March 4, 2009

Obama Strengthens Pell Grant Programs

Posted by Aaron Tang at 9:00PM

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In a bold announcement last week, President Obama charted a striking and controversial new course for college access and affordability. The President's proposals were unveiled as part of the Department of Education's 2010 proposed budget, and they contained two major changes to long-standing higher education spending practices.

For starters, the Department is poised to increase its spending on Pell Grants by $17 billion over each of the next two years, which was part of the stimulus bill passed in February. But the Obama administration is going three steps beyond just increasing the amount of money available to the program, which is the government's chief need-based scholarship program to assist low-income families with college tuition (90 percent of the grants go to children from families earning less than $41,000 per year).

The first step is that the administration plans to increase the maximum grant allowance from its current amount of $4,731 in the current school year to $5,500 in 2010-2011. Second, the administration plans to move the Pell Grant program in its entirety from the discretionary portion of the federal budget to the mandatory entitlement portion, ensuring that support for low-income college students will never be cut subject to near-sighted political calculations. Finally, the move would require the annual size of Pell Grants to grow at the rate of inflation plus one percent--ensuring that the aid given to needy students keeps pace with the rising costs of tuition. The move comes at a critical time, as Pell Grants at current funding levels cover only 35% of the cost of college compared to 77 percent just thirty years ago.

In addition to shoring up the Pell Grant program, President Obama took the opportunity to propose sweeping changes to the federal government's college loan policy as well--a proposal that amounts to a solid "Take That!" to the embattled banking industry. As it stands, the federal government provides loans to at-need college students through two different programs. One program, created in 1965 and which provided about four-fifths of all loans to students last year (totaling $56 billion to 6 million students) does so by subsidizing private banks who make the actual loans. In this subsidized program, the private banks who make the loans keep as profit the interest paid by students, but any time a student defaults the federal government steps in and picks up the tab--essentially holding the bank's part of the operation completely risk free. The second program, first created under the first Bush administration and bolstered under President Clinton, offers federal dollars directly to students without the banks in the middle skimming a substantial and risk-free profit margin. President Obama has proposed to eliminate the subsidized program and make all federal loans directly to the students themselves.

Which program is better? Well it depends on who you ask. If you ask the banking sector, the subsidized loan program is better because (privately) it is an easy and major source of revenue for a struggling industry and (publicly) because banks can provide a more efficient loan system through what some have mistakenly labeled a free market. In reality, however, there is nothing "free" about the government loan subsidy market, since it creates an eerily similar perverse incentives problem to mortage backed securities: the group making the loan (banks) have no incentive to guard against default and track down borrowers who are in arrears. On the former front, the banks have been saved by the fact that both loan programs use the same financial aid application process, so borrowers in both programs have the same initial risk of default. But the latter incentive problem has proven all too real: the direct loan program has a student default rate 4% lower than the subsidized program.

That default rate, combined with the handsome profits that banks take off the top (instead of getting those dollars to the needy students) means that President Obama's proposal will save as much as $4 billion a year that can be given to college students who drive our economy and create wealth, rather than the very banks who are partly to blame for our current economic crisis. The plan still has to gain approval in the Congress, where the banking sector's lobbyists have a shot to kill it, but the moment is ripe if indeed there ever were such a moment for reforming a system that disadvantages students and taxpayers to benefit bankers. There's no reason, of course, to spite bankers just for the sake of spite--but when a sound economic decision can help send millions of young people to college, it's hard to find fault in it.

For more on the difference between the two loan programs and why the direct loan program is better, check out this issue brief.