Congress passed a bill on June 23 that will provide much-needed relief for borrowers in default on their federal student loans.  President Obama is expected to sign the bill.

There are only a few ways for federal student loan borrowers to get out of default.  Loan cancellations or bankruptcy discharges are available only in limited circumstances.  However, many borrowers are able to get out of default and avoid the government’s extraordinary collection powers by rehabilitating or consolidating their loans.

Rehabilitation is not necessarily the magic solution that some lenders and guaranty agencies claim.  In many cases, consolidation is just as effective.  The main advantage to rehabilitation is that borrowers can get the default notations removed from their credit reports if they successfully rehabilitate their loans.  These FAQs provide information about the pros and cons of rehabilitation and consolidation.

The problem since last year is that rehabilitation has not been available for many borrowers.  The credit freeze meant that there were no longer many (or any) buyers wiling to purchase the rehabilitated loans.  The Department of Education insisted that the resale requirement could not be waived.

When there was just a hint last year that borrowers currently in school might not be able to get their loans, Congress and the Department acted right away.  There was no such urgency for loan defaulters.  Thousands of borrowers who had completed their required rehabilitation payments were stuck, unable to begin clearing up their credit and in some cases continuing to face collection actions.

Even though relief was slow in coming, the good news is that it is here.  The new bill allows guaranty agencies to sell rehabilitated federal loans to the Department of Education if they are unable to find buyers for those loans.

There are many to thank for this result.  The Obama Administration supported this change and Congress finally did the right thing as well.  The Congressional committee leaders, Senator Kennedy and Representative Miller, provided critical support.  During the long wait, some states, such as Illinois came up with their own solutions for borrowers in their states.

Although many guaranty agencies took advantage of borrowers during this difficult time, others tried to help.  For example, some agencies figured out ways to purchase the loans in-house.  The National Council of Higher Education Loan Programs stated in March 2009 that guaranty agencies would not offset state tax rebates of all borrowers who made the required rehabilitation payments and continued to make payments while waiting for a buyer to purchase their loans.  Other guaranty agencies spoke up for change.

We have a message for these guaranty agencies:  Act quickly to complete the rehabilitation process for your borrowers.  We will be watching.   We also urge borrowers to let us know your experiences.

There is still work to do on the rehabilitation program, as we will write about in future posts.  There should be more complete credit reporting relief and clear rules about reasonable and affordable payments, but this is a critically important first step.

The Supreme Court announced this week that it will hear a student loan bankruptcy dischargeabilty case, Espinosa v. USA Funds.  The Associated Press states that the Supreme Court will be deciding whether student loans can be dismissed through bankruptcy with just a notice to the collector instead of a hearing proving that paying the money back would cause an “undue hardship”.

Not exactly.  The Espinosa case deals with a narrow aspect of student loan bankruptcy law that does not cover all student loan debtors seeking bankruptcy discharges.  Rather, the case deals with a small subset of borrowers– those who file Chapter 13 cases in bankruptcy AND complete those plans (by most accounts, somewhere between 30 and 50% of debtors who file Chapter 13 plans complete their plans) AND get those plans confirmed without the creditor objecting to the discharge and requiring the debtor to prove hardship.

Even if the Supreme Court agrees with the borrower, this will not be the end of the unfair treatment of student debtors in bankruptcy.  Instead, it will be a wake-up call to creditors to stay alert and object in a timely way to pending Chapter 13 confirmation plans.  As long as a creditor does this in a particular case, the borrower in that case, like all other student loan borrowers, will have to prove undue hardship through an adversary proceeding in order to discharge student loan debt.  Most likely the creditors will catch on (most already have) since as the Ninth Circuit noted in the Espinosa decision in describing the creditors, “we aren’t talking here about destitute widows and orphans, or people who don’t speak English or can’t afford a lawyer.”  Instead, creditors are “huge enterprises” who usually act aggressively to advance their interests.