WHEN the federal government opened shop two years ago as a provider of education loans, shaken private-sector lenders in Texas raced to improve the quality of their service to students in order to remain competitive.
''For the first time, competition has entered in,'' says Nancy Cotton, spokeswoman for the Texas Guaranteed Student Loan Corporation (TGSLC), which helps banks lend to students.
Now the future of direct lending is threatened by a Republican-led Congress. Opponents portray as adequate the old system of low-interest bank loans that the government guarantees to repay if the student defaults. Advocates say the Texas experience shows why direct lending is needed.
Nationwide, 2 million students at 1,400 schools have borrowed from the Department of Education. Student loans of all types will reach $24.6 billion this school year, with direct lending accounting for 40 percent, the maximum allowed under current law.
Republicans in Congress last week agreed to restrict the program to 10 percent. In a response Wednesday, Education Secretary Richard Riley said the department couldn't run the program efficiently at even double that level. ''Ten percent is effectively killing direct lending,'' he said.
Direct lending is dealt with in the Republican-designed bill to balance the budget in seven years, which the president has threatened to veto on several grounds. The administration has warned Congress not to cap direct lending. ''Let it compete straight up,'' urges Education Undersecretary Marshall Smith. Since by law interest rates for direct and guaranteed lending are the same, the programs can compete only on the basis of service.
Direct lending is regarded as a signature program of President Clinton. Once he intended it to take over the entire student-loan business, which would have, in essence, made the Department of Education a major bank.
Lost to some 8,000 real banks would have been the market for government-guaranteed student loans, their second-most-profitable lending line after credit cards. Guaranty agencies and secondary markets, which play a role in the guaranteed-loan program, would also have been shut out.
The administration criticizes the multiple players in guaranteed lending as greedy middlemen who provide poor service for high profits with little risk. Guaranteed lenders say the threatened Education Department sees salvation in direct lending. But its 300-person lending bureaucracy lacks the expertise and profit incentive to carry out the mission efficiently, they charge. Both sides claim they can do the job at the lowest cost to taxpayers.
Elbert Barreda, director of financial aid at the University of Texas-Brownsville, says ''not unless I were forced'' would he switch his students to direct loans. One reason is an experiment this fall that shortened getting a bank loan to five days instead of three weeks.
That improvement, however, merely moves guaranteed lending closer to the convenience of direct lending. And the experiment's originators at the TGSLC admit being driven by direct lending's potential threat.
In Texas, the TGSLC decides which loans to guarantee, duns deadbeats, reimburses lenders for defaults, and itself is reimbursed by the federal government. Like 40 other such entities around the country, the TGSLC is nonprofit but very committed to survival, Ms. Cotton says. Direct lending was ''definitely an impetus'' to TGSLC to improve its performance. That's why defenders of direct lending want it to survive. ''If the competition is not there, what is the incentive'' for guaranteed lending to improve? asks Claire Roemer, the district coordinator for financial aid at Tarrant County Junior College.
Ms. Roemer says she switched the school entirely to direct lending because the Department of Education is much more responsive than banks. She cites, for example, direct lending's state-of-the-art, on-line system. With guaranteed bank lending, ''you were burying yourself in paper.''
Cheri Whitten, a Dallas banker who is a past president of the Association of Texas Lenders for Education, insists that major banks went on-line with guaranteed loans five years ago. ''We can compete with direct lending,'' she says.
In the TGSLC experiment, applications for guaranteed loans are received on-line from UT-Brownsville, approved, and returned in under two minutes. Students leave Mr. Barreda's office with a laser-printed confirmation that any banker will lend against.
But that is just a pilot project at one school, says Roemer. ''What about the rest of us?'' Cotton says that having proved successful, the project will be tried at other schools this year and statewide next year.