(MONEY Magazine) – It took 10 years, but last fall Gary Lynn (right), a 34-year-old marketing consultant in Troy, N.Y., finally paid off his $9,959.62 in student loans. Or so he thought. The U.S. Department of Education (DOE), for its part, still considers Lynn a deadbeat. In dispute is some $12,361.50, including $8,891.25 in principal and interest as well as $3,470.25 in collection fees. Says the DOE: Lynn's partial payment is ''gratuitous.'' As far as the agency is concerned, he owes a total of $22,321 on the four 1982 loans (totaling $9,959.62) that he defaulted on in 1985. What caused Lynn to pay up the principal? Possibly the fact that the DOE has begun identifying loan defaulters to credit bureaus. As a result, Lynn couldn't qualify for a mortgage, a car loan or even a credit card. An indignant Lynn insists: ''Of course I knew I owed the money, but I wrote about a dozen letters to faceless, nameless people and could never find out how much I owed or to whom. At one point I was even getting bills from two different creditors. Then they got my account confused with another student's loan. I called more than 20 times asking for information. But when the collection agency finally called me last year, all they said was, 'Look, you are seriously delinquent, and we're going to start proceedings against you.' '' Lynn figures he shouldn't have to pay interest or penalties for the years he tried to sort out the confusion. Responds Daniel Oppermann, director of the DOE's San Francisco collection office: ''Such letters are immaterial. He owed principal, interest and fees, and he kept trying to lowball our efforts to settle.'' No doubt government agencies can be maddeningly bureaucratic and autocratic. ''The managerial competence of the Department of Education is a real question mark,'' says Thomas Wolanin, staff director of the House Subcommittee on Postsecondary Education. ''We are not talking here about a well-oiled machine.'' Doubtless too, Lynn knew he was behind on his student loan payments and that the clock was ticking on interest fees. Wherever the blame belongs for Gary Lynn's messed-up student loans, one fact is clear: When his loans defaulted seven years ago, the U.S. Treasury paid off the bank that originated the loans with revenues collected from ordinary taxpayers like you. And, unfortunately, that's hardly unusual. Out of the estimated 38 million current student loans, one in five will be paid by the Treasury -- for a tab of $3.4 billion this year alone. All told since 1965, when the Higher Education Act created the loan program, taxpayers have footed the bill for around $17 billion in defaulted loans -- and these numbers are mounting fast. Born in the heady days of Lyndon Johnson's Great Society, the federally insured student loan program guaranteed bank loans to help high school graduates from lower- and middle-income families get higher education. To entice lenders to participate, the government assumed all financial risks. While the student attended school, the government paid the interest on the loan. After graduation, the student began payments, usually at 8% interest for the first four years and 10% thereafter. And in the unlikely event the student defaulted, the feds paid off the lender with revenues collected from taxpayers. No one envisioned wholesale defaults. But, relieved of risk, many lenders didn't police their federally insured student loans aggressively. Students, who were often first-time borrowers, repaid their loans slowly or not at all. And inexorably, the DOE lost control of the program. The grim facts: -- There have been 62 million loans made since 1965, and an estimated 10 million students have defaulted. From 1988 to 1990, the annual default rate has climbed from 17% to 20%. -- With tuition, fees, and room and board running $10,000 to $20,000 a year at most four-year private colleges (up from $5,947 in 1981) and averaging $5,500 at public colleges, more applicants than ever are seeking federal loans (maximum four-year limit for undergraduate students: $17,250, up from $10,000 in 1986). ''We have created a new indentured class in the United ) States -- the student debtor,'' says Rep. William Ford (D-Mich.), chairman of the House Education and Labor Committee. -- A 1991 General Accounting Office study indicates that more than 25% of the defaulters earn enough ($15,000 or more) to make loan payments. ''There are a lot of people who make a sport out of trying to beat the system,'' says Dallas Martin, president of the National Association of Student Financial Aid Administrators. -- The taxpayers' bill, an estimated $3.4 billion in 1992, is up from $200 million in 1980. At the same time, this year the government will hand out nearly 5 million new student loans worth nearly $14 billion. That turns out to be more than double the number of loans awarded in 1980 -- and almost triple that year's money. And given America's dreary job prospects, the stage is set for more dramatic default rates. The student loan debacle is ballooning into another taxpayer- financed bailout, as if the S&L scandal weren't enough. There will, however, be an opportunity over the next few months to rework the federally insured loan system into a credible program that not only lends money to deserving students but also gets paid back. Every half-dozen years, Congress must renew the Higher Education Act and its provisions. The looming deadline: before Sept. 30 of this year. So you may want to press your congressional representative to turn off the faucet that's leaking taxpayer dollars. There are several possible solutions, but in order to understand the different choices, you need to know how the present system went wrong. The basic idea behind the federal program, of course, was admirable. If more students had paid back their loans, the effort would be labeled a success today. But they did not, and therefore it cannot. While the program surely helped some people -- college graduates earn about 99% more than high school graduates do -- it has hurt others, notably taxpayers. Why have defaults exploded? Fraud is part of the answer. Callousness accounts for much of the rest. Since 1980, when the government program was amended to allow students who have not completed high school to get student aid, federal loans have proved a bonanza for trade school operators who simply take the money and run. And don't think trade school swindlers are found only in beauty academies and air- conditioner maintenance courses. They also operate business and computer- training schools. From 1982 to 1988, loan volume to trade school students increased sixfold. At the same time, the number of DOE reviews of schools eligible for aid fell from 721 in 1984 to 417 in 1986. The result: Today, trade school students account for around 35% of defaults, and the numbers continue to increase. The DOE's weak oversight has allowed scam artists to prey on students like Angela Jones. During the summer of 1987, Jones, now 23, enrolled in the American Career Training Travel School (ACT), a Pompano Beach, Fla. school for would-be travel agents that's partly correspondence and partly in-residence. Through ACT's participation in the student loan program, Jones obtained a $2,415 guaranteed student loan to pay for her yearlong course. Jones claims ACT mailed her only a fraction of the course work. In October 1988, ACT sent Jones a notice that her enrollment was canceled because she hadn't completed the course work. Today the school, which no longer accepts students, is under investigation by the FBI on charges of fraud. ''ACT got me nowhere but into debt,'' Jones told a Senate subcommittee in February 1990. Otherwise honest lenders have exploited the program too. According to a recent DOE study, student loans are the third most profitable type of lending, beating out both car loans and mortgages. Secure in the fact that the loans are risk-free for them, some lenders put little effort into collecting. They know that if a borrower goes for six months without making a payment, the government will pay them back -- with interest -- and that they will have avoided the high cost of servicing the loan. ''It is convenient when a loan gets in trouble to hand it back to the feds, get their money and get out,'' says Robert Atwell, president of the American Council on Education. Take the case of Katherine Reardon, 38, of Fairfax, Va. From 1986 through 1988, while Reardon studied music at Sonoma State University in Rohnert Park, Calif., she borrowed $6,500 in federally guaranteed student loans from the Great Western Bank in Northridge, Calif. After graduation, when her loan came due, Reardon says she asked AFSA Data Corp., the firm servicing her loans, for a six-month grace period. She says AFSA sent her two different forms, which she signed and returned. One was for an unemployment deferment (no payments or interest for six months), and the other was a forbearance (no payments, but interest accrues). AFSA officials, however, rejected her deferment because she didn't send proof of unemployment, and then accepted her signed forbearance. | Reardon claims she thought both papers were for deferments, and AFSA never told her otherwise. Although Reardon has made her regular $78 monthly payments, she stubbornly refuses to pay the $94 in interest that accumulated during the disputed six- month grace period. And AFSA, likewise, refuses to waive that $94 interest. ''I have spent a ridiculous amount of time and money trying to get AFSA to fix my problem,'' says Reardon today, ''but all they have done is harass me.'' If the adamant Reardon misses just one monthly installment, her loan could default. That would be bad news for Reardon, whose credit record would be stained -- but not bad news for the original lender, the creditor that bought the loan, nor for AFSA. The three of them would be rid of her. The taxpayers would pick up her tab instead. Sometimes, even the most cooperative students end up delinquent. This year, the pressure of paying back loans is particularly daunting for graduating seniors, who are entering the worst job market in a decade. Laura Singel, 22, is typical. She graduates this month from DePauw University in Greencastle, Ind. with a degree in psychology and Spanish. The first in her family to attain a college degree, this youngest daughter of an Elk Grove, Ill. fire department captain qualified for $38,000 in government grants, scholarships and work-study income. ''Even with all that, there was absolutely no way I could have paid for my college education without that $14,000 in student loans,'' explains Singel. Now, with no savings and few employment prospects, she'll owe $1,970 to her lenders by the end of 1993. ''I'm getting really scared,'' says Singel. ''Am I going to get a job? Will I earn enough to be able to pay?'' Another reason for the rising tide of defaults rests at the DOE's door. A 1989-90 Senate investigation headed by Sen. Sam Nunn (D-Ga.) blasted the department for running a multimillion-dollar loan operation with a computer data system that contained incomplete, inaccurate and unreliable information. ''For more than 15 years the department has tried to build a student loan data base and failed over and over again,'' says the Council on Education's Atwell. ''They have absolutely no idea who is holding loans or where they live.'' Nor has the DOE kept tabs on the 10,000 primary lenders and the 64 institutions operating in the secondary market. These firms, such as Sallie Mae (Student Loan Marketing Association), purchase loans from the original lenders and service them. As one result, Senate investigators found that eight out of 10 lenders were not following DOE procedures -- for example, mailing at least six collection notices to a borrower within a six-month period and making ''diligent'' phone calls to collect before declaring a loan in default. Testified chief investigator David Buckley: ''We were told, time and time again, that given the profits being made, there is inadequate government oversight of the lenders.'' The DOE claims to have made improvements since the Senate report. Lamar Alexander, Secretary of Education, says: ''We have asked lenders to offer realistic repayment options and keep better records to track down defaulted borrowers.'' Among the DOE moves so far: -- Beginning this year, a new ruling will prevent schools whose student bodies run up default rates over 60% from offering federally guaranteed loans. At the urging of Sen. Claiborne Pell (D-R.I.) and Rep. William Ford (D-Mich.), the Senate and House each passed a bill early this year that would cut off loan money for students at schools that have default rates higher than 25%. -- The DOE is developing a computer system that will track all borrowers' payment records and Social Security numbers. The network is scheduled to be up and running by 1993. The Internal Revenue Service has been scooping up student loan defaulters' income tax refunds (regardless of how long ago they defaulted) and sending the money to the U.S. Treasury since 1984. By December, the IRS will have collected an estimated $451.9 million this way from about 730,000 deadbeats. -- The DOE has started turning over defaulters' Social Security numbers to the three dominant credit bureaus (TRW Information Services, Equifax and Trans Union). If you have ever been plagued by a bad credit report, you know just how difficult that can make life. ''We really wreck them,'' says Jean Frohlicher, executive director of the National Council of Higher Education Loan Programs, an association of loan servicers and secondary market firms. Clearly, tougher penalties for defaulters and tighter screening of schools and lenders can start to clean up this mess. But there's more work to do. Congress and the DOE should: -- Force the lenders to take more responsibility for student loans. The best way to achieve that is to stop reimbursing them 100%. One idea: 80%. ''This would surely heighten the lenders' interest in reducing defaults,'' says Sen. Nunn. -- Create an information clearinghouse. ''Students need a single source to call to update their status, clear up problems or locate the holder of their loan,'' says Sallie Mae's chief executive, Lawrence Hough. -- Require colleges and universities to make sure students truly understand their loan responsibilities. -- Make the interest on college loans tax deductible. This proposal, put forward by President Bush in his State of the Union address, would help millions of young people repay their debts. For example, the deduction would save Singel, who faces yearly bills of $1,970, nearly 10%, assuming she is in the 15% tax bracket. And that 10% might be just enough to save you, me and our fellow taxpayers from having to swallow yet another tuition bill.