When Good Loans Go Bad

National credit bureau TransUnion revealed recently that the 90- and 30-day delinquency rates on private student loans were 6% and 7.5%, respectively, in the first quarter of 2010. That’s up from 5.4% and 6.8% in the previous year. Meanwhile, the Department of Education recently released its fiscal year 2008 draft student loan cohort default rates, which showed that federal loan defaults rose from 6.7% in 2007 to 7.2% in 2008.

Rising delinquency and default rates indicate that borrowers are struggling to repay the loans that they took out for college, especially in the midst of the current economic environment. The fact that student loans are unable to be dismissed in bankruptcy has created a financial nightmare for some borrowers. They’re drowning in a mountain of student debt and can’t collect the dividends that a college education is supposed to pay.

For years students have been unable to seek protection from their student loan debts through filing bankruptcy. Bankruptcy protection of student loans was originally established in 1978, and was only applicable to government issued or guaranteed student loans, in an effort to "safeguard federal investments in higher education." In 2005 bankruptcy protection was extended to cover privately issued student loans.

But on April 8, 2010, Sens. Dick Durbin, D-Ill., Sheldon Whitehouse, D-R.I., and Al Franken, D-Minn., joined House Reps. Steve Cohen, D-Tenn., and Danny Davis, D-Ill., to introduce legislation that "would restore the bankruptcy law, as it pertains to private student loans, to the language that was in place before 2005, so that privately issued student loans will once again be dischargeable in bankruptcy." According to the congressmen, the legislation would "restore fairness in student lending by treating privately issued student loans in bankruptcy the same as other types of private debt."

Despite the rising rates of delinquency and default, I have mixed feelings about this policy proposal. On the one hand, student loans are a financial debt that consumers voluntarily shoulder, and there is responsibility that comes with choosing to borrow money–mainly to pay it back. But it’s also clear that consumers sometimes run into circumstances in life that make it impossible for them to meet their obligations, and that there should be some form of reprieve when debts become too onerous.

Bankruptcy allows people the opportunity to get a fresh financial start in life, alleviating what can amount to suffocating financial oppression, the result of past unwise financial decisions. Unfortunately, going to college has become an unwise decision for a growing number of Americans who are being herded onto campuses across the country. Some people made the wrong decision at a very young age to attend college, and perhaps deserve a second chance, one which allows the student debt to be discharged in bankruptcy, the same way that credit card, mortgage and automobile debt is dismissible.

But that said, there are a number of troubling issues related to the proposed policy to make private student loans dismissible in bankruptcy.

First, the possibility of student loans being dismissed in bankruptcy increases the risk for lenders. After all, college degrees cannot be traded on the secondary market in the same manner as real estate, vehicles or other goods. Therefore, lenders take on a tremendous risk by making uncollateralized loans, as they are unable to repossess and resell the college degree from a borrower who fails to keep up with his payments. This will almost certainly lead to higher interest rates to reflect the heightened market risk of providing student loans without any collateral.

Next, it is damaging to students who rely on private students loans to pay for their education. It is very common for students who elect to pursue a private college education or a professional program to take on private loans because they don’t qualify for the federal loan programs, are unable to borrow enough from them to cover the cost of their education, or simply prefer the services of the private lending market over the public one. As interest rates on private student loans rise, more students will be deterred from borrowing the money that they need to pursue their educational goals. This will likely lead to a worsening of the access problem for low- and moderate-income students wishing to pursue an education in medicine, law and business, as they will be deterred by the high cost of borrowing.

Finally, it targets private student loans while protecting taxpayer-backed loans. The government already has the advantage of leveraging the public’s capital on the risky endeavor of student lending. This allows the government to offer more favorable loan terms than the private market, and puts taxpayers on the hook for burgeoning amounts of subprime student loans that were made at non-market rates to otherwise unqualified borrowers. This bears a remarkable resemblance to poor government policy that encouraged and subsidized subprime mortgage lending, and spurred the economic crisis that led to the massive Wall Street bailouts Americans are still fuming about.

So how do we avoid this looming fiscal crisis? A few ideas come immediately to mind.
The simplest is to get the government out of the student loan business altogether, and let the market handle it. There are ways to ensure that student loans will still be available at competitive interest rates by the private market, and to ensure that lenders take caution when extending uncollateralized loans, by analyzing the potential of students to repay and factoring default risk into the interest rates charged. This is similar to how the private market extends other forms of credit, and would take the taxpayers off the hook for potential losses that may result from student loans gone sour. These loans are a huge liability for the public that can easily be avoided by getting the government out of the student loan market.

Another option is to hold colleges accountable for providing a valuable education to their students, by transferring the losses from default and bankruptcy from the public to the colleges themselves, or at least sharing the risk. For too long colleges have received an infusion of taxpayer-provided money in exchange for very little accountability. Let’s make all student loans dischargeable in bankruptcy, but instead of the taxpayers taking the hit when student loans go sour, colleges should absorb the loss, or at least a portion of it.

This would incentivize colleges to focus on providing educational value and help their students launch a career–knowing that if they fail in their mission, there are real consequences. Maybe then colleges would be more attentive to helping their students succeed.

Daniel L. Bennett is a research and policy analyst at the Center for College Affordability and Productivity, an independent higher education think tank.


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