Mint.com, the online personal finance aid, tweeted an important question yesterday: Are Student Loans the Next Debt Crisis? Also, is bad policy encouraging irresponsible lending in America again?
A recent report on student debt by a group of bankruptcy attorneys illustrates an eerie similarity to what lawyers on the frontline saw during the subprime mortgage crisis. The report by the National Association of Bankruptcy Attorneys should act as a tipping point in student loan reform now that “4 out of 5 bankruptcy attorneys say that potential clients with student loan debt have increased “significantly” or “somewhat” in the last three-four years. Rising debt, out-of-control tuition costs, and the financial ruin of American families in pursuit of economic betterment are factors that highlight the need to undo harmful changes to the bankruptcy code. These modifications of the bankruptcy code have been lobbied into place since 1976. They hurt the mission of bankruptcy relief for honest debtors, encourage irresponsible lending, and leave students and their parents in crushing financial circumstances. Specifically, the government’s special treatment of education loans in the bankruptcy code encourages lenders to take overly risky bets on students likely to struggle in repayment.
The NACBA deemed student lending to be a ticking “debt bomb” on scale of the housing crisis. Pundits and economists cite mortgage debt as drags on the economy and consumer income. Did our experts somehow fail to notice the nondischargeable $1 trillion in student loans? The average student debt burden has risen to over $25,000 per student and has even surpassed our nation’s credit card debt. Combine education debt with unemployment and you have a very dangerous combination for those entering the workforce. In the same manner that criminal debt is treated (unpaid taxes, child support, alimony), student loans are one of the only classes of finance that cannot be discharged through bankruptcy. In a complex lending environment with little transparency and encouraged risk, we have a situation very similar to what we saw pre-2008.
So how do we start to defuse this debt bomb? Congress should amend the bankruptcy code’s Section 523(a)(8) back to its more original state. Congress should restore the ability to discharge federal education loans after five years of repayment. Also, just like any other form of unsecured debt, Congress should absolutely not exempt private educations loans from dischargeability. The bankruptcy code in its current form is harmful from both a macroeconomic and consumer perspective. As we have learned already, if lenders think they can give loans like candy and get their money back for it, we risk an overleveraged economy. This next time around, borrowers will get hurt more than lenders. For consumers, the purpose of bankruptcy is to offer the honest debtor a fresh financial start. Instead of education loans leading to better opportunities, overly easy access to nondischargeable loans can trap students in worse financial circumstances than which they started.
Opponents of restoring the bankruptcy code assert that banks would reduce access to credit, borrowing costs/interest rates would increase, default rates would increase, and allowing discharge would encourage bankruptcy abuse. First, why should a bank lend to someone they think will default in the first place? Also, the reasoning behind non-dischargeability from 1976 to the 2005 changes has been proven to be unjustified on multiple counts. Interest rates haven’t changed significantly before and after private loans were exempted from discharge in 2005, which begs the question: Why did the financial lobby request this exemption reasoning that credit availability would increase?
Also, longer ago when legislators feared that conniving doctors and lawyers would intentionally ditch their student loans and go on to earn high incomes, a study carried out by the General Accounting Office reported that less than three quarters of a percent of bankruptcies were declared in this abusive manner. Not to mention, bankruptcy is a very undesirable, last resort alternative for struggling students. One’s credit score and future ability to borrow takes significant damage. Finally, tired of getting bashed by consumer advocates, even private lender Sallie Mae supports the discharge of education loans provided that borrowers make an honest effort to repay for five years. By allowing discharge after demonstrating an effort to repay for five years, coupled with recent changes to the bankruptcy code that essentially require debtors to set up a repayment plan, any concerns of moral hazard on behalf of the borrower should be satisfied. The current game is disproportionately in favor of creditors, where concerns of moral hazard would be more appropriately placed. After the Bankruptcy Abuse Prevention and Consumer Protection Act in 2005, creditors will enjoy unprecedentedly higher recollection rates on bankrupted loans.
Bankruptcy reform is by no means the end-all solution to our nation’s student debt problem. Increasing consumer education, having a strong financial watchdog, and cost-controls for tuition are areas that require improvement to create a transparent, sustainable lending environment. However, repairing the bankruptcy code is critical to offering urgent relief for current struggling debtors and restoring the integrity of our bankruptcy system. By removing the exemption from discharge, we can take a step to reign in America’s most punishing debt and encourage smart, not risk-free, student lending.
Photo Credit: sakeeb