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The investment banking industry – and its friends in Congress – have cooked up that they say would reduce the federal debt and cut federal spending. Supposedly, the plan would take the government’s $555 billion direct student loan holdings off of its books. In reality, the plan, which would allow the bankers to earn fees on a $555 billion deal, plus $100 billion more every year, would not reduce the debt or cut spending. But that hasn’t stopped Wall Street from trying.

A proposal that could only have been be cooked up by investment bankers is circulating on Capitol Hill. It would refinance the $555 billion direct student loan portfolio with new debt backed 100 percent by the federal government. But this new debt would not be called U.S. Treasury debt, despite the 100 percent guarantee, and therefore not counted as part of the national debt. In other words, the new debt would be used to pay off the old debt (Treasury bonds) that the government issues to finance direct student loans. To be sure, the mechanics of the proposal are more complicated than that, but the effect of the proposal would be to move all outstanding and future student loans from bonds backed 100 percent by taxpayers to another set of bonds backed 100 percent by taxpayers but not counted as part of the national debt.

That wouldn’t be quite so ridiculous of a proposal if it didn’t also increase spending and increase the annual budget deficit. In other words, the phony debt reduction that the proposal is based on would come at a significant cost to taxpayers compared to the status quo.

So it is particularly puzzling that the sponsors of the proposal have pitched it to the Joint Select Committee on Deficit Reduction (the “supercommittee”) which is charged with finding ways to reduce the deficit by $1.3 trillion over 10 years. Even the most financially-challenged member of Congress knows you can’t reduce the deficit by increasing spending.

The proposal would increase federal spending because the new securities the government would issue to finance direct loans would have higher interest costs than the Treasury bonds they would replace, effectively increasing the cost of every direct loan. Investors would view the new securities as slightly less desirable than Treasuries (even though they still carry a 100 percent guarantee from the federal government) because they will not be as liquid (easily bought and sold among investors). The new securities would also be subject to prepayment risk – the risk that an investor loses interest income when he buys a 20-year security but gets repaid sooner when a borrower pays off his student loans early. Treasury bonds don’t have any prepayment risk. Then there are the fees that the government would have to pay to investment banks (the “syndicate of underwriters”) to put the new securities on the market each year. Those fees could cost taxpayers tens or even hundreds of millions of dollars every year.

The proposal’s sponsors argue that the new securities are needed to “diversify funding sources” for the direct loan program because “Treasury securities may not always be an attractive option” and don’t provide “stability” for the program. In other words, someday investors might not want to buy U.S. Treasury bonds, or they may demand high interest rates to do so, and that would be bad for the direct loan program.

This is a longshot argument. Again, even the most financially-challenged member of Congress has to wonder why an investor who balks at buying a bond backed by the U.S. government would buy a security backed by the U.S. government used to finance student loans. Both bonds are guaranteed by the same entity and therefore have the same likelihood of default.

Some members of Congress – particularly Republicans – would simply feel better if the direct loan program were funded with “private capital” rather than U.S. Treasury bonds. This is a common refrain. These lawmakers might see the direct loan refinancing proposal as bringing private capital into the program. But the “private capital” argument is a distinction without a difference. All capital is private since someone in the private sector has to earn it before the federal government can tax it. What’s more, the same private sector investors who purchase U.S. Treasuries would no doubt purchase the same securities issued to refinance direct loans. In other words, the securities would be sold in the same markets as Treasury bonds and the capital raised to finance direct student loans would be no more or less “private” than it was before.   

If the Wall Street proposal to refinance direct student loans doesn’t actually reduce the debt, increases the federal budget deficit, and doesn’t make the program’s financing any more dependent on the private market than it already is, what does it do? It effectively addresses what some see as the direct loan program’s biggest shortcoming; it doesn’t allow Wall Street to make a ton of money off of it.