Thoughts on Student Loans and the FRESH Start Act

A new bill from Senators Durbin and Cornyn promises a way out of student loan debt through a change in the bankruptcy laws. The Fresh START Through Bankruptcy Act of 2021 makes one principal change. After 10 years from the date they first came due, federal student loans would be freely dischargeable. Before 10 years, student loans would be dischargeable only if the debtor could show undue hardship, which is the standard currently. Private student loans would remain nondischargeable at all times except upon a showing of undue hardship. This is not the bill I would write, but it's a step in the right direction.

How could the bill be improved? First, ten years is too long. It is the entire regular repayment period for a federal student loan. Do we really think that debtors should have to struggle for ten years before becoming eligible for a student-loan discharge. For example, from our "Life in the Sweatbox" paper, 60% of the people who reported they struggled for at least two years before bankruptcy said they went without medical attention and 47% said they went without a prescription they needed. 

My personal preference would be to make federal students loans freely dischargeable 3 to 5 years from their original due date. Immediate discharge raises potential for abuse that the bankruptcy system would not be able to completely police.  The American Bankruptcy Institute's Commission on Consumer Bankruptcy had similar concerns and recommended a 7-year waiting period. This bill with a 10-year waiting period is obviously a compromise for Senator Durbin, who has previously supported complete dischargeability for student loans as well as outright cancellation of some student loans outside of bankruptcy. Senator Durbin's political judgment is better than mine. A shorter waiting period is better than the one currently in the bill, but at least having any time window after which student loans become nondischargeable is much better than what we have now. Notably, the National Association of Consumer Bankruptcy Attorneys supports the legislation. 

The new bill does nothing to address private student loans. Some protection for government loans makes sense because the government has to lend and at the same rate regardless of the creditworthiness of the student borrower. If the bill does become law, however, we will have the perverse situation where private lenders who can make their own underwriting decisions about to whom to lend and at what rate will have more protection than the federal student loans. In this compromise, someone is carrying the water for the financial industry, and I am guessing it is not the senator who previously had argued for very broad discharges of student loans.

The bill also has a clawback provision aimed at colleges and universities whose graduates discharge their student loans in bankruptcy. If at least one-third of a school's student body receives federal loans, the school would have to reimburse the Department of Education for a percentage of the discharged loan if the school's graduates fell above fairly generous thresholds for default and below repayment thresholds. The amount would range between 20% and 50%, depending on how far above or below the thresholds the school fell.

Colleges and universities should have "skin in the game," but this clawback provision is not ready for prime time, to say the least. First, it has no mechanism to initiate the clawback. For example, does the trustee or the court notify the Department of Education about the dischargeabilty finding on a student loan? Second, there are serious due process issues if a court judgment triggers a payment obligation to a school. The school would seem to need to get notice and a right to be heard. If so, the law would put the school in an adversarial position to its former student. Third, because a school would have an interest now in not having the loan nondischargeable, does that give the school the incentive to offer the former student some money to "settle" the nondischargeability complaint and make it go away. Fourth, do bankruptcy courts even have the constitutional power to issue an order with the consequence that a nondebtor would have to pay a third party? Yes, under the proposed legislation the bankruptcy court finding of dischargeability is not formally a "judgment" against the school, but it walks and talks like one. Given the problems with it, the clawback provision would have to be substantially changed if the bill were ever to become law. A more direct approach would be to delink clawback from bankruptcy and instead amend the Higher Education Act of 1965, perhaps creating an obligation on any college or university who receives federal student loans to make a payment to the Department of Education if graduate default rates fell above some threshold.

The Fresh START Act is far from perfect, but if the political judgment is that it is the best path to do anything about student loans given the political realities of today, it is worth exploring.  

Comments

[Robert Hertz]

Thanks for a very thoughtful article.

I am several years from being in the trenches on these loans, so forgive what may be an ignorant question...

I thought that virtually all federal loans could go to an extended repayment plan. The required payments are generally a modest percentage of income. A person on such a plan could not declare bankruptcy just due to student loans, I assume, even though in a global lifetime sense they are bankrupt as all heck.

So, what kind of debtors would be filing bankruptcy under this law?

[Bob Lawless]

Thanks for a thoughtful question. Pamela Foohey just wrote on this blog about ideas of things the Department of Education could do administratively to help with the student-loan problem (https://www.creditslips.org/creditslips/2021/07/the-department-of-education-can-help-with-student-loans-in-bankruptcy.html).

At the heart of the question is the scope of bankruptcy's fresh start. Even if many (although not all) student-loan borrowers might qualify for income-driven repayment (IDR) plans, should they have to spend decades in these plans? After all, most of us don't feel that we should say to someone with thousands of dollars in medical debt, "That's OK. You can just pay a few hundred dollars each month for the rest of your life."

Even if the IDR amount is zero, how long should the debtor have to stay in the IDR? The law does not require people who filed bankruptcy years ago to repay the discharged debts if their circumstances improve.

A big part of the motive for bankruptcy filers under this law would be the clean slate. An IDR does not eliminate the debt. It continues to hang over the person and affect ability to borrow. Also, as an administrative forbearance, it can be taken away should the political pendulum give us another secretary of education who is hostile to student borrowers. Finally, there can be tax consequences to any debt forgiven outside the bankruptcy system. Discharging a student loan in bankruptcy generally will not have any tax consequences.

[RT]

The American Rescue Plan Act of 2021 included tax-free status for all student loan forgiveness and debt cancellation through December 31, 2025. This primarily affects the forgiveness after 20 or 25 years in an income-driven repayment plan, since most other forms of student loan cancellation already had tax-free status.
Normally, the cancellation of debt is treated like income to the borrower. The borrower received an IRS Form 1099-C to report the cancelled debt as income. The cancelled debt is subject to income taxes just like any other income.