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.

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.

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?

Emma (not her real name) is typical of borrowers we assist at the SLBA. She is 60 years old, sufficiently disabled to qualify for Social Security Disability and Supplemental Security Income, but not considered permanently disabled by Department of Education standards. She has over $5,000 in federal loans from a community college she attended in the mid-1990’s. She paid for a while, but could not continue after she was no longer able to work. She gets by on about $760 from Social Security and lives on her own.

There is no perfect solution for Emma, but there is an imperfect one. It is a resolution we seek for many of our clients. Emma can get out of default by consolidating her loans with the Direct Loan program and selecting an income contingent repayment plan (or income based repayment as of July). Under the income contingent (ICR) or income based (IBR) formula, Emma’s payments will be 0. If her income improves for some reason, she can start paying more.

At this rate, she will never pay off the loan, but she will be free from collection. After 25 years, if Emma is still alive, the remaining balance should be written off, although under current law some of that amount could be taxable income.

It is not easy to get this imperfect resolution. The first problem is that until Emma sought legal assistance, no one told her about this option. Our experience is that guaranty agencies, collection agencies, the government, and just about everyone servicing student loans rarely takes an objective look at each borrower’s situation to review the pros and cons of different options. This is a lost opportunity because many borrowers would not end up in default if they were counseled properly.

The second hurdle occurs at the application phase. All too often guaranty agencies cause unreasonable delays by sitting on these applications. The applications that get out of guaranty agency offices often get stuck in Department of Education back logs.

The third hurdle is unique to borrowers seeking ICR. This problem has arisen with every borrower we have represented. While the Department is calculating the ICR amount (unclear why this takes so long), they send misleading billing statements that confirm that the borrower has an income contingent payment plan, but then list the interest-only amount as the required payment.

Our clients usually panic when they get these statements because they are expecting a 0 or very low payment and instead get what appears to be a bill with a higher amount. Nowhere on the statement does it explain that the borrower can request forbearance or deferment and postpone payments until the ICR amount is finalized.

The stakes are huge. If borrowers think this is another loan they cannot repay, they will default again. If they default on the new consolidation loan, they will not be able to reconsolidate. There are costs to taxpayers too. If the process is successful, the government will not waste resources trying to collect from borrowers who can’t repay.

There are a few simple steps the Department can take to help address this problem. They can change the billing statements to:

• explain to borrowers that the Department is still calculating the ICR payment;
• explain that borrowers can request forbearances or deferments instead of paying the interest-only amount; and
• that they will get a future billing statement with the ICR amount and that this is the amount they will be required to pay.

They should also figure out a way to calculate the ICR payments more quickly and efficiently.

We have been urging the Department to make these changes for over two years now. They keep telling us that it is very difficult to change a letter, even though they agree that it would be a positive change for borrowers. It is head-bangingly frustrating for us, but of course, much worse for our clients.

Changing a letter is not a catchy rallying cry. It is far from the radar screens of most policymakers and the media, but it is one of many important procedural issues that can make a huge difference for borrowers.

If you are a borrower seeking this option, this self-help packetwill help you find your way.

We have assisted many borrowers over the years and we continually encounter collection, guaranty agency and government staff that do not follow the rules governing the federal student loan programs. To make matters worse, many collection employees treat borrowers horribly even when those borrowers are trying to resolve their accounts.

When we call on their behalf, we are treated just as badly…at first. The difference is that we have the tools and knowledge to fight back on behalf of our clients.

Why does this occur? Is it because the workers are bored? Underpaid? Do they feel that so many borrowers are out to game the system that it doesn’t really matter if a few fall between the cracks?

After all of these years of representing borrowers, I can only say that I don’t know the reasons why borrowers are treated so poorly. It appears to be a combination of bad training, lack of oversight, incompetence, bad attitudes, and conflicts of interest. These problems are compounded by the fact that borrowers are getting information about rights from the parties that are trying to collect from them. Private collection agencies are delegated complex responsibilities such as determining the monthly payments for reasonable and affordable payment plans. These collection agencies also help determine if borrowers have defenses to collection procedures, even though the collection agencies’ financial incentive is not to offer reasonable and affordable plans or to acknowledge defenses.

Regardless of the reasons, the important point is that borrowers are not given accurate, objective information about their rights. It is unfair and counter-productive to treat borrowers this way if we want to help them get back on their feet. All student loan borrowers deserve a fair process. And fairness, as Supreme Court Justice Potter Stewart once said, is what justice really is.