This is the first of a series of articles addressing common arguments in the student loan bankruptcy debate.
“If private student debt can be discharged in bankruptcy, that creates risk, and the result will increase the cost of tuition.”
Scott Talbot, Financial Services Roundtable, quoted in a May 15 USA Today article
Mr. Talbott seems to be saying that treating student loans the same as other debts in bankruptcy would create greater risk for creditors. This is far from obvious. If most borrowers who file for bankruptcy don’t have the money to repay their debts, a more restrictive bankruptcy policy isn’t going to make the loans less risky.
It is certainly true that private student loans, made without government guarantees, can be risky for both creditors and borrowers. Many students are young, with little or no credit history. Their earning power is mostly speculative. Yet responsible underwriting of student loans is not impossible. Recent trends in the industry show that creditors know how to sell less risky products. Lenders such as Sallie Mae are creating loans with “safer” features such as requiring students to pay interest during school and requiring co-signers.
Mr. Talbott also assumes that creditors will be less likely to lend if there is too much risk. But this clearly wasn’t true during the subprime lending heyday. Creditors generated huge profits making risky student loans mainly because they sold the loans after origination, passing the risk along the food chain.
There is no evidence that student loan creditors adjusted their lending in response to changes in bankruptcy law. The private student loan market was growing rapidly long before Congress in 2005 made private student loans harder to discharge. This shouldn’t be so surprising. During the past decades of irresponsible lending, creditors threw credit around like candy in markets where the credit was dischargeable in bankruptcy (such as credit cards) and those where it was harder to write off debts in bankruptcy.
There is simply no good evidence that bankruptcy policy affects creditor behavior. Interest rates, for example, were largely the same before and after the 2005 bankruptcy law which made private student loans more difficult to discharge in bankruptcy. Until recently, the private student loan market was growing rapidly, but there is no proof that this was because of the stricter bankruptcy policy. The market has shrunk dramatically in the last year even with a restrictive bankruptcy policy.
The second part of Mr. Talbott’s statement connects bankruptcy policy to the cost of tuition. It’s not clear what he means by this. Mr. Talbott could be saying that if bankruptcy policy becomes less stringent, fewer creditors will make student loans and tuition will increase as a result. As we noted earlier, there is no evidence that bankruptcy policy affects the volume of loans. But assuming for the moment that there is a connection, Talbott’s conclusion is that a smaller private loan market will drive up the cost of tuition. Is there a causal connection here? If students have less money to pay for education, couldn’t this drive down the cost of tuition? The high cost of education is generally a big mystery, but at least some studies have found that the widespread availability of financial aid creates incentives for schools to raise tuitions.
The truth is that lending always involves some risk. No credit scoring model can accurately predict every contingency. People get sick, lose their jobs, or fail in their careers. Should we keep constricting the safety net for borrowers because we think this will encourage creditors to keep lending? Is this really better for creditors? Do they make more money from loans without consumer protections? This is not entirely clear. It is certainly not better for students who need a safety net. Is it better for society? Certainly not if the goal is to improve equal access to higher education because under the current policy of increased loans and lower grant aid, the gap in access to education for lower income students keeps growing. The path to equal access to education will never be paved with predatory student loans.
Ultimately, it is better for society if individuals have some flexibility to take chances. If public policies only encouraged safe choices, few would borrow to go to college. Few would start businesses either. Megan McArdle notes in a recent article in the Atlantic that one of the worst decisions anyone can make from a financial point of view is to start a business. She says that “all of the business literature indicates that starting a business is a phenomenally stupid thing to do.” Most businesses fail, even those started by those who have previously run successful businesses. Yet we have decided as a society that we want people to start businesses even if this means writing off some bad debt. Why isn’t the same principle applied for education?