Probe into student lending spotlights dual role of U.S.

With $85 billion up for grabs, competition for student borrowers helped ignite a financial aid scandal that has USC and several other universities drawing heat from investigators.

But the market forces propelling the student loan industry are not exactly textbook. In the strange world of education lending, the federal government is both a key competitor and the rich uncle that subsidizes its private-sector rivals.

Now, as legal authorities and lawmakers broaden their inquiries into allegations that campuses might have received kickbacks from private lenders, the federal government’s dual role in the financial aid arena has also come under heightened scrutiny.

In California, the stakes include an estimated $6.8 billion in new student loans made annually through the state’s public colleges, as well as private schools such as USC, where the financial aid director is under investigation for acquiring shares in a lending company.

The University of California and California State University systems have become laboratories for the odd and often confusing nature of taxpayer-guaranteed lending, with individual campuses divided on the question of which of the two loan programs is better for borrowers.

Neither program is required to disclose as much information to consumers as mortgage companies are, including the annual percentage rate of interest and costs. And college administrators say most students and parents -- the customers taking on increasing loads of debt -- are not aware that a pair of competing packages is available, because campuses usually subscribe to one or the other.

“It needs a complete overhaul and a complete reformation,” said Cal State Long Beach President F. King Alexander.

Since the 1990s, schools have quietly made a choice between the two principal types of federal lending -- a 1960s-vintage program that consists of financial institutions backed by the government, and the newer alternative that provides loans directly from the U.S. Treasury. Campuses are not barred from offering both programs, but officials say doing so would duplicate processing efforts and drive up costs.

And just as schools differ on which program is best, so do politicians.

Democrats frequently call the private-sector option -- known as the Federal Family Education Loan Program -- a lucrative giveaway to lenders, citing numerous studies that show it costs taxpayers far more than direct government loans.

But many Republicans say those studies are flawed. They label the direct loans an exercise in bureaucratic inefficiency that couldn’t possibly handle the entire demand. Lenders, for their part, insist that their loans are more affordable largely because of discounts the Education Department cannot by law offer.

No end to the debate is in sight, although the Democratic majority in Congress has pushed to bolster the direct loan program, reduce subsidies to lenders and lower interest rates paid by some borrowers in each program. Given the huge influence of the lending lobby, any attempt to kill or dramatically scale back the private loan program would face long odds, Democrats say.

The conflict-of-interest scandal has focused on private lenders that also make student loans outside of the federal programs. In addition to USC’s Catherine Thomas, who has been placed on paid leave, financial aid officials at Columbia University and the University of Texas are under investigation for their stock holdings in the parent company of Student Loan Xpress Inc.

All three schools listed Student Loan Xpress as a preferred lender for students. Investigators are examining whether the officials received the stock as part of a quid pro quo.

New York Atty. Gen. Andrew Cuomo has taken the lead in the inquiries, which have been joined by the Education Department and California Atty. Gen. Jerry Brown. Congressional committees also are investigating.

Cuomo’s office is looking at more than a dozen lenders and 100 schools. It already has obtained $6.5 million in legal settlements from lenders Sallie Mae, Citibank and Education Finance Partners.

The probes have emboldened critics of the federal government’s split position on financial aid -- as a direct lender on one hand and the guarantor of its competitors on the other.

“It really doesn’t make sense to have two different ways to deliver a federal benefit,” said Robert Shireman, president of the Institute for College Access & Success, a nonprofit advocacy group for disadvantaged students. “We should just pick one program and run it as efficiently as possible.”

Democrats say that was the idea when President Clinton sought to gradually replace the private loan program with direct lending. A Republican-dominated Congress thwarted Clinton’s phaseout plan but kept the direct loan program -- with limits on its ability to compete in areas like rate discounts -- to give consumers some choice.

The government thus found itself vying for borrowers with hundreds of lenders while continuing to pay lenders interest rate subsidies and bailouts for defaults. This year, the lenders received about 80% of the federal loan pie.

As unusual as the competition may be, college administrators and others say, it has forced both programs to improve their service and keep prices down. They say the terms of the programs are roughly the same, with each offering advantages the other lacks.

The private lenders often pay origination fees for borrowers, which can range from 2% to 2.5% of the loan. Many will eventually reduce the annual interest rate for borrowers who make on-time payments for an extended period. The rate is now set at 6.8%, but the U.S. House of Representatives recently voted to cut it to 3.4% over the next five years for students who qualify for interest subsidies. Generally, these are borrowers from lower- to middle-income families.

John Dean, special counsel for the Consumer Bankers Assn., a lobbying group for major lenders, said the payment of loan fees makes the private program “in every case less expensive to the borrower.”

The Education Department is prohibited from paying origination fees but does rebate part of them to borrowers who make their first 12 payments on time.

The direct loan program also gives borrowers greater leeway to reduce or suspend their payments during times when their income drops. And because these loans come from the Education Department, schools and borrowers are not inundated with lender sales pitches.

UC and Cal State administrators say the pros and cons of the programs make it difficult to declare one superior. Six of the 10 UC campuses use direct loans, and the rest rely on the private program. For Cal State campuses, 13 have signed up for private loans, and 10 for direct lending.

“I’m extremely happy with the way direct lending works,” said Ron Andrade, financial aid director for UC Santa Barbara. He said that switching to the program in the mid-1990s meant that administrators and students no longer had to deal with a multitude of private lenders.

“Our world became so much nicer and calmer,” Andrade said.

Down the coast, UCLA Assistant Vice Chancellor Thomas Lifka said his campus has stayed with the private program because the variety of lenders gave students more flexibility.

Lifka said some of the firms also pick up the school’s processing costs for their loans.

Cal State Long Beach’s Alexander, who is a higher education economist, said he wants his school to move from the bank program to direct loans. He said private lenders have profited too much at the expense of the taxpayers -- and funding for school grants -- and that federal guarantees against defaults have encouraged colleges to raise tuitions.

Allison Jones, a Cal State University assistant vice chancellor, said other campuses were happy with private lenders. In light of the scandal, however, the university is adopting tougher restrictions on the relationship between financial aid officers and lenders, he said.

For example, Jones said, lenders will no longer be permitted to conduct advisory sessions with groups of students on borrower responsibilities. He said the sessions were not improper, but officials were concerned about any appearance of special treatment for lenders.

“We’re very straight, very clean,” Jones added.

The UC system is also re-examining its guidelines for lender practices. Nancy Coolidge, UC’s financial aid coordinator, said the system is considering prohibiting lenders from paying travel and meal costs for administrators who serve on the firms’ advisory boards.

Meanwhile, Coolidge said that both federal programs should be required to disclose to all prospective borrowers the annual percentage rate of interest charged for the life of a loan.

It isn’t enough to simply state that the Congress-set maximum is 6.8%, she said, because of the discounts that many lenders offer students, as well as fees that could be incurred. The problem with discounts is that they are not given to every borrower and can vanish if the loan is sold to another company, Coolidge said.

paul.pringle@latimes.com