Guarantor Finances 101

Education-loan guarantors, such as USA Funds^®, support services that are critical to the success of the Federal Family Education Loan Program (FFELP), the largest single federal source of financial aid for postsecondary education. These services include:

• Loan-application processing.
• Loan-status maintenance.
• Default-prevention.
• Default-recovery activities.
• Training and policy guidance to financial-aid and education-lending professionals.

In addition, guarantors provide a host of services that promote access to higher education through scholarships, outreach programs and financial-literacy initiatives.

To support these vital activities, most of the nation's 36 guarantors, which are nonprofit organizations or agencies of state government, receive funding based on a model enacted by the U.S. Congress in 1998. Under this model, guarantor activities are financed from two distinct funds: the Federal Reserve Fund and the Agency Operating Fund.

Federal Reserve Fund
This fund consists of federally owned resources managed by the guarantor. The use of these assets is restricted to:

• Paying lender claims. When borrowers default on their loans, the lender submits to the guarantor a claim. If the claim is approved, the lender receives 98 percent of the loan-default amount from the guarantor, which purchases the loan and is then responsible for continuing to recover the outstanding debt from the borrower. The guarantor in turn is eligible for reinsurance of up to 95 percent of the amount it paid the lender on the default. This maximum reinsurance rate is available only if the guarantor maintains an annual trigger default rate of less than 5 percent. If the guarantor's default rate increases beyond this limit, reinsurance can drop to 85 percent and as low as 75 percent. As a result, federal reinsurance does not cover at least 5 percent of the guarantor's outlay for a loan default. To meet this unreinsured expense, as well as other obligations, an additional source of revenue is required. That revenue source is the guarantee fee. Federal law permits guarantors to charge borrowers of Stafford and PLUS loans up to 1 percent of the loan amount as a guarantee fee.

• Supporting the guarantor's default-prevention efforts. When a guarantor successfully prevents a borrower, who has fallen 60 days or more behind in loan payments, from defaulting, the guarantor is entitled to receive a fee from the Federal Reserve Fund. This fee may be paid only once per borrower, even if the same borrower subsequently falls more than 60 days behind in payments again. The fee must be rebated back to the Federal Reserve Fund if the borrower subsequently defaults.

The combination of the unreinsured portion of the loan default, reinsurance rates based on default-rate experience, and the default-aversion fee provide guarantors with strong financial incentives to prevent loan defaults. Importantly, USA Funds invests far more in its default-prevention efforts than it receives in default-aversion fees.

Guarantors are required by federal law to maintain a minimum level of reserves based on the dollar value of outstanding loans in the guarantor's portfolio.

Agency Operating Fund
This fund includes guarantor-owned assets that may be applied to a wide range of initiatives in support of financial-aid-related activities. In fact, a guarantor must support all of its activities, other than the payment of lender claims, from this fund. These activities include:

• Application processing.
• Default prevention.
• Default collections.
• Investment in new technologies to improve the student-loan process.
• Support of other financial-aid or debt-management-related programs.

The Agency Operating Fund receives federal payments designed to cover a guarantor's expenses for administering new and existing loans from origination through repayment. In addition, as an incentive to continue to seek recovery of outstanding amounts due on loan defaults, a guarantor is permitted to retain a small portion of the revenue it collects from defaulted borrowers. The lion's share of guarantor default collections is remitted to the federal government, however.

Agency Operating Fund resources could be used to extend guarantee fee waivers. However, using operating funds to sustain a zero guarantee fee would cost USA Funds between $95 million and $100 million annually and would require USA Funds to sharply reduce or eliminate services, such as training programs for financial-aid administrators, debt-management initiatives, scholarships and other outreach programs, as well as the research and development of enhanced loan-delivery services. These vital services would have to be curtailed for years merely to provide a short-term extension of a guarantee-fee waiver.

Voluntary Flexible Agreements
Under Voluntary Flexible Agreements (VFAs), four guarantors have been granted special exceptions to the rules and funding structures that other guarantors must follow. VFAs were enacted by Congress to give guarantors the opportunity to test innovative practices that ultimately could be extended to all guarantors. Although federal law permits all guarantors to apply for a VFA, the U.S. Department of Education has approved only the four. The most-recent U.S. Department of Education assessment of the performance of VFAs reported that "the results are inconclusive and require a more detailed analysis."

Student-Loan Guarantor-Funding Model
Primary Sources and Uses of Revenue
As Authorized by the Higher Education Amendments of 1998

	Agency Operating Fund (AOF) Assets owned by the guarantor.	Federal Reserve Fund (FRF) Assets owned by the federal government and maintained by the guarantor.
Sources of Revenue	Loan processing and issuance fee based on new guarantee volume. Paid by U.S. Department of Education. Account-maintenance fee based on original principal of all outstanding insured loans. Paid by U.S. Department of Education. Guarantor retention on default collections. Default-aversion fee paid from Federal Reserve Fund.	Pre-existing reserve funds before 1998 amendments to the Higher Education Act. Guarantee fee of 1 percent of new loan amount. Deducted from borrower’s loan proceeds. Federal reinsurance at a rate of 95, 85 or 75 percent (depending on annual default rate of guarantor) of default claims paid to lenders.
Uses of Revenue	Supports application processing, loan disbursement, loan-status management, default prevention and collection, school and lender training and compliance. Also supports student counseling and improved service to students and other program participants by investing in new technology and services, as well as financial-aid awareness and outreach activities and other student-financial-aid-related activities.	Restricted to payment of lender claims and payments to the Agency Operating Fund for successful default-prevention activities.