Senator Dick Durbin held a hearing on March 20th to highlight America’s education lending problem and advocate his proposed legislation, the Fairness for Struggling Students Act.
Durbin’s legislation proposes to make private education loans dischargeable through bankruptcy, as they were pre-2005. Restoring the ability to discharge education loans is a smart move. It would encourage lenders to play smart with their money and play nice with borrowers. By removing default risk from lenders’ risk analysis, the bankruptcy code’s special treatment of student loans encourages lenders to disregard students’ (and their parents’) ability to repay. It also encourages abusive collection methods, since private lenders have no incentive to work with struggling borrowers. Even in bankruptcy, lenders can garnish your wages, social security, or even that practitioner’s license (law or medical) that you went to school for in the first place.
For background, when Congress, heavily lobbied by creditors, changed the bankruptcy code in 2005, an unnamed lawmaker slipped in a special exception for private education loans. This change made private education loans non-dischargeable except in very rare circumstances. This move lumped student borrowers with criminals who owe taxes, alimony, and child support. Private education loans are a form of unsecured credit (no collateral) just like credit cards or car loans. There’s no reason they should get special treatment.
Opponents of this bill worry about bankruptcy abuse and a potential increase in borrowing costs. One might say, what discourages a dishonest person from taking on debt and intentionally discharging it through bankruptcy? Well, why not make all types of debt non-dischargeable then? The purpose of bankruptcy is to offer the honest debtor a fresh financial start. Also, the bankruptcy abuse provisions added in 2005 should satisfy any concerns of moral hazard on behalf of borrowers. There are means tests to ensure that able-bodied, high-earning debtors don’t ditch their debt intentionally. Concern of moral hazard is more appropriately aimed at education lenders, who have been coddled with recollection rights that traditional creditors would drool over. Mark Kantrowitz, publisher of FinAid.org, says, “credit card companies collect less than 10 cents on the dollar of every bad loan while the federal government gets 85 cents. The borrowers are on the hook more than the government or taxpayers.”
Opponents of the bill also assert that lenders will deny more loans or increase interest rates to compensate for default risk. Stanford University Law professor, Marcus Cole, believes that allowing discharge would "result in a dramatic increase in the cost of student loans for all borrowers, ultimately drying up the availability of such loans for those who need them most.” He called Senator Durbin’s proposal an "unjust transfer from innocent lenders who did nothing more than give money to people in hopes of being repaid someday."
On the contrary, the current bankruptcy code disproportionately impacts minorities and low-income families to a detriment. Exempting discharge inappropriately removes the incentive for proper risk analysis. Saying that the government should exempt education loans from discharge to keep interest rates low is like saying Fannie Mae should insure our mortgages again. Cheap loans are only good if borrowers can repay. Assessment of borrowers ability to repay is a lower concern when the debt is non-dischargeable (given, students’ ability to repay is hard to measure, since most have low or no income). Student loans, like mortgages, are securitized, sliced up, and sold to a secondary market of investors (aka, SLABS, student loan asset-backed securities). Investors will back away from these securities if they are dischargeable, leaving high-risk students with less debt. Furthermore, student lenders will be less likely to engage in abusive collection methods if borrowers have the ability to discharge. The shared consequences of default (the lender’s lost principal and the borrower’s damaged credit) create an incentive for lenders to work with borrowers.
When things go right, student loans can be a great thing. As a first-generation college student myself, they seriously can make dreams come true. Unfortunately, lending has reached a point where student families are steered into loans that they are unlikely to repay. Several for-profit colleges actually operate on a business model that signs up students for terrible private loan terms, even when their cheaper, less risky federal loan eligibility has not been exhausted. In exchange, they receive a worthless degree and a fat liability. For-profit schools only enroll about 10% of the country’s students but account for nearly half of all loan defaults.
Because the bankruptcy code offers special treatment to student loans, the struggling student borrower has become the modern indentured servant (let’s not forget their cosigners too). If Congress does nothing by July, interest rates on federal student loans will double. More importantly, this summer brings an opportunity to shine light on America’s second debt problem of the century. To avoid repeating the financial mistakes that led into the last recession, Senator Durbin’s bill is a common sense move. Restoring the ability to discharge education loans will encourage lenders to play nice with borrowers and play smart with their money.