Federal Student Loan Servicing: Contract Problems and Public Solutions

Abstract

One consequence of the 2007-2008 financial crisis was an abrupt shift from bank-based to direct federal student loans. This momentous change required the Department of Education to rapidly establish the capacity to service loans, which was achieved by outsourcing this responsibility to four large for-profit firms and a group of smaller regional entities. Loan servicing involves routine payment processing, account management and borrower communication, as well as the non-routine yet more labor intensive role of assisting borrowers that face hardship with debt repayment.

Borrowers have expressed dissatisfaction with the present system. Complaints jumped significantly in the first two years of the loan servicing contracts and remain at historic highs. Problems with loan servicers have been a significant factor in these complaints. Both the Education Department and the Consumer Finance Protection Bureau have identified questionable practices regarding how servicers process and credit loan payments, and their failure to provide adequate advice and assistance for borrowers with delinquent and distressed loans.

To understand why the system is underperforming, we examine the public-private contracting system for student loan servicing, and conclude that the contract terms establish incentives to reduce operational costs that far outweigh the incentives to be responsive to the needs of borrowers. This case illustrates the inherent limitations of performance-based contracts as an administrative tool. Regardless of design, contractors will strive to minimize operational commitment to any labor-intensive task, in this instance attending to the personal needs of borrowers.

We identify two remedies improving the efficiency and responsiveness of student loan servicing. The first is more robust contract monitoring and contractor performance oversight by the office of Federal Student Aid (FSA). The second is the establishment of a public loan-servicing unit that would raise standards by competing against the private loan-servicing agents. While these two options are not mutually exclusive, we view the latter as having the greatest potential to improve the student loan servicing system. The concept of loan servicing as a government function is not novel. The Department of Agriculture, for instance, successfully issues and services farm loans. A similar function can be established within a federal agency for student loans. The loan servicing function could be added to FSA's existing role under the Direct Loan program, or assigned to another federal agency, such as the Treasury Department or the Internal Revenue Service. We identify some particular advantages in assigning this function to the United States Postal Service, which has a history of providing financial services, manages an accessible retail network, and enjoys a favorable image among the public.

Keywords: student loans, government contracting

JEL Classification: E61, H11, H52, H81, I22, I28, L33