MEMO To: From: Subject: Date: Interested Colleagues Barmak Nassirian Interest Rate Discussions June 19, 2013

As discussions about the rate formula enter final stages, I thought I'd share some additional comments on the trade-offs involved with the various policy options that might be in play. I'll offer these observations in no particular order, but should point out that beyond the direct impact of each variable, there are significant interactive effects associated with the combination of various options. 1This is the worst possible time for changing the formula from a fixed numerical statutory rate to an index-based rate, regardless of which index is used. This is because interest rates are at historical lows, and given the mandate that any rate change be budget-neutral, any conversion to a formula based on a market-based index would result in a much higher add-on margin than would be needed if interest rates were at more historically typical rates. (Any formula that is budget-neutral within the five- and ten-year CBO budget-scoring windows would in effect overcharge borrowers in the out years, probably by about 2 percent if rates bounce back to their historical levels.) 2In light of the first observation above, a permanent legislative change is ill-advised because it would move the scoring baseline so high that a future correction would carry unaffordable paygo costs on the budget. It would be much wiser to negotiate a temporary five-year policy that would revert back to current law than to fix the issue with an exorbitantly high, but effectively immutable, rate for perpetuity. 3The Administration's criticism of variable rates notwithstanding, formulas that lock the rate for the life of the loan are bound to treat different cohorts of borrowers in a random and nonsensically unfair manner. Locking rates based on market conditions that prevail at the time the loan is taken out would base the true cost of borrowing on luck of the draw, and reward those who happen to borrow when rates are low while punishing cohorts who borrow when rates might be anomalously high. This becomes a real problem in student lending, whichunlike mortgagesdoes not provide refinancing options for those caught in high interest rate loans. In addition, locking rate for the term of these loans does not provide the the lender (i.e., the federal government) the benefit of asset-liability matching, since the federal government does not fund direct loans through a dedicated Treasury auction. A variable rate with an annual reset would be a much more economically logical mechanism of sharing the interest-rate risk between borrowers and the federal government, treating all cohorts of borrowers consistently, and synchronizing the repayment burden with economic conditions that prevail in real time. Those who are skittish about the uncertainties associated with variable rates should recall that we've had millions of borrowers (the 1993-2006 cohorts) in variable-rate loans that reset every July 1, with no adverse impact due to the inability to disclose the exact rate to prospective borrowers. In addition, borrowers from these cohorts who are still in repayment have derived real benefits from the plummeting rates, like a 2.5% rate under today's circumstances. Should a locked rate prove an absolute non-negotiable, serious thought should be given to additional borrower protections like a rate cap or a step-down rate reset that would allow anomalously high rates to be capped or reset once high-rate circumstances pass. Neither of these would be absolutely necessary in a variable rate system, since unusually high rates would, by definition, be temporary.

4Given that the federal government does not match its loan assets with a dedicated (or specific) financing mechanism, a longer-term Treasury index is less efficient than a short-term one. The 10-year T-Note index can neither be justified on the basis of asset-liability matching (since that simply doesn't apply here), nor does it truly match repayment terms. Shorter Treasury instruments are more efficient (and more accurate) because they carry less interest-rate risk. While the resolution of other options (i.e, variable vs. locked) would complicate the choice of the underlying index, a shorter index would generally be preferable. 5Any continuation of the two-tiered sub/unsub rate schemea recent novelty that dates back to 2006should not be financed on the back of unsub or PLUS borrowers. Reducing the sub rate by overcharging unsub borrowers is bad policy because many sub borrowers also have to borrow unsub. Funding a lower sub rate by further overcharging PLUS borrowers is equally as counterproductive because federal policy should encourage reasonable parental borrowing, not discourage it through prohibitive rates that force dependent students (or grad students in the case of GradPLUS) into privatelabel loans. 6Any new interest-rate policy should be evaluated on the basis of its overall distribution of benefits and costs. Many pending proposals have a smoke-and-mirrors quality to them because they provide an illusion of immediately lowering costs at the expense of future borrowers. It is important to judge the impact of any proposed solutions on the basis of projected future costs to borrowers, as well on the internal distribution of subsidies to specific populations. On the basis of all of the above, my own view is that Harkin-Reed is by far the best immediate option, followed by doing nothing (and letting the unsub rate go back up to 6.8%) as a distant runner-up. All of the other proposed options (Coburn-Burr, Administration, House Republicans) carry significant down sides that would have to be addressed to make them palatable. In the unlikely event that this is possible at this late hour, I'd go with the House Republican's choice of index and reset mechanism, narrow the margin to eliminate the unnecessary $3.7 billion surcharge on borrowers, make it a five-year policy and keep the current law as the baseline (this is the most important element of all!) and call it a day. If this proves impossible, I'd push for the 1-year T-Note, pick a revenue-neutral margin with a cap, keep the baseline at 6.8% by sunsetting the policy in five years. In both cases, significant attention has to be paid to fair treatment of unsub, and GradPLUS/PLUS borrowers. While I certainly support the expansion of back-end borrower benefits through improving IBR, I don't believe self-financing of such benefits through higher rates makes a lot of sense, so I'd be very tempted to skip these if the cost has to be borne by the borrowers themselves. I'm traveling and am currently about 9 time zones to the east (where many of you no doubt wish I'd stay), so any comments or questions would best be sent via email. If you need me to call, keep the time difference in mind and let me know how late I can call and give me the right number.