The Federal Family Education Loan Program (FFELP), created in 1946, was eliminated with the passage of the Health Care and Education Reconciliation Act of 2010 and replaced by the Federal Direct Loan Program (FDLP), created in 1993. FDLP was created to compete with FFELP but by 2010, two thirds of student loans were still originated under FFELP. Loan origination (processing the loan application) under the Direct Loan program is performed directly by the Department of Education. Servicing (account billing and payment processing) is done by a select few organizations including Sallie Mae, Nelnet and some State guarantee agencies. Under FFELP, companies that originated loans had the option to service them. The Department of Education defined the terms and conditions; including underwriting criteria, loan amounts, interest rates, origination and guarantee fees, repayment plans and interest rate reductions for features such as automatic payment and on time payments.

The Federal Direct Loan Program uses the US Treasury to finance loans. The Department of Education earns revenue when the cost of the funds charged by the US Treasury is lower than the interest rate charge to the borrower, all other things being equal. FFELP relied on private lenders (both for-profit and non-profit) to finance the loans. Lenders would package their loans and sell them in the auction rate security market and earn fees for servicing them. These securities provided higher returns compared to other investments and were considered less risky because the Federal government in the case of default guaranteed them. In 2008 the auction rate security market evaporated after auctions failed, the securities did not sell for the minimum bid price. The Federal government did provide temporary financing with the stipulation that lenders would have to refinance the borrowed money, or give the loan back to the Department of Education by assigning the loan to one of the FDLP servicer. Lenders with access to capital were able to finance the loans they originated, but lenders without access to capital gave those loans back to the Department of Education.

The provisions in the Health Care and Education Reconciliation Act of 2010 reduced the fees paid for servicing the loans made under the FDLP. To reach the break-even point requires large-scale operations and the provision require servicers to have at least 1 million existing customers. Companies with less than 1 million customers could not increase the number of loans serviced to reduce variable costs and average total costs. Public companies like Sallie Mae and Nelnet have the ability to raise money through bond offerings and have a competitive advantage over private companies that can’t sell bonds. Only companies with these competitive advantages will survive the elimination of the Federal Family Education Loan Program.

Eliminating FFELP and replacing it with FDLP shifted the costs from the Federal Government to the individual borrowers. The Federal government did not use projected savings to lower the cost of the loan to the individual borrowers. Instead it used the projected savings to fund other priorities, such as an increase in the PELL grant program. Lenders under the FFELP program used to pay the 3% origination fee charge by the Department of Education on behalf of the borrower. Under FDLP the borrowers must pay the 3% fee. The repayment terms are more generous, but only if the borrower experiences ‘partial financial hardship’ during the loan term which is defined as a percentage of income available for the repayment and is based on income level and family size. Borrowers under this scenario can limit their repayment amount to 10% of their income. The unpaid loan amount may also be forgiven (left unpaid) after 20 years. The elimination of FFELP changed the opportunity set for borrowers. They can no longer consider having the 3% origination fee paid on their behalf. They now have to consider how their current income affects the amount they have to repay. There will be scenarios where borrowers’ income is just lower enough to qualify for the repayment limitations available under FDLP. They will have to consider the opportunity set when considering incremental increases to their income would cause them to lose their eligibility for these repayment terms.

The elimination of FFELP benefited students that receive PELL grants, and experience ‘partial financial hardship’ for the entire repayment term of their loan. It also benefited the large public companies because they can achieve the scale necessary to cover their operating costs with the lower feeds earned through servicing the loans on behalf of the Department of Education. It did not directly benefit borrowers who rely entirely on student loans to financial their education.