Democratic lawmakers in both chambers of Congress have proposed legislation that would make private student loans eligible for discharge under U.S. bankruptcy laws.
Sens. Richard Durbin of Illinois, Sheldon Whitehouse of Rhode Island, and Al Franken of Minnesota introduced the Fairness for Struggling Students Act (S. 3219) in the U.S. Senate on April 15, the same day that Reps. Steve Cohen of Tennessee and Danny Davis of Illinois introduced the Private Student Loan Bankruptcy Fairness Act (H.R. 5043) in the U.S. House of Representatives.
The House Judiciary Committee recently held a hearing on the proposed House bill (webcast of the House Judiciary Committee hearing on the Private Student Loan Bankruptcy Fairness Act, April 22, 2010).
Student Loans Among Most Difficult Debts to Discharge
As the U.S. bankruptcy law stands now, private student loans — credit-based student loans issued by private banks without the backing of the federal government — are grouped together with government-backed federal college loans under the category of “education loans,” which are exempt from discharge in bankruptcy in all but extreme cases.
In order to have one’s private student loans erased in bankruptcy, a borrower must be able to show that repaying the loans would result in “undue hardship,” a legal standard that can be extremely difficult to meet and that has generally been reserved for government- and court-mandated obligations — unpaid alimony and child support, tax debts, criminal fines. Neither car loans nor credit card debts, not even home mortgages, are subject to the undue-hardship requirement to be dischargeable in bankruptcy.
In fact, the legal requirements for discharging education loans are so onerous to meet that most bankruptcy attorneys avoid the process altogether.
Of the roughly 72,000 student loan borrowers in bankruptcy in 2008, only 0.4 percent sought discharge for their student loans, notes Mark Kantrowitz, the publisher of FinAid.org and FastWeb (“Congress Proposes Allowing Private Student Loans to Be Discharged in Bankruptcy,” FastWeb, April 22, 2010).
Half of those roughly 2,880 cases have been resolved, with only 22 percent of those borrowers succeeding in having some or all of their student loans discharged. Out of all 72,000 borrowers, just 29 had their student loans discharged entirely.
Private Student Loans Would be Redefined as Private Consumer Loans
The protected status currently allocated to private student loans in bankruptcy wasn’t always the case. Until a change in bankruptcy laws five years ago, private student loans, like credit cards, car loans, and other privately issued debts, were dischargeable in bankruptcy.
But in 2005, as a bankruptcy reform bill — eventually signed into law by President George W. Bush as the Bankruptcy Abuse Prevention and Consumer Protection Act (S. 256) — was taking shape, a provision was added to recategorize private student loans as education loans, granting private student loan lenders the same protections against debt write-offs in bankruptcy as the federal government, which issues federal student loans that are subsidized by taxpayers.
“The 2005 bankruptcy restrictions penalize borrowers for pursuing higher education [and] provide no incentive to private lenders to lend responsibly,” Rep. Danny Davis criticized, in the comments from lawmakers that accompanied the notice on Sen. Richard Durbin’s website announcing the proposed student loan bankruptcy reforms (“Durbin, Cohen, and Others Introduce Legislation to Restore Fairness in Student Lending,” April 15, 2010).
Davis, Durbin, and the other sponsors of the House and Senate bills seek to rectify what they see as an unfair bankruptcy exemption by redefining private student loans as private consumer loans, which could then be considered for discharge, as any private debt would be in typical personal bankruptcy proceedings.
The legislation is aimed at “restoring fairness in student lending by treating privately issued student loans in bankruptcy the same way other types of private debt are treated,” Durbin said.
Added Sen. Sheldon Whitehouse, “By repealing special treatment for private lenders, we will hold big banks accountable, protect young people from abusive lending practices, and make college more affordable.”
Lenders and Advocates Offer Mixed Support for Student Loan Bankruptcy Bills
Federal student loans are unaffected by the proposed legislation and will remain categorized as education loans and exempt from discharge in bankruptcy except in cases that meet the “undue hardship” standard. Unlike private student loans, federal student loans, as government-funded and taxpayer-subsidized loans, were shielded from discharge even prior to the bankruptcy reforms of 2005.
This ongoing exclusion in the submitted bankruptcy bills has led to mixed support among student loan lenders and consumer advocates, some of whom see the omission of federal student loans from the proposed legislation as creating an uneven playing field tilted against private lenders.
Supporters of the federal-loan exclusion point out that private student loans mostly lack the consumer protections guaranteed by federal student loans, such as fixed, capped interest rates, income-based repayment plans, and payment deferment options — all of which leaves struggling borrowers more in need of bankruptcy protection.
Borrowers of private student loans are “at the mercy of the lender if they face financial distress due to unemployment, disability, or illness,” said Rep. Hank Johnson, D-Ga., in his testimony before the House Judiciary Committee.
Without monthly payment caps or flexible repayment alternatives, and subject to interest rates that can reach into the double digits — as much as two or three times the interest rates for federal college loans — “private student loan borrowers are often unable to work out terms that ensure a reasonable and fair payment schedule,” Johnson said.
Sallie Mae, the largest private student loan company in the United States, while backing the spirit of the legislation, objects to the singling out of non-federal private student loans.
“Sallie Mae continues to support reform that would allow federal and private student loans to be dischargeable in bankruptcy for those who have made a good-faith effort to repay their student loans over a five-to-seven year period and still experience financial difficulty,” Sallie Mae spokesman Conway Casillas told Kantrowitz.
Casillas emphasized Sallie Mae’s position that Congress should “extend the same consumer protections to all education loans, regardless of the source or tax status of the entity or governmental institution providing the funds.”
Alan Collinge of StudentLoanJustice.org, an advocacy group for borrowers in default on their student loans, agrees that Congress should provide bankruptcy protection for “all student loans, public or private, held or guaranteed by nonprofits and for-profits.”
But Collinge objects to any sort of special preconditions — like the repayment caveat proposed by Sallie Mae that would require borrowers to have been repaying their student loans for at least five years before the loans are dischargeable — saying that student loan borrowers should be afforded “the same fundamental consumer protections that all other borrowers enjoy.”
Another student advocacy group, the United States Student Association, has thrown its strong unilateral support behind the reform bills. “This legislation ends the special treatment private student lenders have enjoyed for years at the financial and personal expense of debt-ridden college graduates,” said USSA’s president, Gregory Cendana (“Students Back Measures to Restore Fairness in Private Student Loan Bankruptcy Laws,” United States Student Association, April 20, 2010).
“If a struggling individual can file for bankruptcy on their home, credit card, or even gambling debts, then why not student loans? This is an anomaly in bankruptcy law that arbitrarily treats student borrowers worse than other types of borrowers,” Cendana added.
According to the USSA, student loan borrowers in the Unites States currently hold an estimated $730 billion in outstanding federal and private student loan debt, of which 60 percent, or $440 billion, is in deferment or default.
Republicans Express Concern for Potential Impact on Student Lending
Although some Congressional Republicans agree with the need for reform to address the issue of ballooning student loan debt, Trent Franks, the Republican representative from Arizona and the House Judiciary Committee’s ranking minority member, doesn’t see the dischargeability of private student loans as a solution.
“H.R. 5043 is not the answer to the growing debt burden that our nation’s graduates face. The real culprit is the rising cost of higher education,” Franks said during the Judiciary Committee’s hearing on the Private Student Loan Bankruptcy Fairness Act.
He also questioned why private student loan lenders are being targeted. “This bill singles out private student loans for less favorable treatment in bankruptcy than loans funded by the government and nonprofit organizations. Now, why should we single out private student loans for less favorable treatment?” he asked.
“The exception from bankruptcy discharge that private student loans currently receive is vital, … ensur[ing] that private capital continues to flow into the student lending market,” Franks said.
Franks maintains that the availability of private student loans is critical for families to be able to pay for college. Private student loans “are used to help fill the gap between the actual cost of attendance and the limits on federal loans and school-provided financial aid,” he said. “And because this gap is increasingly growing wider, private loans are becoming a more and more important tool to finance education.”
Under the proposed bills, with greater exposure to the risk of bankruptcy write-offs, lenders of private student loans would have to tighten credit restrictions even further to appease investors, making private student loans even more unavailable to all but those borrowers with the most sterling credit histories.
“Student lenders are finding it more difficult to raise capital because investors are not buying securities backed by student loans,” said Franks. “Legislation like H.R. 5043 that makes student loans less attractive to investors will inevitably have the effect of shrinking an already depressed private student loan market.
“If lenders are forced to scale back student lending because private student loans are subject to bankruptcy discharge, many students will be denied access to higher education,” Franks said.
Ultimately, he warned, the proposed legislation “will discourage private lending and encourage abuse of the bankruptcy system.”
Noted Consumer Advocacy Attorney Likens Private Student Loans to Subprime Loans
But Deanne Loonin, attorney at the National Consumer Law Center, who was also called to testify at the House Judiciary Committee hearing, disputes Franks’ prognosis of the bills.
“The harsh treatment of students in the bankruptcy system was built on the false premise that students were more likely to abuse the bankruptcy system,” Loonin said in her submitted written testimony. “Yet there is no evidence, and has never been any evidence, to support this assumption.”
Speaking before the House committee, she also accused private student loan lenders of engaging in predatory lending.
Private student loans reflect “all the features of subprime lending, including the failure to assess reasonable ability to repay,” Loonin said. “Poor underwriting, irresponsible lending, high fees, origination fees up to 10 percent, APRs … all variable-rate — 15, 20, over that percent.”
Moreover, she testified, when she contacts student loan lenders on behalf of struggling borrowers to try to negotiate more manageable repayment terms, the lenders “offer virtually nothing” to the borrowers. Without being able to discharge their private student loans in bankruptcy, even as a last resort, financially distressed borrowers are left with no recourse and ongoing student loan payments that can keep them from being able to save money and get back on their feet.
“Basically, the most vulnerable borrowers are the least likely to be able to repay the loans,” Loonin said, “and they are the ones who are hurting the most.”
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