[Editor's Note: the following article is a condensation of a much more extensive paper on this subject by the author.  You can read the full article here.]

Recently, Peter Zuckerman published a piece arguing for the repeal of USC 523 (a)(8) -- the student loan exception to a debtor's ability to discharge debt under the US. Bankruptcy code.  The argument Zuckerman puts forth, while strong and compelling, does not take into consideration the systemic consequences that removing bankruptcy and other protections appear to have had on the lending system.

By removing the threat of bankruptcy (as well as statutes of limitations, usury laws, and other consumer protections that exist for all other loans), and establishing a very lucrative compensation system for the collection of defaulted loans, the largest lenders, all of the guarantors, and likely even the Department of Education now make more revenue from defaulted loans than loans that remain in good stead.  This is a very significant and troubling fiscal environment that appears to correlate to all manner of systemic faults and failings in the federal lending system.  This is a key point that frequently goes unacknowledged in public discourse on this issue, but shouldn't.

While it's a bit unclear whether the fiscal preference for defaults extends to the Direct Loan program [Ed. Note: These are loans made directly by the Federal Government].  It is quite clear for the FFEL program [Ed. Note: These are loans that were made by private lenders, but were subsidized and guaranteed by the Federal Government.  Though this program was terminated a few years ago, many billions of FFEL debt remains outstanding].  Large FFEL Program lenders like Sallie Mae and Nelnet own collection subsidiaries, which are allowed to keep almost 20% of every payment on a defaulted loan before applying the payment to principal or interest.  Because lenders are reimbursed nearly full-book value on defaulted loans, there is really only upside for defaulted loans compared to loans that remain in good stead.  It's a "second bite of the apple," so to speak .  Sallie Mae cites collection costs on these loans prior to defaulting as the reason they would prefer that loans not default.  But this claim really doesn't hold up under scrutiny.

Guarantors derive, on average, about 60% of their income from penalties and fees from defaulted loans.  Therefore it is even less controversial to claim that guarantors have financial preference for defaults, than the analogous claim for lenders.

Supplemental materials in the President's 2009, 2010, 2011 budgets (and prior) show that for every dollar paid out by the federal government for defaulted Federal Family Education Loan Program (FFELP) student loans (which comprise a large majority of all outstanding student loans), the Department of Education recovers $1.22 (we assume this is before collection costs, and the government's "cost of money") .  Making generous assumptions about these costs still leaves a significant amount of profit on defaults that isn't realized for healthy loans.  The savings on subsidies and the ending of spread payments that a defaulted loan triggers makes defaults even more attractive from the Department of Education's perspective.

   

To be clear:  Any lending system where the lender would rather a loan default than remain in good stead is unacceptable.  It would tend to promote bad loan administration, inaccurate reporting, and a plethora of other systemic failings.  It would also tend to push up the price of the commodity being purchased if the lending system finances a significant portion of the market.  And indeed this bears out in the case of student loans.

For example:  It is a matter of record that lenders actually defaulted student loans without even attempting to collect on the debt.  In 2000, Sallie Mae paid $3.4 million in fines as a result of the U.S. Attorney's office discovering that the company was invoicing for defaulted loans where the borrower was never contacted.  Rather, records were fabricated to indicate that the borrower had been contacted.  While it is unclear how common this type of behavior is across the industry, we do know that other lenders have been found to be making similar false claims.  That it happened at all demonstrates perverted fiscal motivations, however.

Another example: Despite repeated claims by the Department of Education, the student lending industry, their lobbyists, and the universities that default rates were relatively low, it turns out that they were being vastly undercounted.  This is a fact that the Department of Education, lenders, and universities are loathe to acknowledge even today.  The public is routinely mislead about a school's default rates, and the Department of Education does essentially nothing to correct this.

Also, most citizens with outstanding student loan debt were never informed that bankruptcy protections, statutes of limitations, truth in lending requirements, and other fundamental consumer protections were gone prior to taking out the loans.  Because these protections exist for every other type of loan in the nation, they had no reason to suspect or ask about this possibility.

The Department of Education, should have been "sounding the alarms" about this growing problem years ago, pushing for stricter lending limits, lower tuition, etc.  But it did not.  Instead, it seems to have assumed a "cheerleader" role that essentially enabled the prices, and associated debt levels to rise to where they are today.  This is a critical institutional failing that is almost never pointed out, but should be.

There are other examples that, taken together, indicate strongly that the Department has been working for the lenders (and schools) either without regard to the interests of the students, or even against their interests, but the examples already mentioned are sufficient to demonstrate broad systemic failings that could, should, and would never have happened had adequate oversight been exercised.

The argument for repeal of 523(a)(8) -- the bankruptcy exclusion for student loans --gets much stronger in view of this.  Reorienting the fiscal motivations to their proper alignments is urgently needed.  Returning, at a minimum, the bankruptcy protections that should never have been removed is the obvious first action that would achieve this, in all likelihood.

In so doing, the federal government will, once again, have a financial interest that student loans not default, and will be compelled to use its considerable influence to encourage the universities -- in a serious and meaningful way -- to both provide a quality education that gives the student the best chance for success, and also to do this at a reasonable cost.

Instead of looking the other way, or worse, as Congress deliberates on whether to raise the loan limits yet again, the Department of Education will be compelled to object.  Instead of dumbing down regulations meant to keep schools accountable (like the gainful employment rule), the Department would be inclined to go the other way, and start cracking the whip on the schools where needed, instead of coddling them.

The Department of Education might even come up with new tools for ensuring academic excellence, low cost, and ultimately, student success... tools that will work because the Department, institutionally, will want them to work.

© 2013, Alan Collinge.
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Alan Collinge is the founder of http://StudentLoanJustice.org, and the author of The Student Loan Scam.

The Irascible Professor comments: Recently passed legislation will limit, starting in 2014, the repayment amount for new student loans to 10% of disposable income, and will provide forgiveness for any remaining debt after 20 years.  While these much needed reforms are welcome, they do little to solve the problems faced by those with outstanding student loans not covered by the reforms.  There is nearly a trillion dollars of such loans outstanding.  Unfortunately, this debt never goes away regardless of the circumstances of the borrower and his or her cosigners.  For example, borrowers who through no fault of their own are unable to maintain their payments often find their student loan debt skyrocketing as lenders put their loans into default and begin to charge late fees and penalties.  Almost all other types of debt can be discharged in bankruptcy if a debtor finds himself or herself unable to repay.

While the IP does not have much sympathy for deadbeats who can repay their loans, but won't; he realizes that many people end up in situations where they simply cannot repay their outstanding debt.  One frequent factor is illness that prevents the debtor from working.  It's estimated that about half of the personal bankruptcies in the U.S. are caused by overwhelming medical bills.  A person with student loan debt who cannot repay because of illness can discharge his or her other debts through the bankruptcy process, but not the student loan debt.  That fundamentally is unfair!  The reforms that will go into effect for new student loans starting in 2014 go a long way towards towards restoring reasonable consumer protection to the student loan market.  However, these new protections do nothing for the millions of people with student loans not covered by these new protections.  Thus, restoring the bankruptcy option is essential.

 

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