Government raising rates for students, but cutting them for lenders

Last week, 7 million Americans received a most unwelcome early July 4 present: The interest rate on their federally subsidized student loans doubled to 6.8 percent.

While the government raises interest rates for college students and graduates, it is continuing to provide hidden subsidies for private student lenders.

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What’s even more remarkable is that these subsidies are coming through a Government Sponsored Enterprise (GSE) whose original mission was strictly to support small, community banks in making mortgages. This is not Fannie Mae or Freddie Mac, but the “other” GSE: the Federal Home Loan Bank system.

Congress created the system in 1932 to help provide a secondary mortgage market for thrifts, which back then were very different from commercial banks. The system was made up of 12 regional Home Loan Banks, similar to the Federal Reserve Regional Banks. The original law limited each Federal Home Loan Bank (FHLB) to accepting only mortgages for middle-class homes as collateral from member thrifts, which, by their nature, were institutions based in the same region. In fact, what became Freddie Mac originally started as an internal company within the FHLB system. Freddie was privatized to cover the incredible losses resulting from the savings and loan debacle of the 1980s (savings and loans were another kind of thrift).

The FHLB system has many special features that allow it to access funding incredibly cheaply. The government grants it first-in-line status in any bankruptcy, ahead of the Federal Deposit Insurance Corporation and taxpayers; the most unique feature, however, is that the FHLB system issues debt with joint and several liability for all FHLBs. This means that the debt of any one bank is really the debt of the entire system, backed by its membership, which includes just about every major financial institution in the country.

This is no small system. FHLBs provided $1 trillion of liquidity during the run-up to the financial crisis, with troubled lenders like Countrywide and Washington Mutual among their largest lenders. Talk about systemically important! 

So how in the world did this system end up funding private student loans? Sen. Elizabeth Warren (D-Mass.) raised this question, asking why the FHLB of Des Moines, Iowa, was providing extremely low-cost funding to Sallie Mae, a Delaware-based company whose main product is private student loans. How could this action possibly be consistent with the mission of the Des Moines FHLB, which, according to its website, is: “To provide funding and liquidity for the Bank’s members and housing associates so that they can meet the housing, economic development and business needs of the communities they serve.”

There were significant regulatory problems with the FHLB system in the prior decade, as evidenced by the chairman of the regulatory agency in charge of the banks being indicted for lying to Congress. Congress responded by eliminating that regulatory body and transferring regulation of the FHLB system to the Federal Housing Finance Authority, which also regulates Fannie and Freddie.

The FHLBs have a government charter to access cheap money. The question is whether they are using this special right to accomplish their mission or just to make additional profits for their members. Warren is right to ask how this relationship of providing cheap funding to Sallie Mae is accomplishing the mission of the FHLB of Des Moines. How is this helping homeowners or potential homeowners in Iowa? It could be promoting additional private student lending, adding to Sallie Mae’s profits and potentially creating liability for taxpayers. If the default were severe enough, the debt of the Des Moines bank is the debt of the entire nation’s system.

I don’t mean to pick on Des Moines. To be fair, that FHLB managed its book of business during the financial crisis far better than other FHLBs like Seattle, which became inadequately capitalized during the crisis. That should not be surprising given all of the problematic lending made by such West Coast thrifts as Countrywide, Washington Mutual and IndyMac, all of which borrowed heavily from the FHLB system to finance their toxic mortgage products.

The Treasury Department proposed reducing the FHLB portfolio, putting a strict limit on advances to any one institution, and better focusing their efforts on helping small- and medium-sized banks provide mortgage credit to their communities. These are worthwhile suggestions.

We must be vigilant against any mission creep from a GSE that is using its government-granted privileges to provide very cheap funding to those offering a financial product that experts are calling a potential time bomb. We’ve seen how that plays out. Let’s hope that we can learn from our mistakes.

Klein is the director of the Bipartisan Policy Center’s Financial Regulatory Reform Initiative and is a former deputy assistant secretary at the Treasury Department.