Should Student Loans be Dischargeable in Bankruptcy ?

At long last, the nation is beginning to acknowledge the very large problem that student debt has become.  The national dialogue has been noisy and confused to this point, however, and the few legislative attempts to address the issue, while pleasant sounding, will do little to ease the debt burdens of the vast majority of borrowers, and do nothing to address escalating college prices and the associated debt loads being imposed upon the citizenry. Ultimately, this distracted dialogue and feeble legislation serve no one well, and the protests we are seeing now across the country echo this point.  In order to understand and solve the student loan crisis we now face, it is critical to understand the unique fiscal dynamics that govern the student lending system, and the institutional and political behaviors that results.  Forget about the for-profit college scandal for a moment.  Put the public vs. private student loan debate on hold.   The following must be addressed if these debates, or others, are to be productive.

First, it must be acknowledged that the lending system supporting our higher education system is structurally predatory.  In the absence of fundamental, free-market consumer protections like bankruptcy, statutes of limitations, refinancing rights, and others), and in the presence of unprecedented collection powers that would make “mobsters envious” (Elizabeth Warren‘s words), we have a student loan system where the big lenders make significantly more money on defaulted loans than healthy loans.  What is worse:  The guarantors (the entities that are supposed to police the lenders) make, on average, 60% of their revenues from penalties and fees attached to defaulted loans. What is almost unbelievable:  Even the Department of Education (According to the President’s Budget), gets back $1.22 for every dollar they pay out in default claims for Federal Family Education Loan Program (FFELP) loans.  Even subtracting generous collection and other costs from this profit still leave them clearly in the black.  Imagine if it turned out that JP Morgan Chase, Fannie Mae, and even The Housing Department were making more money on defaulted sub-prime home mortgages than those which remained in good stead.  This is the reality for student loans- a reality that demands very careful consideration.

A few common-sense questions are compelled here:  Would you want to take a loan from someone who wanted you to fail in your endeavor?  Doesn’t this put the lending system in a position of bad faith?  Is this not a defining characteristic of a predatory lending system?   Adam Smith, Milton Friedman, and every other western economist would answer yes on all counts (Ironically, Republican members of Congress were, by all accounts, more responsible for the legislation that caused this than members from the other party, but that is a topic for another discussion).

These financial motivations explain a wide and deep array of systemic defects, conflicts, and corruptions in the system that involve the lenders, schools, and most importantly, the Department of Education.  One example, Sallie Mae and others have been found to have defaulted student loans en masse- without even attempting to contact the borrowers!  Another example:  all colleges routinely mislead students prior to taking out loans about  their true default rates- they instead doggedly promote their reasonable sounding “cohort” default rates, and the Department of Education never does anything to correct this false impression  (The true default rate across all schools is roughly 1 in 3, and has been for years, whereas the cohort default rate typically lies between 4%-8%).  Similarly, students usually aren’t made aware that all the consumer protections mentioned above- and more- don’t exist for student loans.  These are only a few of the hundreds of significant examples of false information, omissions, and outright deceptive behaviors that one could point to in this discussion.  The readers can imagine the multitude of other dishonorable activities that might result from the anti-borrower financial motivations that have taken hold of this lending system, and more than likely they will find these to be happening, in fact, on the ground.

Those who claim that the new, improved  “Direct Lending” system is cured of these predatory underpinnings are wrong.  Defaulted loans still carry all the same penalties and fees as before, and Sallie Mae and the other big player are still both servicing healthy loans, and collecting on defaulted loans in the same conflicted manner as before.  The collection frenzy around massively inflated, defaulted loans may even be exacerbated under the new system, where interest income is no longer a possibility for these contractors.  In any event, the new system clearly doesn’t curb the predatory nature of the debt instrument.

The most troubling outcome resulting from this lending environment, however, is the massive tuition inflation that the schools are imposing at will upon the students.  Congress enables this, year after year, by repeatedly increasing the lending limits, in the absence of protest from the Department of Education, which has known about the astonishingly high default rates for years, but has promoted this pollyannish view of higher education, instead of telling the hard truth.   And of course this affects all students, not just those who borrow.  Wealthy and moderately wealthy families who must pay out of pocket for kids to go to college feel this, and feel it more sharply, arguably, than those who borrow.

Some perspective is needed here.  If there is an infectious disease outbreak, the CDC is pretty snappy about warning the public.  Similarly for the USGS and earthquakes, NOAA and tsunamis, etc. Should we not expect the same type of response from the Education Department in the face of exponentially increasing student loan debt and astonishingly high default rates?   When we were looking at a Trillion dollars in national student loan indebtedness, and the default rate was north of 1 in 4, why wasn’t the Department of Education sounding the alarm?    These questions have yet to be posed to those in charge at the Department, but need to be.  By Congress.   Department staff who should have warned congress and the public but didn’t should be held accountable. This isn’t a question of good government. Rather it would seem that is a question about minimally adequate government.

So the question now is how to “fix what is broken”, to borrow a phrase from President Obama, Secretary Geithner, and others following the most recent State of the Union Address.  Gainful employment rules, dickering around with the Pell Grant, and similar activities do nothing here.  Neither do the various repayment programs that are being marketed by the higher ed crowd as viable substitutes for the consumer protections that were stripped from the system. Some policy “thought leaders”, in fact, are pointing to these untested, unproven programs as a basis for dramatically increasing the federal loan limits!  This is not the direction we want to go. We cannot afford it, and to claim otherwise is hugely irresponsible.

Don’t be distracted by the sophisticated, confusing rhetoric being forced into this debate by those who would maintain the status quo no matter what the cost, or those who would end public support for higher education altogether.  Neither extreme has the interests of the citizens at heart. Remember only that reall, this is not a difficult problem.   Congress created it by removing fundamental, free-market consumer protections from student loans.  Congress can and must fix it by essentially undoing what they did.  Quite simply, it begins by returning, at a minimum, the bankruptcy protections that were removed without rational basis (when bankruptcy was the same for student loans as all other loans, far less than 1% of federal loans were discharged this way).  With this fundamental, free market mechanism returned, the Department of Education will have a vested interest in compelling the schools to provide a high quality product at a low cost, and at reasonable debt levels.

With financial motivations aligned with the interests of the students, instead of against them, we should expect the Education Department to take its job seriously, crack the whip on the schools, lenders, and ultimately compel not only a significant decrease in college prices, but also an end to a myriad of corruptions and conflicts that have taken root across higher education and are too numerous to mention, here.

Until Congress does what is right and the Department of Education has skin in the game for students, the invisible hand will not operate like it does for all other lending systems, and no fix (like gainful employment, for example)  will have any meaningful effect.  Prices, debt, and defaults will increase to the point where the American public will reject the entire lending system and all it supports. The related social consequences of this are not clear, but it is clear that we don’t need to go there.  And as the American Street demonstrates, this is likely something that Congress must do sooner rather than later, and in a non-partisan manner.
Alan Collinge is founder of StudentLoanJustice.Org and author of The Student Loan Scam: The Most Oppressive Debt in U.S. History – and How We Can Fight Back (Beacon Press, 2009).