Student loan turmoil stresses families

NEW YORK (CNNMoney.com) -- Paying for college is rarely easy, but this year parents and students could have a tougher time securing the necessary financing.

Lenders are dropping out of the federal student loan program because of the continuing credit crunch on Wall Street. Congress has entered the fray as fears mount that conditions will worsen this summer when a flood of students apply for funding.

"The ongoing turmoil in U.S. credit markets ... could leave millions of students in a last-minute dash to secure the financial assistance they need to attend college this academic year," Sen. Christopher Dodd, D.-Conn, head of the Senate Banking Committee, said at a hearing Tuesday.

More than 55 lenders who originate 13% of college loans have stopped making loans in recent months. Financial firms say they are leaving the program because subsidy cuts enacted by Congress last year, combined with the credit crunch that has made it costlier for them to sell the loans to investors, have slashed the market's profitability.

The departures come at a time when lenders are also tightening their standards for private student loans, a smaller but growing segment of the industry.

This doesn't mean funding has dried up, however. The U.S. Department of Education has surveyed schools that could be affected by the exodus and all have found alternative options for their students. There are more than 2,000 lenders in the program, though the 10 largest provide the vast majority of funding.

"We're not seeing a crisis yet," said Sarah Flanagan, vice president for policy development, National Association of Independent Colleges and Universities. "A lot of smaller banks are backing out, but the bigger lenders are jumping in to fill the void."

Flanagan was one of five industry experts who testified Tuesday. She gave a more optimistic view than did two witnesses from the financial industry, who warned that funding applications could overwhelm the system this summer.

No federal officials spoke at the hearing, but Education Secretary Margaret Spellings has said the government is monitoring the situation to prevent a breakdown.

$60 billion for loans

At stake is a $60 billion source of federally-backed funding for college and graduate students. More than three in four families who borrow money rely on the federal program, which includes Stafford loans that students take out and PLUS loans for which parents apply. The government sets the interest rate, currently 6.8%, and Stafford loans are not subject to credit checks. Most students take it for granted that they'll receive the financing.

But that might not be the case in the coming months as lenders' profits are increasingly squeezed. A law enacted last year cut the subsidy that the federal government provides lenders, reducing the margin by as much as 3/4 of a percentage point.

Also, the credit crunch plaguing the mortgage industry has affected college lending. Many lenders finance their operations by bundling student loans into securities, similar to the mortgage funding process. But these days, investors are demanding an interest rate nearly 1.4 percentage points higher than they did a year ago to buy the student loan-backed securities, experts said.

"Right now every loan we make today, we're making at a loss," testified John Remondi, chief financial officer at Sallie Mae, the nation's largest lender. "Every lender is in this same set of circumstances. There's a limit to how much people will lend to Sallie Mae so we can then turn around and lend it at a loss. Not many people are in that business."

Unless the Wall Street crunch eases or the government steps in with funding, families might only have a handful of lenders to which to turn in the coming year.

"There will probably be a mass exit in the next three to 12 months," said Mark Kantrowitz, publisher of FinAid.org, an online student loan resource. "If there is no government intervention or a thawing of the capital markets, by the end of the 2008-09 academic year, I expect there will only be 15 to 25 lenders."

Deeper federal involvement?

Both colleges and the government are getting ready if more lenders pull out.

Since Feb. 29, more than 130 schools have applied to join the education department's Direct Loan Program, which allows students to borrow directly from the government. More than 1,500 colleges are enrolled in the program; that's about a quarter of the number participating in the Federal Family Education Loan Program. Financial institutions provide the funds for the government-backed loans in the latter program.

Lawmakers, meanwhile, have introduced bills that would allow federal officials to inject money into the market and purchase debt from lenders, among other measures. It would also raise the loan limits by $2,000 a year to reduce students' need for costlier private loans. The House is expected to vote Thursday on one proposal from the House Education and Labor Committee.

To alleviate the crunch, Remondi said the Treasury Department's Federal Financing Bank should start purchasing the loans, as it is authorized to do. Not only would this inject liquidity into the market but the government's action would also help restore consumer and investor confidence.

Dodd said Tuesday that he would ask Paulson and Federal Reserve Chairman Ben Bernanke to consider using the Federal Financing Bank or other tools to avert a student loan funding crisis.

At the hearing, Sen. Charles Schumer, D-N.Y., said that there's no reason to panic, but that the government will step in if the industry falters further.

"We will provide some backup," he said. "This is just too important to allow 100,000 people who deserve to go to college not to be there. The markets may come back, and if they don't, we will have to step in."