By Megan Barnett, Julian E. Barnes and Danielle Knight
For eight years, students at Michigan State University borrowed tuition money directly from the federal government. But last spring, university officials shucked that arrangement and signed up with private lenders and a state agency that provided loans under a separate federal plan. They guaranteed a profit to the university--something the federal government could not do. Sounds sweet for Michigan State, but it's not so terrific for federal taxpayers, who will almost certainly wind up shelling out $23.5 million more each year as a result of the change.

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Michigan State is not unique. Today, dozens of colleges and universities are abandoning the Department of Education's direct-loan plan, lured by the promise of a quick buck from banks, state lending agencies, and, most significantly, Sallie Mae, the giant private lender based in Reston, Va. In all, 62 colleges and universities have dropped out of the Education Department's direct-loan program since 2000, and the list is growing. Sallie Mae says it has won over $1 billion in loan business from former direct-loan schools. The development is costing the U.S. treasury perhaps as much as $250 million a year, according to U.S. News calculations based on information provided by the government.

The stakes are enormous, for the private loan industry--and for taxpayers. Since last October, under the federal student loan program, 6.3 million students and their families have borrowed a total of $44 billion to help cover the cost of tuition. There are two basic types of federally backed loans: Students can borrow directly from the government--at schools that have signed up with the government's direct-loan plan--or they can borrow from a lender such as Sallie Mae as part of the Federal Family Education Loan Program, or FFEL. Typically, a college or university participates in one program or the other, but not both.

Many education finance experts consider the direct-loan program more efficient than FFEL. Simply put, direct loans cut lenders out of the picture. Instead of paying subsidies to banks for making loans, the government earns the profits. Government figures show that direct loans typically bring in 22 cents for every $100 borrowed, after deducting for administrative expenses. FFEL, meanwhile, costs the treasury $12.80 for every $100 borrowed.

But for private lenders, the FFEL program is a no-lose game. The federal government guarantees repayment of defaulted loans. The loan program, growing each year, can be a hugely profitable business. Sallie Mae, formally known as the SLM Corp., earned $792 million last year, and its chief executive, Albert Lord, pocketed $33.6 million in salary, bonus, and stock option payments the year before (box, Page 40). Its student loan business provided the lion's share of Sallie Mae's profits.

Things weren't always so rosy. Just six years ago, the government's new direct-loan program was gobbling up more and more student business. What to do? For Sallie Mae and other private lenders, the answer was simple: Go for the jugular.

What follows is the inside story of how these powerful private interests turned things around, undercutting the direct-loan program and wooing away big schools like Michigan State. Much like old-time political ward bosses, they used money and favors, along with their friends in Congress and the Department of Education, to get what they wanted. Sallie Mae, for one, engineered changes in education laws that increased its profits and damaged the direct-loan program. One such change, adopted last year, could cost taxpayers up to $8 billion by 2011. Critics of the private lending industry also fault President Bush's education team for undercutting direct loans. Says Barmak Nassirian, an official of the American Association of Collegiate Registrars and Admissions Officers: "The administration is causing a slow strangulation of the direct-loan program."

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