that not-for-profit      and state agencies
wiU have to curtail services to borrowers.

    Increased due diligence regulations    implemented   by the Department      of Education     in
 1988 have increased the cost of servicing and operations         and, directly influenced     the
secondary market profitability.    In light of increased servicing and operation      costs, it is
inconceivable  that further cuts can be made in the special allowance or any other facet of
the program which reduces secondary market profitability.

   HEAF situation

    HEAF’s    apparent collapse has created substantial       doubt abcut the stability of the
student loan industry.     Statements   by the Department      of Education    implying   that the
federal government’s    guarantee applies only to the guarantee agency and not the lender
has caused anxiety among originating       lenders, secondary      markets, and letter of credit
providers.    To date, several letter of credit providers       have expressed strong concern
regarding HEAF-guaranteed        loans and others have requested that subsequent purchases
not include HEAF paper. As the uncertainty         persists, the possibility  exists that student
credit providers    may cease any and aU involvement         with student loan financing       thus
creating a serious access problem for students.

    These three areas of change have created an operating        environment  quite different
from that of 1985 - 1988 when your study took place. While your report provides an
excellent historical perspective on the profitability of secondary markets, it should not be




    Page 61                                      GAO/HRlM@13OBR               Profitability     of Guaran teed Student   Loana
   Appendix IX
   Comments From the Nebraska               Agency




Page 3, Franklin    Frazier,    August   22, 1990

used to predict    the future   or set policies     governing   secondary    markets.

Sallie   Mae

     The inclusion of Sallie Mae as just another secondary market skews the report and its
conclusions.     The federal agency status that Sallie Mae alone enjoys and the economies
of scale created by their sizable portfolio    and lending powers place Sallie Mae in a totally
different    competitive   arena.   Sallie Mae’s many advantages    and few limitations  make
realistic comparisons    to state or bank secondary markets impossible. The required parallels
do not exist.


    As perceived today, the student loan industry presents greater risk than ever to credit
providers.    Increased risk means increased cost of funds. Since the federal government
has, through arbitrage     regulations, placed a cap on return to the secondary   markets,
special allowance provides a way to offset those increased costs. If secondary market
income is cut by decreasing special allowance payments, secondary market liquidity drops,
and access is reduced.

    If issued as drafted, your report has severe implications  for the entire student credit
industry and could result in restricted  access to higher education.   The conflict between
the mandate of the student loan programs which is access, and the standards by which
we, and other providers of those programs are increasingly judged (including profitability),
is escalated by your report.

   Once again, I appreciate  the opportunity  to comment on this draft of your report              and
your attention to our concerns.   If you have any questions, please contact me.

Sincerely,




Don R. BOW
President




   Page 62                                    GAO/HRD9@12OBB                prontability   of Guaranteed   Student   Loans
Appendix X

CommentsFrom Nellie MAR



                                 /
                          i x’      i,..
                                      IX,
                      /           J/r       A?-       -.
                                 ,I’ i,”          ..
                                                    __---        --..-..-     ~~             -    --.        _ -..        .-
                                                ’      The New England Education Loan Marketing                         Corptation
                                              :-------                -----      ~                                       ----.--
             l.,_                      .. ”




                                                                                   August   7,   1990



                    Mr. Franklin    Frazier
                    Director,    Education  and Employment
                        ISSUM
                    U.S. General Accounting     Office
                    Washington,    DC 20548

                    Dear Mr. Frazier:

                           Thank you for          the opportunity       to comment on the draft            report   of GAO
                    regarding      the profitability            of guaranteed       student      loans   to lenders      and
                    holders.       I believe      that the GAO staff      has done an effective        job of compiling
                    and analyzing          data provided       by study participants        who themselves     are quite
                    diverse      in structure,       financing    and servicing      characteristics,      and portfolio
                    composition.

                            The draft   study clearly       demonstrates    how political          and economic factors
                    effect     program   participants         in different      and often      dramatic     ways.    It is
                    important     for Congress to know that these factors               are delicately      balanced and,
                    when out of balance,          result    in program     participants,        including    some of the
                    largest    in the nation,     suffering     diminished    financial     returns      and even losses.

                            It is telling       that four of the five non-profit          secondary markets realized
                     lOSST?S in some years,           snd that both commercial banks, while being Drofitable,
                     achieved     earnings       well    below      those   of other     bank products.       The only
                     consistently     profitable       entity    wss Sallie   Mae. buttressed     by the advantages  of
                    low   cost "agency" borrowing             and lower cost centralized      servicing.

                           It   is also interesting   to review how fast the statutory   and regulatory
                    environment      (both Department of Education and Treasury)  have changed.    Simply
                    over the period covered by the study we've seen:

                            Reduction     in SAP yield    to T-Bill    + 3.25%
                            Gramm-Rudman-Hollings        sequestration     reduction  to T-Bill  + 3.1%
                            Creation,     expansion    and reduction    of SLS program
                            Consolidation       loan program
                            Department of Education         strict   due diligence   and cure regulations
                            Private    Activity     Bond caps
                            Change in Plan for Doing Business approvals
                                               50 Bramrrcct-lilt Pnrk, Suite 300. Braintrce, Maswhuxrtr I)ZIX1-1761
                                                               617-H49-I32>        WbEDU-LOAN




                             Page 63                                        GAO/IilUMI%13OBlZ           Profltabillty     of Guaran teed Student Loans
                                  Appendix X
                                  Comments From Nellie Mae




                              Mr. Franklin      Frazier                                                             August        7. 1990
                              Page two




                                     Further,       the Treasury     regulations         proposed in July       1989       and      effective
                              January,      1990 including       SAP within         the arbitrage    calculation           and        limiting
                              permissible        operating     expanses       to 2%, effectively        eliminates               the use of
                              tax-exempt      financing    for federal      student    loan programs.

Material deleted, see p. 37




                                    Two minor     corrections:

Now on p. 2.                        Page 3: the "New England Loan Marketing    Association”                       should    be “The
                                    New England Education Loan Marketing  Corporation."

Now on pp.23-24.                    Page 25:      In 1985 and 1986 the US Department                   of Education     was
                                    refusing    to iSSIX    approvals     of many "plans           for doing    business"
                                    submitted    by non-profit       secondary      markets.         Such approval      was
                                    necessary     in order     to receive        special     allovance     payments, not
                                    interest    benefits,  when using         tax-exempt funds.         To continue     our
                                    secondary    market support of lenders,         Nellie     Mae did not receive      SAP
                                    on loans funded with tax-exempt        bonds until       the   Higher Education     Act
                                    was amended to transfer       responsibility         for   plan for doing business
                                    approval  from the Secretary      to the Governor of the State.

                                     Again.    thank you for the opportunity             to comment.        I hope that               you will
                              take    my comments here and those submitted               earlier into        consideration              before
                              releasing     the final report.

                                                                                  Very     uly   yours

                                                                                        bW4AdT        lrlc-
                                                                                   p'
                                                                                  Lawrence W. O'Toole
                                                                                  President

                              LWO/dms

                              Attachment




                                                          The New England Education Loan Marketing           Corporation
                                                                                   .._-__-~-                   -.~-              -.




                                                                                                                                                         I




                                                                                                                                                     i




                                   Page 64                               GAO/HRD9&13OBR           Profitability       of Guaran teed Student     Loans
Appendix XI

CommentsFrom the ColoradoAgency




               August          17, 1990



               Mr.  Franklin  Frazier
               Director
               Education and Employment Issues
               Human Resources Division
               United States General Accounting                 Office
               Washington,   D.C. 20548
               RE:       Draft     GAO      Study Regarding   Secondary   Market     Profitability
               Dear      Mr.     Frazier;
               Enclosed   is our response        to the draft        of    your organization's
               proposed    report   to Congress           regarding     the profitability        of
               guaranteed   student loans to secondary market lenders.                  During our
               review of the report       draft,       we did make several          observations
               concerning    the report’s   findings         and conclusions    which we would
               now like to submit to your          office       for additional    consideration
               before the final    report is issued.
Now on p. 3.   Page 5 of the cover letter        to Senator Kennedy states unequivocally
               that "The 1986 subsidy reductions           had little,        if   any, effect     on
               lenders'     revenues .*I While this may be true for the period under
               review,     we were not able to find a meaningful               reference     to what
               percentage of the study's portfolios         was subject to this reduction.
               It would appear that, as the secondary markets continue to provide
               lender liquidity,        and the loans within    the portfolio          continue    to
               have declining        balances  through normal borrower             repayment,    the
               percentage of loans within the portfolio           which is subject to lower
               subsidy will       play an ever increasing     part in the calculation              of
               gross revenues as a percent of outstanding              loans.       Therefore,   the
               statement      quoted above should be modified           to reflect       its narrow
               application.
               The report's          conclusion    that Variations     in profitability    among
               (secondary         markets) indicate    that revenue and cost information    does
               not provide         a sufficient   basis for determining   appropriate    subsidy
               levels"         and that a number of the agencies you investigated         showed




                Page 66                                  GAO/HRD9@13OBR      Profitability    of Guaranteed   Student   Loans
                     Appendix=
                     Comment.9 From the Colorado       Agency




                   Mr. Franklin Frazier
                   August 17, 1990
                   Page Two


                   losses       from time-to-time      suggests   that  there  may have been
                   insufficient      scrutiny     by Congress when reducing   subsidy levels.
                   These conclusions        indicate  that much more detailed    research must
                   be accomplished      before subsidies     are changed.

                   Bond funded secondary            markets     earn income from student               loan
                   interest,    special     allowance      payments,     in-school    interest      if the
                   loan is purchased prior to graduation,                and investment      income.      As
                   opposed to the free market,                secondary       markets    cannot adjust
                   interest    rates     to meet changing         market conditions.             They are
                   confined to a legislatively-mandated              rate structure:      normal market
                   oompotitive     prioinq      struotures     do not exist        in this      industry.
                   Hence, secondary markets are restricted                 in the earning potential
                   on a student loan.
                   Profitability      of a secondary market hinges largely              on costs.       As
Now   on p.   3.   pointed out on pages 4 L 5 of the draft,               "profit    variations      were
                   due primarily     to differences      in the landers'     financing,      servicing,
                   operating,     and other costs."         Financing    costs depend greatly           on
                   market conditions     and timing of the issue.          State secondary markets
                   exist under a restrictive        state volume cap, vhich can affect timing
                   of a bond issue or portfolio         purchase.     If timing is off,       financing
                   costs      can spiral     or portfolios       cannot be purchased.               These
                   restrictions     do not apply to Sallie        Mae or banks.
                   We ask that        the reference      to financing     costs being related       to
                   outstanding        portfolio     balance     be  corrected      to reflect     the
Now on   p.   29   relationship      to outstanding     DEBT (Page 33).      The ability   to be cost
                   effective      in    issuing   debt is hindered          by   state   volume cap
                   restrictions.         Colorado   would   prefer  to  offer   fewer,   larger  bond
                   issues and access the financial           markets with the obvious economies
                   of scale,     however, current       volume caps on tax exempt issues make
                   this impossible.
                   Servicing     costs have recently          been    escalating    because of federal
                   due diligence         requirements.        The study used data prior              to the
                   impact of the new due diligence               regulations     rendering    the finding
                   somewhat out of date already.                The Office of Education has found
                   technical     violations        of due diligence        in almost every secondary
                   market    and servicer,       the cost implications         of which are unknown at
                   this    time.        Also,     those   secondary       markets    using    third-party
                   servicing     cannot directly        control     these servicing      costs.




                      Page 66                             GAO/HBD9&13OBR         Profitability   of Gum-an teed Student   Loans
                               Appendix Xl
                               Comment8  Prom the Colorado Agency




                              Mr.    Franklin     Frazier
                              August     17,    1990
                              Page Three


                              This essentially       leaves operating    cost5 as the major control   factor
                              in "costs".        For most organizations,       this cost is a very small
                              proportion     of overall      costs,     much smaller   than financing       or
                              servicing   costs.       Thus, state secondary markets are faced with a
                              situation   where cost control,         to a large degree, is not directly
                              under their     influence.
Now on p. 5.                  The report's        heading statement on page 7 ("Loans financed with tax
                              exempt funds can be more profitable                      than others".)        is very
                              misleading.         The study defines profitability            as gros5 revenues less
Now on pp, 18 and 5           costs (page 17).             What is being said on page 7 is that tax exempt
                              financed loans may, UNDERCERTAIN NARKBT CONDITIONB, earn a higher
                              special       allowance       (revenue)   than loans financed         by other means.
                              Profitability         includes costs;        the report'5     statement doe5 not and
                              is a major disservice               to state secondary markets which use tax
                              exempt financing.             If this referenced     statement      is to remain part
                              of the report,          it should read as follows:
                                                                tax -funds                           cerv
                                                        rate more in rev-a                                 I, If the
                              term uprofitabilityn             is used, then costs must be included.
                              As Colorado is a non-profit,                   state secondary market, we find of
                              particular        interest       the      report's        statement     that       for-profit
Now on p. 22.                 secondary markets were consistently                      profitable    (page 23), while
                              also stating        that those agencies which use tax exempt financing
                              included      some of the least profitable                   of the agencies           studied.
                              State secondary markets are under far more restrictions                                in terms
                              of the markets        they must serve.              Enacting legislation         requires       we
                              provide liquidity          to all lenders for all eligible                loan5 (guaranty
                              still     in effect,       certain      geographic        requirements      of    either      the
                              borrower     or the school etc.).             The result is we frequently             purchase
                              and service         the highest          risk      loans,     without    any off-setting
                              compensation         derived       from       increased        subsidy    (normal         credit
                              environments        provide     an increased           rate of return        for     increased
                              risk).

Material deleted, see p. 37




                                Page 07                               GA0/EJRD90430BR Profitability            of Guaranteed Student Loana
      Appendix Xl
      Comments Prom the Colorado   Agency




    Mr. Franklin Frazier
    August 17, 1990
    Page Four


    We appreciate    the opportunity  to comment  on the GAO report     draft
    and sincerely   trust our concerns will be seriously     addressed prior
    to the final   report being issued.    Please feel free to contact       me
    or my staff   should you have any questions    regarding   our comments.

    Sincerely,



    William A. Stolf&
    President
.




      Page 68                       GAO/HBD90-13OBB   Profitability   of Guaranteed   Student   Loans
    Appendix XII

    CommentsFrom the Pennsylvania Agency




                                            PENNSYLVANIA         HIGHER         EDUCATION          ASSISTANCE             AGENCY


                                                                              680 806   STREET
                                                                HARRISBURG.      PENNSYLVANIA    1,102-,346

                                                                      August         31,    1990




                   Mr.   Franklin    Frazier
                   Director,      Education     and
                      Employment Issues
                   U.S. General Accounting          Office
                   Washington,      DC      20548

                   Dear   Mr.    Frazier:
.
                          This is in response    to your letter   of July 19,                                  1990 concerning          PHEAA's
                   comments on the draft      report   of the GAO regarding                                    the profitability          of
                   guaranteed    student loans to lenders    and holders.

                           A review      of the draft    report    clearly   indicates                         that GAO's staff     has done
                   a very       good lob of compiling           and analyzing       data                      provided   by the ten
                   participants         in the study which demonstrate             quite                       a diverse   approach    to
                   providing       capital    for secondary     market purposes.

                          Although      PHEAA does hold approximately         $40 million    in Stafford        loans
                   purchased     from various    lenders',   the statutory     and public   purpose     is served by
                   making loans for postsecondary          education    purposes    to Pennsylvania      residents    at
                   or below market rate levels          to provide    middle income families        with a moderate
                   cost source        of credit   to fund the costs        of postsecondary     education.         To
                   accomplish      this goal,   PHEAA must:

                          a.      Finance       at tax-exempt       rates.

                          b.      Subsidize    the     tax-exempt                financings     via   an issuer
                                  contribution    valued at five                 to ten percent     of the face                    amount
                                  of the financing.

                          C.      Administer        the    direct      loan      program,    including                       loan
                                  origination        and servicing         within     the limitations                       of co?t
                                  recovery        mechanisms      controlled        by the allowable                         spread
                                  inherent       in tax-exempt      financing.

                          d.      As Stafford      loan eligibility          continues   to become less of a
                                  reality     for the middle and upper income family,                 the need for
                                  PHEAA to meet this increasing              demand for direct       loans and the
                                  PBEAA "secondary      market"     activity       is of the utmost importance
                                  and our program is not driven              by concerns    of profitability     or
                                  competition.

                          Because of the unique role of PHEAA, staff       believes                                 the Agency        should be
                   excluded    from this    secondary   market report or placed     in                              a separate        category
                   for the purposes      of the report.




                               Page 69                                 GAO/HRD99-13OBB                    Profitability      of Guaran teed Student   Loans
                                                          -2-



             Also,      it is important       that the final        report     makes it clear      to Congress
    that     political        and economic factors        directiy     affect    the administration       of each
    of the program             participants     and th,ese factors         need to be considered         before
    legislative           changes are made.        This is clearly         evident    when you look back at
    the numerous changes on both the statutory                        and regulatory        level    that have
    taken place which greatly               impact on profitability            of student     loans to not only
    secondary         markets     but aLso direct      lenders     and guaranty      agencies.

          Thank you for the opportunity              to     comment,         and I will     be looking         forward
    to reviewing   the final report.

                                                                Sinqerely,

.
                                                            'Thomas il.         Fabian
                                                              Executive         Deputy    Director

    TRF:mbm
    TF4.99900831/03




              Page 70                               GAO,‘iilWW19oBB               ProfkabUity        of Gumn     teed Student   Loans
    Qpendix    XIII

    Major Contributors to This Briefing Report


                                   Joseph J. Eglin, Jr., Assistant Director, (202) 401-8623
    Human Resources                William A. Schmidt, Advisor
    Division,
    Washington, D.C.
    *
    Seatt1e     Re@ona1   Office   BeNjamin p. pfeiffer   Evaluator
                                   Susie Anchell, Evaluator
                                   Keith C. Martensen, Evaluator




.




    (lo4aaa)                       Page 71                   GAO/HRD!W-13OBB   Profitability   of Guaranteed   Student   Loans