Student Loans and U.S. Bankruptcy Law: Hard to Understand

Student loan debt in the U.S. is a growing problem, with college students graduating with an average debt load of nearly $20,000 as of 2006.  In my last post, I pointed out a recent opinion suggesting a bankruptcy approach that might help students with these loans, even though the debts are nearly always nondischargeable.  Comments to this post suggested that there is an underlying problem in the way U.S. bankruptcy law treats student loan debt.  The comments are right: this treatment of student loans is very difficult to understand.

In last weekend’s debt symposium at the University of Illinois, Heidi Hurd presented a draft paper discussing the theoretical underpinnings of discharging debt.  She noted that the dominant explanation for discharge  is “utilitarian”—holding that discharge promotes the overall good of society by encouraging individuals burdened by debt to engage in productive activity that they would otherwise forgo, since it would only benefit their creditors.  Professor Hurd also pointed out two problems with this rationale: it allows people who may be culpable in incurring debt to escape responsibility, and it imposes losses on individual creditors who may not be able to afford them.

The discussion following Professor Hurd’s presentation noted that U.S. bankruptcy law can be seen as mitigating these problems with utilitarianism.  Some exceptions to discharge—e.g., for fraud or intentional injury—punish wrongful conduct in incurring debt.  Others—e.g., for domestic support obligations—assure payment to creditors who may be in particular need.  Priority of payment in bankruptcy similarly protects needy creditors.  These considerations certainly help rationalize the U.S. bankruptcy  system.

The treatment of student loans, however, can’t be explained using this modified-utilitarian rationale.  Student loans are generally incurred in good faith; indeed, they are encouraged as wise investments.  And providers of student loans are not in particular need of repayment; they can easily spread their risks either to other student borrowers (through higher fees and interest) or to society at large (through government subsidies).  Moreover, if it were thought that repayment of student loans was necessary for the lenders, some sort of priority, even if not a requirement of full payment in Chapter 13, would be expected.  But there is no such priority—which makes the treatment of this debt punitive, despite the absence of wrongful conduct by the debtor.

As originally enacted, the 1978 Bankruptcy Code provided that student loans could be discharged either if five years had passed from the time payment was first due or if the debtor provided for repayment during a three-to-five year Chapter 13 plan.  This provision could be supported by the sort of “needs-based” rationale that underlies the means test: an intuition that while students might not be able to repay their loans immediately after graduation, they would likely be able to do so a few years later.  But once student loans were made permanently nondischargeable, this rationale was lost.

If there is a way to explain current U.S. law on the dischargeability of student loans, it is not apparent.

Comments

[Anonymous JD]

I find it highly ironic (but not surprising) that the most vehement "supporters" of student loan reform via dischargability through bankruptcy are the same teachers benefitting from the indentured student population and exorbitant tuition rates.

What we need, and what is coming, is that a generation of students will wake up to the fact that college and post graduate education is a cash cow for the teaching industry. Yes, it is an industry and we are the customers that are getting fleeced. Eventually, we will say enough and demand immediate entry into the workforce after high school, and more on the job training.

Seven years of education for a JD is completely unnecessary. I could be doing what I'm doing now after two years of college, if that.

-A

[bob]

I thought the rationale was that, by construction, a student loan could not be collateralized and its likelihood of repayment was conditioned on the human capital accumulation it financed. But a person with student loans cannot be made to work. In the absence of a strong form of commitment, such as a higher hurdle to discharge under chapter 7, or subsidies (government guarantees) student loan interest rates would be very high.

Still, this does not explain why obtaining a hardship discharge, for a permanently disabled person for example, is so difficult in many states.

[Patches]

Not difficult in many states. Difficult period! You have to be "On your way out" to get a hardship discharge these days.

I understand the need to keep people from rushing into chapter 7 bankruptcy to discharge their student loans. The way tuition is rising (out pacing inflating year over year over year) we will have a generation of Americans that will not be able to afford college or will be mired in almost insurmountable undischargeable debt.

There is no getting around the fact that my kids will have to make a “correct” life changing decision at 18. If you get into the wrong major and end up having to pay 15-30k for a degree that is not in demand at the time of graduation life will be miserable. Who is going to go into "drama, acting, music" majors? The stakes would be too high because the odds of getting a job with those degrees will be to low. Not dogging drama classes. I was a music major myself for a semester or two. Thank God for community college and their prices.

[bob]

As a liberal arts major and a member of a household that paid off 80k in student loans (half govt and half private) I have a very personal understanding these concerns.

But the mix of grants vs. loans is largely a question of public policy. I am not sure lenders should be blamed if we collectively fail to choose the appropriate mix.

[Patches]

Judge, you make awesome points and I am learning a ton.

Why did they make student loans non-dischargeable if liquidity was not an issue? I don't know exactly where I get this from but I seem to remember reading (i think) that Student Loans were made non-dischargeable because of Liquidity issues. Private lenders were hesitant in getting into the student loan markets because of the old 7 year dischargeable test. Or was it 5 years like you said?? I guess left out of the Bankruptcy Reform mix was how to treat them in chapter 13s..?? Why did they then make it harder to obtain a hardship discharge if they already had made student loans non-dischargeable in the first place? It’s not like I used to see a ton of hardship discharge Adversaries. They were a rare thing even before they made the test for "Hardship Discharge" tougher.

If they were so worried about liquidity in the first place why did they not give debtors a chapter 13 “out”? It just does not make sense. AMC did make a good point, in that requiring the pay back (in full) in a 13 would hurt debtors. That I have no doubt but the whole structure doesn’t make sense to me. Now we have private lenders in the mix and we still hear of liquidity problems with private lenders making student loans. There are I know as AMC and your Honor pointed out, that there are a lot of student loans out there that are not in bankruptcy or may never be a part of a bankruptcy proceeding. But to me that does not explain all of the amendments to BK code pertaining to Student Loans. For Congress to take such steps, it would seem to me that there was an enormous hemorrhage of money somewhere….or Politics.

[Martha Sherwood]

In going through student loan hardship discharge cases and noting the large number of them in which discharge was denied on some technicality of one prong of the Brunner test, even though it was abundantly clear that the person could not possibly make meaningful payments on the loan, I was puzzled as to why lenders and guarantee agencies fought discharge tooth and nail on a loan guaranteed by the US Government, until I realized that every year they postpone default and payoff adds to the amount to be paid. In a typical case the amount the person seeks to discharge is twice what he or she originally borrowed. The Government, meanwhile, is postponing the day when it will have to make good on its guarantee - at the expense of the taxpayer.

Restoring the old seven year rule, closing about half the institutions of higher learning in this country, and funding the remainder at a level which made student loans a realistic investment for the average young person might restore a modicum of sanity to this out of control system, but that's not going to happen any time soon barring total financial disaster in the entire public sector - in other words, probably not before the election.

[Patches]

Your comment just connected the dots for me. Thank you for your comment. I have seen Hardship Discharges overturned by the cir. courts on tiny technicalities as well.

What burns me is that when debtors’ starts to make any kind of substantial payments towards their Student Loans the servicers start to do this "musical chair" dance. First your paying the servicer, then they tell you to you pay a different co., then its back to the first, then it gets kicked to Sallie Mae..on and on and on.... Just like mortgage servicers, I see that payments get mixed up and not credited correctly, or the debtors made payments to the wrong company, and then it’s quite the ordeal to correct it. When the debt gets bounced around like that it is super easy to lose a payment or two, add a penalty or two....it goes down hill fast from there if you are not careful and financially savvy.

I am starting to see the financial logic of such tactics now. It works so well for the mortgage servicing industry. I never would have thought of the fact that private lenders would have so much to gain by keeping student loans differed for so long and by shuffling them back and forth like they do. More money they can collect from the government..... wow! It’s so simple. I guess I needed to see it from a different perspective. I’m too close to the action.

[Anonymous JD]

http://jdunderground.com/thread.php?threadId=15606

[Roxanna Groves]

I am fascinated by the discussion on the discharge of student loans. I think one issue is that all student loans are being put into one big basket and there actually several different kinds of loans out there. Personally, I agree that Federal Perkins Loans should be nondischargeable in almost every case. Why? These loans are made from a revolving fund held by the school. The interest is at most 5% and the students' repayment of these loans funds other students' education. Their non-payment depletes the fund and deprives incoming students of the same opportunities.

I was delighted to see the loopholes tightened that chased a lot of lenders out of the business of private lending and I am hopeful that this will go a long way towards reducing the 'musical chairs' factor where loans are bundled and sold causing the who-do-I-pay issue. That being said, the interest on student loans is still traditionally very low and if used wisely these loans remain a way students can complete an education and hopefully (in this economy it is problematic) find a job that will let them repay their loans in a timely fashion.

Student loans are the only kind of loan I know of that there are deferments, forbearances and renegotiated payment plans available for borrowers in trouble. Try getting a deferment on your car loan! Borrowers do need to accept responsibility for knowing what the hell they are borrowing before they take the money. Statistics show that 1 out of 4 borrowers is clue free as to what is available to help keep them out of trouble.

Why? Look at the schools. Schools must begin to accept responsiblity for educating their borrowers before they hand out large pots of money to those students. How many 18 and 19-year-olds do you know that can borrow the equivalent of a luxury car with just their signature? For Federal Direct, Stafford and Perkins loans there is no credit check and nothing but a pro-forma interview (yawn) before the new borrower gets a big check. In most cases the money goes to tuition and books and housing but personally I have known people who bought cars or paid for weddings with their student loan checks.

It was the huge defaulted barrel of money that caused the Department of Ed to take a hard look at how to recoup their money for future students' use. That played directly into student loans becoming non-dischargeable. If I could change the rules I would make sure students understood WHAT they were borrowing and what the effect would be on their lives in about 7 years, wishful thinking, but if we want to avoid more of these bankruptcy issues with giant loans we need a "Scared Straight" version focusing on loans.

Universities are supposedly not for profit and having worked in this industry for over 25 years I know the staff are not getting rich although tuition and housing keep rising. And,I find it odd how many people are just focused on going to a school with a name instead of a less expensive state school--guess what? After you graduate and enter the work force no one cares where you got the degree and that top ten private school may cripple your income for life.

America needs to stop howling about the problems of bankruptcy and student loans when its too late. Let's take a good look at the students feeding into the system--are they counseled before they enter those really expensive schools and rack up enormous debt? How old are they when they are introduced to the concept that college costs money--a lot of money? How do we get junior high and high schools to be proactive and work with colleges and universities to reduce the burden before it happens to the next generation? No answers, just questions and a belief its time to think outside the box.

[Zakk]

I find all of this depressing at best. I am 43, totally and permanently disabled with an amputation, insulin-dependent diabetes, heart disease with three heart attacks so far, and more to come ...guaranteed. What really gets me is I am treated like I am trying to fault the government for my health, I am not. I do fault them however for their total and permanent outlook on the disabled period. Yes, I took out loans to further my education, to make something of myself, I held a 4.0 and better thru the three years I attended class, during those three years, I amassed a good chunk of loans I intended to pay back in full; ...but, first an amputation of my right leg, and then three consecutive heart attacks changed all that; when I was physically able to resume my classes the US Dept of Student Loans and the University I attend told me ..."You can come back and finish your degree, when and only when you pay off the $33,000 you owe for loans already taken." Basically, my degree is being held ransom for a sum of money I cannot produce because of my health; and now the USDoE is trying to garnish my measly disability income. It's sick, it's depressing, and the only way out for me now it seems would be to just not survive my next heart attack. Hmmm ...maybe a bullet would be quicker. It's never going to be fixed, this I believe.

[butterfly]

GREEDY GREEEEEEEEEDY GREEDY GREEDY GREEDY GREDY GREEDY GREED A BASKET OF WICKEDNESS,OPPRESSION AND TYRANNY.....THATS ALL I HAVE TO SAY....OH ....YOUR LIFE IS WORTH MORE THAN 33000 DOLLARS. IS THE US DEPARTMENT OF EDUCATION GUILTY OF CREATING A SUICIDAL PLACEBO GROUP?

WE WANT NEW CIVIL LAWS THAT OVER RIDE THESE OPPRESSIVE, RANSOM HOLDING, GREEDY, SHAMMY OFFICES THAT WILL FREE AMERICAN CITIZENS AND OTHER STUDENTS TO FULFILL THE PURPOSES THAT THEY WERE CREATED FOR...THE LAWS ON UNDISCHARGEABILITY SEEM TO EVEN EXALT THEMSELVES ABOVE OUR CREATORS PURPOSE FOR CREATING INTELLIGENCE AND THEREFORE PROPERLY DEVELOPING A PERSONS SKILLS AND SERVICEHOOD SO THAT THE BLESSING OF A EDUCATION CAN BE SURMOUNTED...PERHAPS IT'S THE JUDGES THAT ARE BEING UNMERCIFUL. WE WANT LAWS THAT BRING REAL SOLUTIONS THAT BUILD THE AMERICAN PEOPLE...YES EDUCATION IS A CIVIL RIGHT!! PRINCIPLE SHOULD ALWAYS COME BEFORE A LAW....THERE SHOULD BE PRE REQUISITE CLASSES ON BORROWING STUDENT MONEY FOR EVERY POSSIBLE STUDENT BORROWER AND THEIR FAMILIES....IT SHOULD BE A LAW THAT NO LENDER CAN LEND WITHOUT THE CLASSES "UNDER THE BELT"....(AN IDEA) IN THE HIGHLY TECHNICAL AND DATA FREE WORLD WE LIVE IN TODAY....IT SEEMS "LUD" THAT THESE LAWS HAVE BECOME HIGHLY OPPRESSIVE AND OUT OF DATE FOR OUR GROWING POTENTIAL S AS A creative RACE,CREED AND NATION...priniciple should come before the law....love should be the foundation of the law.....not technical difficulties...

[butterfly]

GREEDY,GREEEEEEEEEDY,GREEDY, GREEDY,GREEDY,GREeDY,GREEDY,GREED (8 is the number of new beginnings)A BASKET OF WICKEDNESS,OPPRESSION AND TYRANNY.....THATS ALL I HAVE TO SAY....OH ....YOUR LIFE IS WORTH MORE THAN $33,000 DOLLARS. IS THE US DEPARTMENT OF EDUCATION GUILTY OF CREATING A SUICIDAL PLACEBO GROUP in America?

WE WANT NEW CIVIL LAWS THAT OVER RIDE THESE OPPRESSIVE, RANSOM HOLDING, GREEDY, SCAMMY OFFICES THAT WILL FREE AMERICAN CITIZENS AND OTHER STUDENTS TO FULFILL THE PURPOSES THAT THEY WERE CREATED FOR...THE LAWS ON UNDISCHARGEABILITY SEEM TO EVEN EXALT THEMSELVES ABOVE OUR CREATORS PURPOSE FOR CREATING INTELLIGENCE AND THEREFORE PROPERLY DEVELOPING A PERSONS SKILLS AND SERVICEHOOD SO THAT THE BLESSING OF A EDUCATION CAN BE SURMOUNTED...PERHAPS IT'S THE JUDGES THAT ARE BEING UNMERCIFUL. WE WANT LAWS THAT BRING REAL SOLUTIONS THAT BUILD THE AMERICAN PEOPLE...YES EDUCATION IS A CIVIL RIGHT!! PRINCIPLE SHOULD ALWAYS COME BEFORE A LAW....THERE SHOULD BE PRE-REQUISITE CLASSES ON BORROWING STUDENT MONEY FOR EVERY POSSIBLE STUDENT BORROWER AND THEIR FAMILIES....IT SHOULD BE A LAW THAT NO LENDER CAN LEND WITHOUT THE CLASSES "UNDER THE BELT"....(AN IDEA) IN THE HIGHLY TECHNICAL AND DATA FREE WORLD WE LIVE IN TODAY....IT SEEMS "LUD" THAT THESE LAWS HAVE BECOME HIGHLY OPPRESSIVE AND OUT OF DATE FOR OUR GROWING POTENTIAL S AS A creative RACE,CREED AND NATION...priniciple should come before the law....love should be the foundation of the law.....not technical difficulties...WHAT ABOUT MERCY...I SAID MERCY A MORAL FOUNDATION.

[Rachele]

I finished a 4 year degree (which turned into a 5 year bachelors degree because I lost 5 family members in a 2 month period during my 3rd year of college). Because of fees, I have $85k in student loans (I graduated 2 years ago). I have $25k in fees that were added to my loans, AND I have been paying on at least half of them (the rest are defered) I can not find a job in my field (human development) because you need a masters degree or a car to get most of the jobs in this field. I cant get a car because my student loans made my debt to income too high. I thought I was doing a good thing being the first in my family to go to college (most of them didnt finish highschool). I was wrong. I dont make enough to pay the $500 minimum payments on my loans every month, that is 1/3 of my income! There is nothing I can do, and to be honest, I see no choice but to kill myself. My whole life is ruined by this debt that I cant do anything about.... to make matters worse, my job just got outsourced to India.... thanks government! You are doing a great job of protecting people and their jobs!