As part of the effort in the 1970s to ensure that loans would be available for all eligible students, provisions were included in the Tax Reform Act of 1976 to encourage states to issue tax-exempt student loan bonds. In the years that followed, states established more than 30 student loan authorities. These authorities sell both tax-exempt and taxable bonds and use the proceeds to make loans to students. Authorities also buy loans from banks to encourage them to make new loans, instead of lending directly to students, and thereby encourage banks to make new loans to new students.
Congress made states eligible for full federal subsidy payments, the same as all other student loan providers, even though the loan authorities would have the advantage of raising capital to be lent out to students from low-cost, tax-exempt bonds. Congress also gave states relief from the “arbitrage” tax rules.
Typically, the federal government limits state profits on tax-exempt bonds by requiring state and local governments to rebate excess returns (above 2 percentage points for student loan bonds) to the federal government. However, in 1976 Congress excluded the federal payments from the arbitrage calculation.
Before long, states were issuing bonds at 6 percent interest while earning up to 16 percent interest on student loans. A Congressional Budget Office (CBO) study predicted that the bonds would cost taxpayers as much as $500 million a year, including both tax benefits and federal interest payments.
In 1980, Congress did just that. It halved federal subsidy payments to lenders on loans funded with tax-exempt bonds. States argued, however, that they make long-term commitments to bondholders. If interest rates dropped too low, they said the student loans would not bring in enough income to make payments on the bonds and to cover administrative expenses. So Congress guaranteed a minimum return of 9.5 percent.
Congress did not intend for the student loan bonds to be immensely profitable—only profitable enough so that states would participate. But almost immediately after they were created in 1976, the bonds were earning huge profits for the loan authorities. Ever since, the Federal government has been trying to rein in the problem, but the efforts have often failed or even backfired, compounding the initial error.
P.S. The portions highlighted in red are a VERY IMPORTANT component of this story REMEMBER THEM….Just in case that slipped by everyone.
 Money for Nothing • Skyrocketing Waste of Tax Dollars • A Report by TICAS:The Institute for College Access and Success