Why Not Student Loans?

In the famous decision, Local Loan Co. vs. Hunt, the Supreme Court summed up the relatively simple policy behind our bankruptcy laws: the “honest but unfortunate” debtor is given the opportunity to start over, “unhampered by the pressure and discouragement of preexisting debt.” The idea of periodic debt forgiveness is ancient, appearing numerous times throughout the Old Testament. Why then, are student loan debts not dischargeable in bankruptcy? After all, who is more “honest but unfortunate” than the student who borrows money to fund her education only to find out that her degree is worthless but her loan payments are very real?

What distinguishes the consumer who got in over his head with credit cards from the college graduate whose “earning potential” never quite materialized after borrowing gobs of money to fund his education?

Nothing. Student loans should be dischargeable in bankruptcy as they have been in the past. Prior to 1976, educational debt was fully dischargeable in bankruptcy. When the Commission on Bankruptcy Laws in the United States was formed in 1970 to study ways to reform the bankruptcy system, the modern day problems of private student loan debt and out of control tuition were yet to materialize. In state tuition at UC Berkeley was about $700 in the 1970s, today California families pay over $15,000 a year to have a child attend (a 2,000 percent increase).

Preserving Access to Federal Student Loans No Longer a Concern

The original motivation for reigning in dischargeability of student loan debt centered around preserving government loans, with proponents of reform painting bleak scenarios about federal educational aid drying up if the discharge status quo carried the day. The first student loan reforms took place in 1976 as an amendment to the Higher Education Act and required that debtors wait five years from the beginning of their repayment period, or demonstrate undue hardship, before their student loans were eligible for discharge in bankruptcy. The five year bar was later extended to seven years and in 1998, the laws were changed so that governmental student loans could never be discharged absent a showing of undue hardship. Don’t believe in slippery slope arguments? Well, buckle up. In 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) made all educational loans, public and private, nondischargeable absent a showing of undue hardship (an impossible standard to meet as interpreted by courts across the country).

Arguments in Favor of Nondischargeability of Student Loans

In addition to preservation of government aid, one of the popular reasons given for excluding student loans from the bankruptcy discharge is fraud prevention, the idea being that the degree students receive is an asset that must be paid for, their repayment obligations shouldn’t be wiped away in bankruptcy. The legislative history of the 1978 Bankruptcy Reform Act, the law that added a student loan provision to the Bankruptcy Code, is full of comments by members of Congress concerned with the damaging effects of continuing to allow educational debt to be discharged. Rep. Allen Ertel, the former PA congressman responsible for the amendment adding educational debts to the discharge prohibitions of section 523 had this to say:

Without this amendment, we are discriminating against future students, because there will be no funds available for them to get an education. Rep. John Erlenborn of Illinois put it even more bluntly, criticizing debtors who: Not having assets to pledge, are pledging future earning power. Having pledged that future earning power, if, shortly after graduation and before having an opportunity to get assets to repay the debt, they seek to discharge that obligation, I say that is tantamount to fraud. Call me crazy, but I don’t think college students at the time were racing to bankruptcy consultations still dressed in their caps and gowns. Furthermore, there is a fundamental difference between the government loans that pre-2005 bankruptcy reform legislation was intended to address and today’s private student loans, with variable interest rates and no deferment options. Viewed in the context of $700 annual tuition at Berkeley, Representatives Ertel and Erlenborn sound more reasonable. However, tuition at Berkeley is no longer $700 a year and the amount of student loans outstanding will exceed one trillion dollars this year. To make matters worse, college tuition is rising at twice the rate of inflation, fueled in part by an endless supply of money from the government. Our bankruptcy laws are badly in need of reform to push the needle in the opposite direction. NACBA Study The National Association of Consumer Bankruptcy Attorneys recently came out with a study that offers eye-opening statistics about the state of student loan debt in the United States. Americans now owe more on student loans than they do on credit cards. Other statistical highlights:

Individually, college seniors who graduated with student loans in 2010 owed an average of $25,250, up five percent from the previous year. Borrowing has grown far more quickly for those in the 35-49 age group, with school debt burden increasing by a staggering 47 percent. Students are not alone in borrowing at record rates, so too are their parents. Loans to parents for the college education of children have jumped 75 percent since the 2005-2006 academic year. Parents have an average of $34,000 in student loans and that figure rises to about $50,000 over a standard 10-year repayment period. An estimated 17 percent of parents whose children graduated in 2010 took out loans, up from 5.6 percent in 1992-1993. Of the Class of 2005 borrowers who began repayments the year they graduated, one analysis found 25 percent became delinquent at some point and 15 percent defaulted. The Chronicle of Education puts the default rate on government loans at 20 percent.

Predatory Lending Sure is Lucrative

Although these statistics represent bleak news for consumers, educational lenders couldn’t be happier. The not so well kept secret is that educational lenders, including the federal government, make the majority of their profits when borrowers default. The head of the Consumer Financial Protection Bureau, Richard Cordray has compared the practices of some parts of the student loan business to the subprime mortgage machine. Said Cordray at a recent news briefing:

“We’re seeing some of the schools anticipating as much as a 50 percent default rate on their students, yet they’re making those loans anyway,”

The inability of student loans to be discharged in bankruptcy relieves the Sallie Maes of the world from the responsiblity of underwriting and allows them to indiscriminately lend money to anyone who asks for it. What do they care? They make more money on penalties and interest when their customers can’t pay. Allowing student loans to be discharged in bankruptcy would force lenders to more carefully underwrite the loans they make. As a result, fewer loans would be made, which would cause the value of a college education to rise and tuition to go down as the money dries up (see housing prices from 2008 on).

We Shouldn’t Stop With Private Loans…

Although demonizing private educational lenders is almost too easy, we shouldn’t give government aid a free pass. Federal student loans should once again be eligible for discharge in bankruptcy. All the way back in 1987, President Reagan’s then Secretary of Education, Bill Bennett, wrote an Op-ed in the New York Times entitled: Our Greedy Colleges. In the article, Bennett argues persuasively that it is the increasing availability of student aid that causes colleges to raise tuition at a pace much greater than inflation.

If anything, increases in financial aid in recent years have enabled colleges and universities blithely to raise their tuitions, confident that Federal loan subsidies would help cushion the increase. In 1978, subsidies became available to a greatly expanded number of students. In 1980, college tuitions began rising year after year at a rate that exceeded inflation. Federal student aid policies do not cause college price inflation, but there is little doubt that they help make it possible.

Now with the benefit of hindsight, it’s hard to argue that Bennett doesn’t have a point. He might bristle at the analogy, but his argument is similar to those who blame Goldman Sachs for the high cost of gasoline in the summer of 2008. Many will happily tell you that gas prices were sky high that summer because of increased Chinese oil consumption and a busy driving season. Both story lines may have been factors, however, another reason for the 2008 “pain at the pump” was the flood of speculative money into the commodities markets fueled by investment banks and their institutional clients. Just as Goldman Sachs likes to blame the oil spike on China et. al, college administrators like to blame the rising cost of tuition on technology and staffing costs. However, the elephant in the room is the endless supply of money funding higher education. Anyone who asks can get a loan, with the main beneficiaries the Universities set up to cash the checks. The students are just unwitting middle men driving up the cost of tuition with every new credit hour they finance. Just as it does with commodities, the flood of money into higher education artificially drives up the cost. Bill Bennett was right.

There are private colleges whose sole reason for existence is to suck up as much student aid as possible. The University of Phoenix received 88% of its revenue from federal programs last year, most of that coming from student loans. Were he alive today, Rep. Ertel wouldn’t need to worry about the availability of federal aid for higher education. Instead he’s be able to witness first hand the monster his legislation helped create.

Conclusion

Changing the bankruptcy laws to allow for discharge of student loan debts would do far more to solve the problem of predatory educational lending than any initiative Richard Cordray can conceive. President Obama’s repayment based programs aren’t broad enough and will do little more than plaster over already convoluted legislation with more useless government formulas. Consumer bankruptcy attorneys will be the first to tell you the means test, with its analysis of disposable income to determine chapter 7 eligibility, is arbitrary and illogical.

To appease those concerned with fraud, implementing a minimum repayment period before educational loans would be eligible for discharge makes sense, but the ultimate test would be the value of the “asset” student borrowers are “purchasing.” Those whose degrees have value will file bankruptcy in much lower numbers. By contrast, college graduates forced to turn to bankruptcy will send a strong signal to predatory lenders: stop funding worthless educations, it’s no longer a good business model.

Image credit: michael salafia