Wednesday, September 14, 2011

Student Loans - The Coming Crisis?

Recently some have begun to raise concern about a perspective bubble in the student loan market. In the past student loans served a vital purpose in society allowing intelligent students who lacked the financial means the ability to attend college augmenting their education and helping them develop the necessary skills to succeed in an advanced job. Success in these advanced fields garnered larger salaries which allowed for timely repayment of the loans and effective participation in the consumer-based economy. This system worked as long as each component: high quality colleges, available advanced jobs, available and skilled workers and effective lending institutions were present.

Unfortunately the “Great Recession” has greatly handicapped the availability of not only high-quality jobs, but even medium quality jobs, which adds significant delay to the repayment schedule, if payment occurs at all. In addition to this failure in the original system the rise of ‘diploma mills’ / ‘for profit’ colleges which charge traditional college tuition amounts, some charge even more, but typically provide a questionable education have also added undue stress on the education-loan-job cycle. The development of these stressors demand deterrent options, in case an economic recovery (which would restore the cycle to balance) is slow to develop, to avoid unpaid loans becoming a long lasting problem.

In this cycle a cause of concern is the relationship between private lenders and student borrowers. Before the “Great Recession” private lending to students for college was on the rise largely driven by ‘dream college’ syndrome (where the student wants to attend college x no matter what the cost) and dramatically rising college cost with over 100 now exceeding $50,000 a year.1 These two factors consistently drove college costs outside of the total yearly caps offered by federal government loans demanding that students seek financial assistance elsewhere. The problem for students is that the private lending industry with respect to student loans is almost completely unregulated with a significant number of instances where even the limited regulatory rules are ignored without consequence. This lack of regulation provides little protection for the borrower and its prevalence throughout the entire private student loan industry is frequently an unnecessary burden on student borrowers.

On its face the most glaring initial difference between federal student loans and private student loans is the variable interest rates associated with private loans opposed to the fixed rates of federal loans. Not only do the private loans use variable rates, but also these variable rates are unnecessarily high. Variable rates typically include a quasi-floor in a margin which is added to the prime rate to ensure the rate does not go too low. It is almost unheard of for these loans to have a rate ceiling. The standard argument used by private lenders for these high rates is to absorb risk, but such an argument is not substantiated. The student loan market is similar to the sub-prime mortgage market, which demonstrated that opportunity pricing governed mortgage rates over perceived risk that the borrower would default. Also most of this ‘risk’ based pricing forgets to note that higher interest rates, especially in this economic environment, should increase the probability of default. At the moment private student loan lenders are not deterred by that reality because bankruptcy laws are designed heavily in their favor.

Others try to justify a high variable rate based on the university that the given individual is attending using university prestige as a means to measure of potential future income. The problem with this justification is that outside of a very select few, university prestige has little meaning anymore in the workforce. The fact is that most of the value in the high variable rates stems from the desire to profit, nothing else.

This desire to profit is further emphasized in the numerous fees which private lenders add to loans and their general dealings with borrowers. Lenders constantly charge for loan origination, late payments, arrangement of deferments or forbearances, copies of loan payment histories and loan verifications.2 Not surprisingly most of these services are widely utilized by borrowers especially deferments and forbearances (when available) in effort to avoid delinquency and default when payments cannot be made. It is an interesting strategy by these lending organizations to charge a fee for a service that is designed to limit short-term payment burden due to a lack of available funds.

In effort to ensure a high volume and probability of collection, most observers view the behavior of private student lenders as both ‘predatory’ and unethical. This behavior is demonstrated through a majority of loans have mandatory arbitration clauses, typically buried and hidden, which strip the borrower of most court-based litigation avenues instead directing disputes to arbitration where the arbitrator is frequently selected by the lender.2 Also private lenders rarely offer flexible arrangements which could tie repayment rates to income, initiate rehabilitation for formerly defaulted borrowers or offer long-term repayment relief.2,3 In addition forbearance, is rare and deferment is unsubsidized (interest accrues). A number of subjective or poorly defined default triggers are commonly found in private loans such as a borrower could be declared in default if in the lender’s judgment they experience a significant lessening of ability to repay even if a payment has yet to be late or missed.2 Finally loans are typically not discharged even in the death of the original signatory or cosigner.

In addition the poor regulatory environment does little good for potential borrowers due to a lack of transparency and/or an ample amount of ambiguity. Such specificity gaps allow the lender to quickly change or manipulate elements in the loan to the lender’s advantage without the concern of legal reprisal. The lack of certainty in consequences for failure to abide by the limited existing regulations renders those regulations moot.

For example private loans under $25,000 are covered by the Truth in Lending Act (TILA), which largely governs disclosure and repayment timing.4 The TILA contains a ‘loop-hole’ of sorts in the special rules for interim student credit extension, which are used when the repayment amount and rate/schedule are not known at the particular time when credit is extended.2 Due to the lack of disclosure on the day the credit is extended, mandatory and complete disclosure is supposed to occur when an agreement on the repayment schedule is created; however, the creditor may delay disclosure until the due date of the first payment.2 Unfortunately this delay commonly creates violations mostly stemming from improper or incorrect APRs. Normally lenders provide two APR disclosures, one for the interim period before repayment and then one for the repayment period (the repayment APR is almost always higher). However, a significant number of times lenders incorrectly report this second APR to the borrower which is in violation of the TILA.4

Another regulatory problem is a lack of note inclusion. The lending organization, sometimes legally referred to as the ‘holder of the note’, is subject to the claims and defenses that the borrower can assert based on conditions created by the Federal Trade Commission. The basis of this information is provided in a notice in the note itself and its inclusion is required by the holder. However, a number of lenders (40% in one study) simply do not include the notice in the note in an attempt to limit potential liabilities (liabilities which frequently only exist when lenders break the law).2 In other instances 90% of those who included the notice also included contradictory information or clauses which sought to undermine the ability or the desire of the borrower to utilize the information in the notice.2

With respect to the ‘holder of the note’ one of the issues that is creating concern among financiers is a repeat of the sub-prime mortgage fiasco as securitizing student loans has continued to gain in popularity as a means to increase revenues. However, at the moment it is difficult to see such a crisis coming to fruition because unlike the sub-prime crisis the federal government handles a vast majority of the student loans. Therefore, any crisis from student loans involves one of two issues. The first crisis, as mentioned previously, is a slowdown in the economy due to less available capital that loan holders can spend in the U.S. consumer-based economy because they cannot discharge or steadily payoff their loans. A secondary element of this first crisis is that economic conditions could worsen to the point where individuals elect not to attend college creating further shortages in highly-skilled workers creating employment skill gaps.

The second crisis is lost government funds due to student loans not being paid back at a high rate. This second crisis is a long way off though due to the generally small total amount of the student loan program relative to the size of the government and the interest payments made by those individual who are able to pay back their loans in full filling some gaps. One concern is that if private lending does increase the significant lack of regulation and no borrowing limits the rate of default among student borrowers could increase dramatically worsening both potential crises.

Some may argue that private student lenders fill a need in the marketplace and that if a potential borrower does not like the terms that are given he/she can go elsewhere, that is theoretical basis of competitive capitalism. The problem with the ‘don’t like it don’t do it’ reasoning that is typical for those who want to strip any complexity from an issue due to its potential detriment, is that these practices are endemic within the private student loan industry thus there is rarely a viable alternative which would be more beneficial to the potential borrower. Therefore, if these funds are needed, which they most likely are otherwise a private loan would not be sought out, the borrower typically has to decide on college or no college. Selecting the latter frequently results in a negative for society because an individual is denied an opportunity to increase his/her skill set, intelligence and overall usefulness to society. Overall the argument that government should not regulate the student loan market is a foolish one that is not supported by reality. For example look at usury law for banks; standard government regulation on a similar level should apply for private student lenders because the environment has become homogeneous in a negative manner due to a lack of regulation and pure greed.

One of the crux issues involving the first potential student loan crisis is the difficulty in which student loans can be dismissed through bankruptcy. In 1976 Congress enacted a nondischargeability provision to respond to complaints that recent college graduates were abusing the bankruptcy system to eradicate their student loan-based debts soon after graduation.5 Whether or not abuse was actually occurring was controversial due to a lack of empirical evidence demonstrating the alleged abuse. Logic also seemed to go against this mindset because relative to inflation most college tuition was not excessive in the 70s and bankruptcy came with significant penalties. In some respects the logic behind using bankruptcy to discharge student loans before even trying to pay them back is similar to using abortion as a primary form of birth control, any benefits are heavily outweighed by the costs/detriments. Overall this nondischargeability provision applied to only federal and non-profit loans and had two exceptions. First, a debtor could discharge student loans when filing for Chapter 7 bankruptcy five years after loan maturity. Second, the debtor could discharge if he/she could prove ‘undue hardship’.6,7

The first provision was eventually abolished by the Higher Education Amendments of 1998, after a brief increase in wait time from five years to seven years, leaving undue hardship as the only means in which to discharge federal student loans.8 Seven years later the Bankruptcy Reform Act of 2005 eliminated the differences between how bankruptcy affected private student loans and federal student loans with private lenders receiving similar protections, which were previously held only for the federal government.9,10 Basically prior to 2005 loans from private lenders could still be discharged through normal bankruptcy, after the Bankruptcy Reform Act of 2005 the only means to discharge any student loan, federal or private, was through undue hardship. The U.S. is the only jurisdiction under review to have extended the application of the exception to discharge to non-government funded or guaranteed student loans.6

Applying for undue hardship occurs through filing an adversary proceeding after filing for bankruptcy. Typically the chief, sometimes the only, criteria for determining undue hardship is the Brunner test which includes three elements: 1. the debtor cannot maintain a minimal standard of living when factoring in repayment of the student loan debt with respect to current income and expenses; 2. there is no reasonable expectation that these circumstances will change within the timeline of the repayment schedule; 3. the debtor has attempted to find other avenues in which to provide some means to repay the loans;11

While the Brunner test is supposed to impart some measure of consistency in whether or not a student loan(s) should be discharged, one of the prevailing problems is that this consistency is left up for interpretation. This dependency on interpretation creates an environment where the attitude of the ruling judge tends to be much more important than whether or not the conditions of the Brunner test are actually met. Overall some individuals seem to misrepresent the student loan crisis as individuals always being mired in debt when in fact a past study found that 45% of individuals who filed for a discharge of student loans through undue hardship were successful. The crisis is that the discharge only becomes available when the point of undue hardship is attained, which means the person is probably in significant financial peril even without the loans. Note that it is a misconception that when discharge is granted through undue hardship that the entire student loan amount is forgiven; instead typically a given percentage is forgiven to a point where the loan debt is not longer viewed as undue hardship. In the above study where 45% of applicants received discharge, approximately 72% of the debt, on average, was discharged.7

From at least this study the fear of being saddled with student loan debt over the course of your entire life seems somewhat overblown; especially in this down economy where the unemployed have less reason to take personal blame for not having a job or having a much lower paying job than previously planned and thus not having the necessary income stream to pay back the loan in a timely fashion. For even those who agree with the premise that student loans are not a forever crippling albatross the problem of consistency is still a significant issue. Thankfully because the Brunner Test does provide some guidance the issue of consistency should be solvable by simply expanding the pool of judgment. Instead of having a single judge presiding over an undue hardship hearing five judges could preside with the majority ruling acting as the official decision. The most important issue for this solution would involve ensuring appropriate scheduling due to the lack of an ‘official’ undue hardship panel for the judges involved would be drawn from the pool.

However, some argue that a 45% discharge rate is too little, what about those 55% that are still saddled with their debt and no feasible means to successfully discharge it? First, it must be assumed that the expansion of ruling judges to 5 will result in a similar discharge rate for undue hardship, the accuracy of such an assumption is unknown. Overall the best solution is to simply eliminate the restrictions on eliminating student loans via bankruptcy, especially since no one has produced valid evidence on the original reason for its restriction, rampant filing to eliminate debt right after completing college. One could argue that the bankruptcy filing and penalties would prove to be a deterrent to fraudulent bankruptcy filing. Also an alternative to simply eliminating the discharge restrictions would be to create some level of interest forgiveness for those that successfully acquire a college degree. In this instance individuals that make effective use of the funds and have a higher probability of contributing to the economy should have a better opportunity to fulfill that potential by not having to deal with superfluous interest.

The issue of bankruptcy is only one element driving the potential student loan crisis; while there are others of minor importance, the second major issue is the rise of for-profit educational institutions. For the purpose of this post a ‘for-profit’ can be defined as: institutions of post-secondary education that are privately-owned or owned by a publicly traded company and whose net earnings can benefit a shareholder or individual.12

The rise of the for-profit educational institution was driven by filling the presumed need to offer more flexible courses and hours to currently employed individuals, typically older than traditional college students, who wanted to pursue advanced degrees largely motivated by thoughts of promotion at their current job. Some also argued that these institutions would remove any stigma associated with older individuals interacting in a traditional college environment with younger individuals. In addition for-profit institutions utilized an open admissions policy so their busy professional applicants would not have to be burdened by taking standardized tests. Unfortunately this intention has seemingly been corrupted by the pursuit of profits.

A scathing report about numerous acts of irresponsibility at best to outright fraud in the for-profit industry were documented by the GAO in 2010.12 While going over the entire report here is not appropriate the most detrimental elements in the report describe multiple instances of fraud where potential recruits were told to lie about their total assets and/or income to make themselves poor enough to qualify for government loans, the tuition disparities between for-profits and other available public institutions and the loan default disparity between students enrolled in for-profits and students enrolled in traditional colleges.12

In 2010 some members of Congress determined that the questionable tactics and frequent complaints regarding for-profits stemmed from a lack of regulations. Regulation was also deemed important because for-profits only accounted for approximately 10% of secondary education students, but utilized 23% of total federal loan funds and their students were responsible for about 50% of total loan defaults.12,13 Therefore, new regulations referred to as ‘gainful employment’ were proposed in typical draft form for all for-profit institutions over a given academic year.13

- At least 35 percent of former students must be actively paying down their federal student loans, defined by lowering their loan balance by at least a dollar.

- Graduates must spend no more than 30 percent of their discretionary income on student loan payments.

- Graduates must spend no more than 12 percent of their total income on student loan payments.

These draft rules would have began in June 2012 with the following conditions applying in each given situation:

- No penalties for a program that is abiding by all three rules;
- Failure to abide by one or two of the rules results in placement on restricted status which could reduce the amount of loans which could be offered to students attending the program;
- Failure to abide by all three rules results in black listing (no loans would be offered to students attending the program);

However, those draft rules were significantly altered in the favor of the for-profit institutions due to changes in enforcement and measurement after what some characterized as heavily lobbying by the for-profit industry. While the rules remained the same the enforcement penalties changed so dramatically that the rules were rendered rather meaningless. For example instead of starting in 2012 the rules associated with ‘gainful employment’ start in 2015, so for-profit institutions have another 4 years to participate in their current questionable practices before changing. Also accountability for rule violation was extended from 1 year to 4 years and a single strike was only given if an institution failed all three rules in a given year. Failure to comply with two of the three rules results in absolutely no penalty or consequence. Finally the penalties associated with various violations over the four-year evaluation period are:

- One strike requires the program to disclose that failure to prospective students;
- Two strikes requires the program warn students of excessive debt, the potential of closure and give students options for transferring to other schools as well as require the single strike penalty;
- Three strikes or more the program is black listed;

At the moment proponents for for-profit institutions, not satisfied with completely neutering these rules, have also filed suit in the U.S. District Court for the District of Columbia towards eliminating the rules entirely. Most proponents cite that the application of these rules will make it more difficult to offer loans, thus reducing the probability that low-income students can attend their institutions and receive a ‘quality’ education. Unfortunately this argument has little to no merit when recalling from above that for-profit institutions routinely and heavily overcharge their students for tuition relative to existing public educational institutions in the same region.

A second argument made by for-profit proponents is that these rules unfairly target only for-profit institutions and all educational institutions should have to abide by them. Once again this argument has little merit because the fraudulent and even predatory environment created by for-profits drove the creation of these rules. So why should a group that has not demonstrated this behavior be penalized in the same way as a group that has? Also a large percentage of for-profit enrollees borrow (upper 80s)14 which is more than traditional students, so once again targeting these rules make sense. Therefore, logic dictates that all these new rules, unchanged from their draft form, would have done on any meaningful scale would have been to reduce the amount of profit that for-profit institutions would have generated from their students, clearly something not in the interest of the for-profit proponents.

Another problem with the above rules is that they do not address the transparency problem that most students face when gathering information about for-profit institutions, especially because recruiters have a tendency to omit information they should not omit in their discussions with potential students.12 Therefore, additions to these rules need to be made. For example all colleges need to have an easily identifiable section on their websites (or a pamphlet available through mail) which identify current tuition costs for a given year, total tuition costs associated with a four year degree over a 4 to 6 year period, what colleges will accept credits from the particular college through transfer, accrediting agency with current status and a working hyperlink to the Department of Labor and Statistics content page to reference starting salaries for a given job.

Also referencing the lenders themselves borrowers should have a clearer picture regarding the terms of any loan, especially after repayment begins. This goal can be accomplished by requiring lenders to provide estimates of all important loan items that will apply once repayment begins. Note that these would only be estimates so they would not be binding, but they would give the borrower a better understanding of whether or not he/she could afford the loan and what to expect when going into repayment. Currently lenders are ‘encouraged’ to provide similar type information, but rarely do, so it should be required. There is no detriment to providing this service unless the lending institution is planning on screwing over the borrower.

Also the above rules do not demonstrate any way to measure the methods used by for-profits to ‘hide’ defaulters by using forbearance and other deterrence tools. Therefore, individuals who are almost guaranteed to default or even exceed the income caps can be shuffled to another analysis period to avoid penalties for the current period. Associating this ability to hide defaulters with the excessive administration failures required to even receive one strike, it is difficult to conclude that these rules will have any negative impact on for-profit practices.

This ‘hiding’ issue is also important because most of the information that is gathered and reported on regarding loan health and default rates only take into consideration defaults, not long-term ongoing delinquency avoidance. Delinquency is commonly defined as ‘failure to make monthly payments within 60 days of the due date when expected to’. Default commonly occurs when a borrower exceeds 270 days of delinquency.14 However, for students that have departed college, tools like deferment and forbearance are usually a bad sign regarding their ability to reengage in loan payments, especially in the current economic climate. Therefore, while these individuals have technically yet to default, for a number of them it is only a matter of time until they do, but when they will is not clear because of continued delay through the use of these various tools.

The problem with this situation is that most of these individuals who are delinquent or quasi-delinquent (avoiding delinquency through continuous use of forbearance, etc.) are basically in default because they are not making significant enough payments to pay off their debt, yet officially these individuals are not counted as in default so statistically the problem is typically worse than people think it is. Such inaccurate information may provide some pause to those that are concerned about student loans becoming another sub-prime mortgage crisis.

Overall if the current economic climate continues a high probability exists for a problem to develop in the student loan environment. While this problem should not be similar to the crisis that struck the sub-prime mortgage industry because the federal government is responsible for a vast majority of lending (over 80%),15 the more pressing issue is that without an effective and reliable means to discharge student loan debt the inability to find jobs will force borrowers out of the economy. Less money in the economy means less economic growth which hurts society in general. This situation can quickly start a self-sustaining feedback cycle (similar to what has been seen in the housing market), which further damages the economy and becomes even harder to escape. Another aspect of this problem is the lackadaisical attitude individuals in government have toward the for-profit education industry which frequently exacerbates the loan problem by charging excessive tuitions and other fees and using potential predatory tactics to convince recruits to pay them. Regulatory enforcement is needed for this industry to stem this contributing problem. In the end steps must be taken to address this problem otherwise the reduced capital in the market will create a significant drag on the economy as well as negatively affect the future educational prospects of millions of potential college students.


1. Brainard, J. “A Public University Joins the Expanding 50K Club of College Prices.” The Chronicle of Higher Education. October 31, 2010.
2. Loonin, D, and Cohen, A. “Paying the Price: The High Cost of Private Student Loans and the Dangers for Student Borrowers.” National Consumer Law Center. March 2008.
3. Institute for Higher Education Policy, “The Future of Private Loans: Who is Borrowing, and Why?” at 6
(December 2006).
4. Truth in Lending Act.
5. B. Hennessy, "The Partial Discharge of Student Loans: Breaking Apart the All or Nothing Interpretation of 11 U.S.C. 523 (A)(8)" (2004) 77 Temp. L. Rev. 71 at 73
6. “Government Student Loans, Government Debts and Bankruptcy: A Comparative Study — Part 2” Office of the Superintendent of Bankruptcy Canada.
7. Pardo, R, and Lacey, M. “Undue Hardship in the Bankruptcy Courts: An Empirical Assessment of the Discharge of Educational Debt.” (Tulane University School of Law, Public Law and Legal Theory Research Paper Series, Research Paper No. 05-06 (August, 2005)).
8. C. Morea, “Student Loan Discharge in Bankruptcy – It is Time for a Unified Equitable Approach.” Am. Bankr. Inst. L. Rev. 1999. 7(193) at n 2.
9. Pardo, R, and Lacey, M. “The Real Student-Loan Scandal: Undue Hardship Discharge Litigation.” Am. Bankr. L. J. 2009. 179(83).
10. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8 § 220, 119 Stat. 23, 59 (to be codified at 11 U.S.C. § 523(a)(8)(B)).
11. Brunner v. New York State Higher Education Serves Corporation 831 F. 2d 395 (2d Cir. 1987
12. Kutz, G. “For-Profit Colleges: Undercover Testing Finds Colleges Encouraged Fraud and Engaged in Deceptive and Questionable Marketing Practices.” Government Accountability Office. Aug. 2010.
13. Program Integrity: Gainful Employment-Debt Measures. Education Department. 6/13/2011.
14. Cunningham, A, and Kienzl, G. “Delinquency: The Untold Story of Student Loan Borrowing.” Institute for Higher Education Policy. March 2011.
15. DeRitis, C. “Student Lending’s Failing Grade.” Moody’s Analytics. July 2011.

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