It’s so hard to agree on how to police our credit market place that policymakers (and sometimes advocates) often give up on regulation and call instead for more financial literacy and counseling.  It’s not surprising that so many financial literacy courses are funded by creditors.  It’s easier to put the burden on consumers to “get educated” and then blame the consumers if they end up in financial distress.

Although most of us agree that education and counseling can be useful, there are costs to promoting financial literacy as a substitute for regulating the market.   Professor Lauren Willis points out a number of these costs in a 2008 article.

There is a shocking lack of evidence that financial literacy is effective.  As Professor Willis details in her article, a number of studies show that financial management programs have no effect on literacy or behavior.  This doesn’t necessarily mean that the courses cannot have an impact on decision making, but the jury is still out.  This is hardly a strong foundation for the millions of dollars that are poured into financial education and the faith that this will somehow improve consumer financial decision making.

There is general consensus that long-term, individually tailored programs delivered in small settings are the most likely to be effective.  The problem is that these courses are too expensive to provide on a large scale.  Further, this type of counseling might be more effective because the providers not only teach, but often intervene on behalf of consumers.    

It is very difficult to close the gap between the current financial literacy levels of the average American and the increasingly complicated credit marketplace.  Even good courses get outdated fast.   There never was a glorious time in the past when we had a more financially literate population, but there was a time when the market was not so complicated. 

Most of us do not understand basic credit math, let alone adjustable rate mortgages and credit derivatives.  In her fascinating book on J.P. Morgan and its role in creating derivatives, Gillian Tett quotes one of the original creators of these products, Blythe Masters that “Financial engineering was taken to a level of complexity which was unsustainable.”  Many on Wall Street can’t even understand the products they push on consumers!

Those who believe in financial literacy have a challenge in delivering a clear message to consumers.   The public education campaigns that work best usually have a straightforward message, such as “Don’t smoke” or “Don’t drink and drive.”   The message is more nuanced when it comes to finances.   Some financial literacy instructors believe that consumers should not go into debt at all.  Others say use credit in moderation and only if you understand it.    NCLC tracked some of these biases in a 2007 report on the bankruptcy education mandate.  The director of one course, for example, told participants that “debt is dumb.”  Another told victims of predatory lending that they had no one to blame but themselves.    

Perhaps most important, even good financial education rarely affects consumer biases such as over-confidence and optimism about the future.  Even when armed with information and education, most consumers are able to consider no more than five features of a particular credit product.  This helps explain why so few consumers consider more “obscure” terms such as arbitration clauses or default fees.  Creditors design their products and advertising to exploit these biases.  Researchers such as Professor Alan White write about how predatory lenders frame their products in ways that obscure risks and overstate benefits. 

Low-income consumers do not collectively make worse decisions nor have more biases.  The difference is that that the consequences of “bad decisions” are so much worse for the lowest-income and most vulnerable consumers.  For student loan borrowers, for example, the erosion of the safety net means that there is less cushion to soften the fall.

2009 was a big year in the student loan world.  Unfortunately, as the economy has worsened and joblessness rates have increased, more and more student loan borrowers are finding it difficult to deal with overwhelming debt loads.  We will write more in 2010 about our clients and other financially distressed student loan borrowers.  We will also write about legislation and the need to push government servicers and collectors to respect borrowers, provide real default management services and at a minimum, comply with the law.

In the meantime, here is a quick look back at 2009 through a few interesting and important pieces from other blogs. 

 On Proprietary Schools and Loan Defaults

From the Education Sector’s quickanded.com: Cohort Default Rates and Proprietary Schools (December 2009)

From New America Higher Education Watch:  Sky High Default Rates at Career Colleges (December 2009)

From Student Lending Analytics:  Defaulted Student Loan Portfolio Crosses $50 Billion (December 2009)

A New York Times Blog piece on default rates (December 2009)

On Private Loans

From the New America Higher Education Watch:  Putting an End to the Subprime Student Loan Racket (October 2009)

From New America Higher Education Watch on the private loan debt swap proposal (December 2009)

On Student Loan Legislation in Congress

From New America Higher Education Watch:  It’s Deja Vu All Over Again (December 2009)

The Education Sector:  Increasingly Desperate Arguments Against Reform (September 2009).

Just a slice of many interesting posts from 2009.  Happy New Year.

The holiday season can be a time for  reflection, so I am thinking  back on the student loan borrower clients I have worked with this year.  On the positive side, we have helped many  borrowers manage their overwhelming student loan debt loads. I will write more about these successes in future posts.  For now, I am thinking about the many clients who are stuck, unable to move forward because of debt loads that will haunt them forever.

The policy debate all too often breaks down over who is to blame… an exercise that is rarely constructive.  When will the finger pointing end so that we can focus on finding solutions for borrowers and hopefully help prevent future problems?

Here is one example:   I met a young Latina woman in her early 30’s a few weeks ago.  This is through a new program where we are representing mostly homeless women or recently homeless women who are trying to get back on their feet.  The key to success is often more education, but many cannot go back to school because of past student loan defaults.

This client recently fled a horrifying domestic violence situation in New Jersey and is living in subsidized housing in Massachusetts with her young daughter.  She receives less than $500/month in public assistance benefits plus food stamps.

This is not where she wants to be for long.  She is educated.  Educated to the tune of about $68,000 in private Sallie Mae loans and about $50,000 in federal loans.  She has an undergraduate degree, but has worked only sporadically.  She wants to be a teacher, but needs a state certification.  She attended a wide variety of schools over the years starting in the mid-90’s– city university, community college, private four year school, proprietary school and most recently the University of Phoenix (she dropped out of there).

For those who think that everyone is trying to game the system, I suggest that you come and meet some of my clients.  Believe me when I say that this woman is committed to  education and learning.  But I agree and she agrees that her education has been a failure on many levels.  She certainly acknowledges  that she should not  have taken out so many loans.  She came from a large family of eight children where education was emphasized.  Her low-income recently retired father even co-signed for the private loans. She  thought when she was young that the best thing to do was to keep going to school because it would certainly lead somewhere.  Isn’t that what usually happens, she asks?

She should have asked for more guidance, she should have looked for less expensive options, she should have figured out a better career trajectory.  But shouldn’t the schools also have played a greater role in guiding her education?  What about the lenders?  Why keep lending to someone who is not completing her degrees?  And why give her  loans with variable interest rates starting at 10% and higher??

These are the finger pointing questions that have little relevance to her life today.  She truly wants to be a teacher and I believe she can.  Most important, she believes she can, but her private loans are about to go into default.  She can get a deferment for the federal loans, but this is a stop gap measure.  They will come back to bite her.

As for the private loans, here is what Sallie Mae says when I speak with them just before Christmas eve.  If she can pay us $150 before the end of this year ($50 charge for forbearance for each loan) , we will bring the loan current, but she will have to start making payments in January.  Minimum payment?  Almost $600.  And even that unaffordable amount makes no dent in the principal.

To avoid this, they say, she  can go back to school and get an in-school deferment.  She likes this idea because she wants to be a teacher.  I caution her about taking our more loans and ask her—Can you go to school somewhere that will not require more loans?  She isn’t sure, she says.  The program that she is looking at requires her to take out more loans and more Pell grants too.  She is going to ask for help to search for less expensive options, but she feels pressured to make a decision to avoid the private loan payments and she really wants to find a specific program that will quickly lead to a teacher certification.

When will the cycle end?  Don’t you realize, I say to the Sallie Mae representative, that this borrower will never be able to pay back almost $70,000 in high rate loans?  Her co-signer father has no money either.  There is nothing we can do, they say, except of course, she can go back to school…maybe get more loans.

When will the cycle end?

On Thursday, November 5, Senators Sherrod Brown (D-OH), Michael Bennett (D-CO), Al Franken (D-MN) and Barbara Mikulski (D-MD) introduced new legislation (S. 2733) to create a private student loan ombudsman program.

This is a promising first step in improving assistance for financially distressed private loan borrowers.  As we wrote in a 2007 report, informal assistance programs, such as mediation, can be beneficial for many borrowers.  The current federal ombudsman program has provided valuable assistance for our clients and many others across the country.

Despite the importance of this program, it is hardly a magic solution for borrowers.  There are limits to the ombuds concept.  As a neutral mediator, an ombudsman should be able to help many borrowers, particularly those with less complex questions and certainly those that need basic information about their accounts.  However, there are many situations where borrowers need advocates that are clearly on their side.  Ombuds programs are not borrower advocates.  Ombuds programs are also not substitutes for private enforcement remedies.

The program is more likely to be successful if the ombuds program is as independent as possible, particularly from creditors.  The ombudsman office must also have the power to require creditors to cooperate by providing loan documentation and other information necessary to assist borrowers.   The federal ombuds staff has this information at their fingertips through the National Student Loan Data System (NSLDS).  There is no similar comprehensive source of information for private student loans.

Probably the most important limit to ombuds programs is their lack of authority to force solutions.  In our experience, the federal ombudsman staff generally work very hard to resolve problems, but they cannot force the Department of Education to accept solutions.  This is not a reason to oppose these programs.  They work very well in many cases, but they won’t work for everyone by any means!

The same limitations will arise with a private loan ombuds program.  Lenders that refuse to assist borrowers are unlikely to change their minds just because an ombuds asks them to.  In addition to mediation, Congress and the Administration must create incentives to push lenders to modify loans and offer other flexible solutions for borrowers. So far,  private student lenders have offered little in the way of volutnary assistance.  There are some signs that this is starting to change perhaps because the creditors have realized that it is often in their economic interests to get something rather than nothing from financially stretched borrowers, but change is coming slowly and is often not enough.

Most important, borrowers should not wait to wait for lenders to get around to providing voluntary assistance.  Borrowers also need options such as bankruptcy rights so that they can find real relief from debilitating private student loan debt.

Tim Ranzetta at Student Lending Analytics wrote recently about curing student loan defaults and rehabilitation.   We have a few responses to this useful article based on our experiences representing and working with borrowers.

1.  Reasonable and Affordable Repayment

Borrowers seeking rehabilitation are required to pay no more than what is reasonable and affordable for them.  The student loan regulations go even further by prohibiting  minimum payments.

Unfortunately, it is very difficult to get a reasonable and affordable payment.  This problem occurs in part because of a system established by the Department of Education which provides compensation to collectors for setting up rehabilitation plans only if the plans require borrowers to make certain minimum payments.

The tips in the CreditCard.com article are often not enough.  In many years of representing borrowers, I have never had a case, regardless of the loan holder, where a borrower was correctly informed at the outset that she had the right to pay only what is reasonable and affordable.  Never.  We can usually get to this place after negotiation, but this is a difficult process.  It is especially difficult for the majority of borrowers who do not have legal representation.

This roadblock occurs even when borrowers provide the requested documentation.  It is a huge problem that makes rehabilitation significantly less attractive than consolidation for many borrowers.

2.  Transition to Affordable Repayment after Rehabilitation

Our clients are consistently told that their payments will likely be higher after a successful rehabilitation.  This doesn’t make sense.  Once a borrower successfully rehabilitates a loan, she is then eligible for all of the pre-default repayment options, including the IBR option.  It is critical to inform borrowers of these options as soon as possible so that they do not go back into default because they cannot afford the monthly payment.

We are unfortunately finding that many servicers are not ready to process IBR applications.  The other problem is that a borrower’s post-rehabilitation payments will be sent to a different servicer.  The current loan holder usually doesn’t know who the new servicer will be.  Many borrowers want to be prepared and apply for IBR toward the end of their rehabilitation period, but they don’t even know who to talk to.

In order to make rehabilitation work well, the current loan holders have to figure out a way to manage this transition period so that a borrower making relatively low reasonable and affordable payments doesn’t end up with a huge increase in payments after resale of the loan.

3. No Prepayment Requirement for Consolidation

In evaluating the pros and cons of rehabilitation vs. consolidation, borrowers should know that there is no requirement that they make three reasonable and affordable payments in order to consolidate.  If you are in default and consolidating with Direct Loans, you must either make three reasonable and affordable payments OR agree to repay using the Income Contingent Repayment Plan (ICRP) or the Income-Based Repayment Plan (IBR).

 4.  Finding Buyers for Rehabilitated Loans

We share the concerns expressed by Tim Fitzgibbon of NCEHLP in response to the SLA piece about the lack of action at the Department of Education to help with the backlog of rehabilitation loans.  More on this in another article!

On September 23, the U.S. House of Representatives Judiciary Committee, Subcommittee on Commerical and Administrative Law held a hearing on discharging educational debt in bankruptcy.

Brett Weiss delivered testimony on behalf of the National Association of Consumer Bankruptcy Attorneys (NACBA) and NCLC’s Student Loan Borrower Assistance Project.  Chairman of the House Committee on Education and Labor George Miller issued a statement in support of the need to change bankruptcy laws to protect student borrowers.  Representative Danny Davis also testified at the hearing.  Other testimony is available on the hearing web site.

We cited a report from the 1970’s in our testimony because 1)  This is the report Congress commissioned during the initial debate on this issue, 2) This report did not support the conclusion that students were more likely to discharge debts in bankruptcy, and 3)  It is the only comprehensive report on this issue that we know of.   There simply isn’t any evidence to support the claim that student borrowers are more likely to declare bankrutpcy than other consumers.

The hearing focused on problems with the current undue hardship system.  The current system is broken in many ways, as we detail in our testimony.  Professor Rafael Pardo also testified about problems with the undue hardship test.

The undue hardship system is broken, but we urge Congress to do more than simply tweak the hardship test.  Low-income borrowers have few, if any, resources to pay for legal assistance to prove to judges that they suffer from undue hardship.  This would still be true even with a more defined standard.   Although it would be helpful to have a clear definition under the current system, the better solution is to restore dischargeability rights for students.

Policymakers should also beware of arguments that changes in bankruptcy policy would constrict the availability of private student loans or make them more expensive.  The reality is that before the bubble burst, lenders spent years making all kinds of loans regardless of risk.  They lent money like candy in cases where the debts were ultimately dischargeble in bankrutpcy (e.g. credit cards) and in cases where debts were harder to discharge in bankruptcy (e.g. mortgages and student loans).   The result was a largely unregulated predatory student lending market.  (Lauren Asher, President of the Institute for College Access and Success, testified at the hearing about key problems with private student loans).

A more restrictive bankruptcy policy probably made the student loan securitization packages more attractive to many investors, but investors were buying up just about anything during the bubble years.  A return to the days of risky lending is not good for borrowers, creditors, or the economy.

We will not rein in abusive credit practices by denying rights to financially distressed borrowers.  Rather, we need regulation to ensure that creditors lend more responsibly.

In April, we released a report about the lack of options for private student loan borrowers.  Unfortunately, our clients and other borrowers who have contacted us tell us that not much has changed since April.

We are hopeful that there will be a brighter future going forward, perhaps with a new consumer financial protection agency.  Even if this much-needed re-regulation occurs, there are countless borrowers stuck with loans that they have no hope of repaying.    Lenders and the government have decided that, unlike the lenders that made these loans, these borrowers are “too small” to help.  In reality, their numbers are large, but their political power is not.

Is there political will to do something about this and if so, what can be done?  We listed a number of possible solutions in our report, including:

1.  Mandating Loss Mitigation Relief

2.  Restoring Bankruptcy Rights for Private Loan Borrowers, and

3.  Creating Loan Cancellations for Fraud Victims

Senator Sherrod Brown of Ohio recently added another proposal to this list.  The basic concept is to allow some borrowers to swap private student loan debt for federal student loan debt.  These borrowers would then be eligible for the range of federal flexible repayment and other options.  Borrowers would choose whether they want to participate and at least in the current proposal, would be able to swap only up to what they could have borrowed (but didn’t) under the federal loan limits.

We have concerns about this proposal.   Among other issues, it does not go far enough to help the neediest borrowers, mainly those who are delinquent or in default.  Also, many borrowers will be left with balances on their private loans even after the swap.

Despite these concerns, we commend Senator Brown for focusing on these financially distressed borrowers and for recognizing the need to talk about possible solutions.   We hope this discussion will occur in Congress, in the Administration and across the country because the borrowers we wrote about in April are still stuck with high cost loans, economic conditions and unemployment rates are still dismal and the lenders who created this mess are not voluntarily providing relief.

Courts have consistently held that there is no private right of enforcement under the Higher Education Act (HEA).   In case after case, borrowers, often without the benefit of legal counsel, are unable to enforce their rights.

Congress has created many new and improved options for federal student loan borrowers.  Congress and the Administration are also working hard to ensure that loan holders provide quality servicing and collection services.  Servicers that do not comply with the law could be eliminated from future student loan contracts.  These changes should lead to much-needed improvements, but what about relief for the borrower when the loan holder does something wrong?  For example, what if the lender, guaranty agency, or school refuses to discuss loan rehabilitation even when a borrower clearly has a right to such a plan?  Currently, the borrower can complain to the Department of Education.  Given documented problems with the Department’s oversight, this is less than a complete solution even for those borrowers who persist and manage to speak to someone at the Department.  Beyond complaining to the Department, it is virtually impossible for a borrower to enforce her rights.

In future posts, we will write more about the problems with the Department’s system for handling complaints.  We have asked the Department to explain the current system, but are waiting to hear back.

The lack of private enforcement shuts the door on borrowers seeking to access programs that they are entitled to under the Higher Education Act.  This glaring problem also undermines the effectiveness of such new programs as income-based repayment because loan holders and servicers are not held accountable when they fail to comply with the law.

A key way to address this issue is for Congress to provide borrowers with a private right of action to enforce the HEA.  This is the only way to ensure that the borrower-friendly options in the federal student loan programs actually reach all borrowers.

“Student loans are not like other forms of consumer debts-they are a direct result of public policy…For the borrower, we acknowledge the different nature of the debt by making it nondischargeable in bankruptcy, meaning that he or she has a higher “moral” obligtation to repay the debt over other consumer debts.”—Paul Combe, President of American Student Assistance (Chronicle of Higher Education, May 15, 2009)

Mr. Combe envisions a moral hierarchy when it comes to debt repayment, but how would such a system work?  Would students always have a heightened duty to repay loans?  What if the student is seeking relief to buy medicine for a gravely ill friend?  What if she is disabled and can no longer work?  What if she gambled the money away?  How would the morality spectrum be applied in these cases?  Ironically, the gambling debts in the last scenario would probably be dischargeable, but not the student loans.

Granting relief based on a subjective sense of morality is inefficient and ultimately impossible.  By all accounts, most students are optimistic when they take out loans, assuming that school will work out and that they will be able to repay the loans.  Is it really “immoral” if life doesn’t work out as planned for them?

The policy question is whether a presumed lack of morality is a reason to deny debt forgiveness.  The truth is that bankruptcy policy is much less about fairness or morality and more about the pragmatic need to offer fresh starts to many debtors.  As Megan McArdle wrote in a recent Atlantic article, by the time someone files for bankruptcy, the time for fairness is already long past.  Bankruptcy is the legal recognition that someone lacks the resources to meet financial obligations.  Our system works well, according to McArdle, precisely because it sets aside our instincts for just desserts and instead focuses on minimizing the costs to everyone.  There are many rules in place to ensure that only borrowers who are financially distresed get relief.  Morality is not the guiding force behind the system.

On a more pragmatic level, those who tout a morality-based system would quickly find that not everyone lives by the same moral code.  Some follow a secular morality that teaches empathy for others.  Among religions, there are different attitudes toward debt forgiveness, but most aim to avoid the ancient practice of debt slavery.  Chapter 15 of Deuteronomy mentions the need for debt forgiveness, which sounds a lot like bankruptcy.  The Koran includes passages about granting debtors time to repay debts if they are in distress.

Injecting morality is not relevant and ultimately destructive of the fresh start concept.  It could be useful perhaps if the goal is to shame immoral people, but that isn’t what’s really going on here and we should stop talking about it that way.

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.