Student Aid Faces an Overhaul

The Administration aims to cut middlemen such as Sallie Mae, Bank of America, and Citigroup out of the student loan game

Last summer the government desperately wanted to keep private lenders in the student loan market. Now, President Barack Obama plans to cut out the middlemen as part of a sweeping overhaul of the federal loan program. While students stand to benefit from the switch, already-hobbled lenders, including Sallie Mae (SLM), Bank of America (BAC), and Citigroup, (C) would likely lose billions of dollars in profits.

Currently, the government distributes education funds through two sources: private lenders and its own in-house program. Each school decides which of the options to make available to its students. Financial companies have been big beneficiaries of the system, collecting huge fees from the government; in the last school year private student lenders handed out nearly 80% of the $65 billion in federal funds. By lending directly to college-bound students, the U.S. figures it can save $94 billion over the next decade and reroute the extra money to needy student borrowers. "The proposal allows us to focus on what we do best, acquire capital for loans—and that saves taxpayers money," says Robert Shireman, a senior adviser in the Administration.

This change, which could take effect in 2010 if Congress gives the O.K., would be a major blow to student lenders. Private-label loans—those without the backing of the U.S.—have already dried up amid the credit crunch. This new proposal, part of the President's budget, threatens the core of lenders' profits. Student lending giant Sallie Mae, the nation's biggest private player, disbursed $19 billion in federal loans last year, roughly 70% of its total volume. That's why the industry is gearing up for a fight. "We believe there are alternative ways to reach the President's education goals," says Sallie Mae spokeswoman Martha Holler. Says Michael Reardon, a student lending executive at Citi: "Schools and borrowers will not enjoy the many critical benefits without private-sector involvement."

Analysts say the industry's arguments may not carry much sway. Lenders insist that they provide valuable services, including running financial-literacy programs that help students budget payments. But the default rate for federal student loans made by private lenders is 7.3%, compared with 5.3% for direct federal loans, according to the Education Dept. Critics contend that the program is simply a freebie for private lenders. "This is the last vestige of Soviet-style capitalism," says Barmak Nassirian, a director at the American Association of Collegiate Registrars & Admissions Officers, an education nonprofit.

Already, private lenders are feeling the pinch as more schools decide they don't need the middlemen. The trend gained steam after New York Attorney General Andrew Cuomo investigated the cozy relationship between private lenders and financial aid officers a couple of years ago. Since the credit crisis, it has only accelerated. Some 1,624 colleges and universities now bypass the private lenders and go straight to the government for money, including Pennsylvania State University, Northeastern University, and Indiana University. That's up from 1,075 last year.

Michigan State University made the switch in the fall. After several lenders exited the industry, harried parents started calling the financial aid office, worried that their children wouldn't get the necessary money. To assuage those fears, the school opted to deal directly with the government's direct-loan program instead of working with private lenders. "Our students have peace of mind that they will get their loans," says Val Meyers, associate director of financial aid at Michigan State. "We haven't had any complaints."

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