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In 1965, the federal government began guaranteeing student loans that were provided by banking institutions and non-profit lenders with the creation of the now-called Federal Family Education Loan Program or (FFEL). Under the National Defense Education Act of 1958, the first federal student loans were provided using direct loans capitalized with U.S. Treasury funds. These federal student loans were originally recommended by economist Milton Friedman.

When Congress wanted to expand the federal student loan program, budget rules made the guarantee system more attractive. Direct loans, under the prevailing budget rules at that time, would have to show up as a loss on the budget during the year that it was made, even though the majority of the loan would be paid back with interest over future years. A guaranteed loan by contrast would appear to have no upfront budget cost at all. These guaranteed loans placed the full faith and credit of the United States and backed behind a private bank loan would not incur government payments for defaults and interest subsidies until many years later. Some of the economists were worried that the government was ultimately making financial commitments without accounting for the costs.

It wasn’t until 1990 that economists finally got what they want. Then acting President George H.W. Bush signed onto the Federal Reform Act for all government loan programs. All commercial loans or loans made directly from a federal agency would ultimately have to account for their full long-term income and expenses, where every loan program would now have an estimated “subsidy cost.”

“Subsidy costs” refers to the amount of money needed to be set aside after the loan is created to cover the costs to the government over the life of the loan. The old approach, according to the Government Accountability Office, “distorted costs and did not recognize the economic reality of the transactions.” The new approach “provides transparency over the government’s total estimated subsidy costs rather than calculating the costs on a cash basis after years and years of payments are paid and the receipts are collected.”

The Student Loan Programs were among the first to be affected, however, this more rational approach to budgeting helped change the nature of policy decisions on Capitol Hill.

In 1992, Congress created a direct lending pilot program in 1992. This was due to the analysis provided by the Bush Administration, who indicated that direct loans would be simpler to administer and in the end be less costly than guaranteed loans. As part of newly elected President Bill Clinton’s deficit reduction plan, he proposed replacing the guarantee program with the direct approach in 1993. From all the estimates, direct lending would help to deliver the same loans to students at much lower costs to taxpayers.

Congress passed a budget reconciliation bill as part of its 1993 budget agreement, which was designed to phase in direct lending, starting with colleges that were willing to participate. These colleges agreed to give the Secretary of Education the power to require the colleges to switch until the percentage of nationwide loans were direct loans. The law officially called for direct loans to replace guaranteed loans, though it did not cover what would happen beyond the 60-percent mark, as these numbers would sit outside the budget’s five year window. The new Republican leadership in 1994, wanted to eliminate direct lending completely; however, many university and college officials had become dissatisfied with the guaranteed loan system and were looking at direct lending as a possible alternative.

Financial aid administers under the guarantee system, had to deal with the Government Accountability Office, which was a complicated and cumbersome process that involves thousands of middlemen. At the time, there were hundreds of institutions that were already participating in the direct loan program, which operated in tandem with other federal aid programs.

In the end, Congress did not eliminate direct lending completely; instead, they passed a new law that prohibited the DOE from requiring or even encouraging education institutions to switch to the direct loan program. This was done to help schools maximize their options, allowing them to choose which program they wanted to participate in. This allowed those who were profiting from the guarantee system to use their substantial resources to retain and lure colleges and universities, while the direct loan program was not able to do the same. Campus participation in the direct loan program declined going forward.

A team of investigative reporters at World Report and US News in 2003, looked into the potential causes of some colleges switching back to the guarantee program. They found that the student loan industry “used money and favors” to get what they wanted from their friends in the Department of Education and in Congress.

The direct loan program by 2007, had dipped to its lowest share volume since it began in the 1990’s. This trend did reverse in 2008, as credit disruptions in 2008 and 2009, threatened the ability of private lenders to make new loans under the federal guaranteed student loan program, causing many lenders to discontinue their participation in the program. Many of these schools switched to the direct loan program in 2008, causing the share of the total loan volume to increase.

The legislative responses to the credit market concerns also changed the entire structure and operation of the FFEL program. In May 2008, Congress and the President Bush enacted a temporary plan to allow the DOE to buy guaranteed loans made by private lenders. The proceeds of the program would be used in the creation of new student loans. This temporary program was called ECASLA, which stood for the Ensuring Continued Access to Student Loans Act, and marked a historical change within the guaranteed loan program as it enabled the use of federal capital to private lenders making student loans. The new program shared some characteristics with the direct loan program in this regard.

President Barack Obama proposed a full elimination of the FFEL program during his 2010 budget request to Congress. His argument asserted that the subsidies paid to private lenders under the program were ultimately unnecessary and that cost savings could be achieved if student loans were provided under the direct loan program.

Congress passed and Obama signed a new bill that fully eliminated the FFEL program for new loans after July 1st, 2010. After this date, all new loans would be made under the Direct Loan Program. The elimination of the program was estimated by the Congressional Budget Office to generate more than $68 Billion in savings over the next decade. The Pell Grant program saw increased funding from these aforementioned savings.