Why All Government Student Loans Are Not Created Equal

The timing of an article in The New York Times couldn’t have been more ironic.

There we were, the day before we celebrate America’s Declaration of Independence, and the Times published an exposé on the hardball tactics that the State of New Jersey allegedly takes against student-loan borrowers who are unable to continue making their payments.

It seems that for those who fund their college education with state-sponsored money — which all 50 states and the District of Columbia offer — the word independence is actually two words: in and dependence.

How Student Loan Management Can Differ

I say that because, generally speaking, the principal difference between the loan programs run by the individual states and those run by the federal government is the government’s willingness to work with financially distressed borrowers so they can remain independent.

Something else that distinguishes federally backed higher education loans from those originated by all others — including the states and private-sector lenders — is the outsize influence the government wields on distressed-loan restructuring without regard for the ultimate disposition of the underlying contract.

In other words, even if a government-guaranteed student loan is sold to another entity — public or private, as has been the case with the discontinued Federal Family Education Loan (FFEL) program — the feds reserve the right to mandate a change in the contract’s repayment schedule, even though such a move would likely to have a deleterious aftermarket effect on noteholder rates of return (for example, when the repayment term is extended or a portion of the principal is forgiven).

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This helps to explain why there has been so much foot-dragging on the part of loan administration companies that are subcontracted by noteholders to service FFEL contracts that have subsequently been securitized.

And then there is the matter of what constitutes a government loan.

Some time ago, a recent state-university graduate contacted me for advice on restructuring his education-related debts. He was the first in his family to go to college and, given his and his mom’s limited financial means, he funded his education by taking on a fair amount of debt — nearly three times his current annual salary.

We talked about the Department of Education’s various income-based repayment plans, and, armed with that knowledge, he contacted his loan administrator. Several days later, he wrote again to say that his debts were not eligible for relief. “How can that be?” I asked. “You told me these were government loans and the monthly payments consume roughly half your take-home pay. Clearly, you should qualify for IBR.”

As it turned out, the “government” loans he believed he’d taken out were from his state (he insists that his university’s financial aid office referred to these loans as “governmental”). A bit more digging on my part also revealed that program was, in effect, a public-private venture. Similar to the manner in which the now-discontinued FFEL program was structured, his state guaranteed against default loans that were originated, funded and later securitized by private-sector lenders. But unlike the federal government, his state seemed unwilling or unable at that point to mandate distressed-debt restructures after the fact.

Consequently, my young friend ended up like too many of his peers: living in his mother’s basement.

There are those who would say, “Yet another reason for the government to get the hell out of the education-lending business!” Certainly, the manner in which public-backed student loans are administered leaves much to be desired.

But that shortfall, as significant as it is, doesn’t outweigh the two key benefits of the Federal Direct loan program and its predecessor: lower interest rates and a panoply of relief options for when a borrower’s financial circumstances cause him to become unable to meet his payment obligations.

In fact, I would take this a step further by advocating for the federal program to accept for restructuring all types of higher-education loans, without regard for origination channel (state, private and peer-to-peer alike) or repayment status.

Think about it. Even if the base rate that the Federal Direct loan program currently charges is increased to compensate taxpayers for the added risk of guaranteeing these nongovernment loans against default, it would still yield a better social and economic outcome for the country, not least because most financially distressed borrowers are sincere in their desire to repay their debts.

The concept of independence is, after all, meaningless if the means for attaining it are nonexistent.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its partners.