Best in Class, troubled funding

If I could tell this story well in fewer words and simpler terms, I would. Sadly, the details seem essential.

The collapse of the Best in Class loan program was a very bad thing. The basic story is discussed here and the failure of communication here, but the underlying finances also deserve attention.

Problem I: Cuts in federal fees
The widely circulated explanation is that the Student Loan People were forced into the cancellation by 2007 federal legislation that reduced some fees they received from the federal government.

That's part of the story, but not all of it.

Reading the Financial Statements: Kentucky Higher Education Assistance Authority/Kentucky Higher Education Student Loan Corporation: June 30, 2008, I'm convinced that the Student Loan People had two other major problems. (Click here to download the report.)

Problem II. Federal guarantees and ineligible loans
For several years, the Student Loan People received growing"special allowance" income on loans that were tied to tax-exempt bonds issued before October 1, 1993. Loans financed by those old bonds were entitled to a 9.5% guaranteed return. By transferring loans from one financing instrument to another, a number of lenders claimed that they could expand the total loan amounts eligible for the guarantee. For several years, the federal government paid what they asked. (Source: Money for Nothing, here)

In September 2006, the Department of Education's Inspector General concluded that another lender's claims like that were wrong and and the loans that had been transferred were ineligible for the guarantee. In January 2007, the Undersecretary of Education announced that the Department agreed and that “Other lenders also will not receive payments at the 9.5 percent floor rate until they can demonstrate that their loans come from eligible sources of funds.” (Source: Press release here)

The Financial Statements document continues the story this way:

On January 24, 2007, USDE sent a letter to the Authority/Corporation which set forth the same restatement and also imposed management assertion requirements for any 9.5% SAP billings after September 30, 2006, as well as guidance regarding the audit and certification requirements for those management assertions. A detailed list of management assertions to retain the 9.5 SAP was included in a separate DCL letter published by USDE on April 27, 2007. Due to the nature of the management assertions needed to bill for 9.5% SAP, the Authority/Corporation was unable to make such assertions and therefore lost all 9.5% SAP payments effective for all quarters ending on or after December 31, 2006.

That is, the Student Loan People asked for guarantee payments on a bunch of loans. When the Department asked for proof that the loans were eligible for the guarantee, the Student Loan People couldn't provide proof the Department would accept.

Cash flow from "special allowances" dropped from $42,483,265 in fiscal 2007 to $15,861,119 in fiscal 2008. I believe that's heavily a result of losing the 9.5% payments.

Problem III. The credit crisis
The credit crisis hit student lending long before it swept the headlines last fall. The Financial Statements take three pages to describe the impact, but a few snippets illustrate the danger:

• "Beginning February 13, 2008, all of the Authority/Corporation’s [Auction
  Rate Securities] from that day forward were in failed auction mode, which triggered the maximum interest rate allowed under the related bond official statement."

• "By May 2008, two-thirds of the Authority/Corporation’s [Variable Rate Demand Obligations] were placed with the liquidity provider, creating a need to refinance these debt obligations."

• "In May 2008, that national bank informed the Authority that it was calling the $170 million line of credit, payable in three installments; $83.4 million upon closing of a planned refinancing bond issue, $16.6 million on September 30, 2008, and $47 million on December 31, 2008."

• "On May 1, 2008, the Authority/Corporation temporarily suspended making FFELP loans to new borrowers due to a lack of funds available."

Later in May, President Bush signed a bill designed to free up loan funds. In the Financial Statement's explanation, I think the key phrases are the ones I've highlighted:

The participation program is operationally complex and results in negative cashflow for fiscal year 2008; as lenders are required to use operating reserves to pay all costs related to loans held in the participation trust.... The participation program is a profitable line of business, but the profits must remain in the closed trust until the loans are sold to another financing deal or the USDE and the trust is dissolved.

Reading that, I think the Student Loan People were compelled to tie up money that might, in better times, have helped the Best in Class borrowers. Best in Class was not canceled in the spring of 2007 when the 9.5% was lost, nor in the fall of 2007 when the federal fees changed. It was canceled later, when student loans faced nationwide danger and needed federal intervention to survive.

Bottom line
The mammoth fiscal crisis is the most important reason the Student Loan People could not do what student borrowers expected from the Best in Class program. The loss of the 9.5% guarantees and the reduced federal fees can vie for second place, but the federal fee issue is simply not the main reason Best in Class collapsed.

(Added source note: this Higher Education Watch post alerted me to the other sources I used to understand the ineligible loans. However, I do not agree with the weight they put on the loan problem. Having read their sources and the Financial Statements, I think that development is a smaller factor than the fiscal crisis, though still relevant to the total Best in Class story.)