The Consumer Financial Protection Bureau (the “CFPB”) reported in 2012 that U.S. borrowers are burdened by more than $1 trillion in student debt, including over $150 billion of private student loans.1 According to TransUnion, a credit bureau, the average student debt each borrower carries rose 30% in the past 5 years and more than half of student loan accounts are in deferral status. During the same 5 year time span, FICO Labs, a unit of Fair Isaac Corp., which publishes consumer credit scores, found that delinquencies increased by 22%.3 In an attempt to defuse the next potential “debt bomb,” Sens. Dick Durbin (D-Ill.), Sheldon Whitehouse (D-R.I.) and Jack Reed (D-Ill.) co-sponsored the Fairness for Struggling Students Act (“S. 114”) in the Senate, and Congressmen Steve Cohen (D-Tenn.) and Danny Davis (D-Ill) introduced the Private Student Loan Bankruptcy Fairness Act (“HR 532” and collectively with S. 114, the “Bills”) in the House.
Currently, all student loans are non-dischargeable, meaning that they cannot be discharged in bankruptcy absent a showing of undue hardship. Showing undue hardship is difficult, so most student loans are effectively non-dischargeable. Federal student loans have been non-dischargeable since 1976. Private student loans became non-dischargeable pursuant to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the “BAPCPA”).4 The Bills would reverse certain portions of BAPCPA to allow borrowers to discharge their private student loans in bankruptcy. Federal student loans, though, would continue to be non-dischargeable.
Consumer advocates argue that private student loans should be treated differently than federal student loans for bankruptcy purposes.5 The advocates say that requiring a showing of undue hardship is reasonable before discharging a federal loan because discharging a federal loan would result in a loss to taxpayers. Federal loans also have several built-in protections, including caps on interest rates, flexible repayments options, and postponement or reduction of monthly payments during times of hardship. On the other hand, private student loans often have higher interest rates and do not allow deferment or income-based repayments. According to Congressman Davis, “private education debt is no different than other consumer debt; it involves private profit and deserves no privileged treatment.”6 By treating private student loans similarly to credit card debt, Sen. Reed hopes that the legislation will “send an important message to lenders and students that they need to be responsible.”7
On the other hand, lenders warn that allowing discharge of student loans would increase the cost for all student borrowers.8 The lenders say that allowing borrowers to discharge their private student loans would increase interest rates and decrease the available funds for new loans because of higher risks to lenders. Furthermore, because federal loans are capped to only cover tuition and certain approved fees, students may nevertheless have no choice but to obtain private loans at the higher interest rates to cover the gaps. The end result would merely increase the total cost of education for many borrowers. In any event, the Bills appear to offer only an incomplete solution to the problem because private student loans account for less than 80% of total student loans in the U.S. Many individuals argue that the root cause of the student debt problem is actually rising tuition costs, so allowing borrowers to discharge their private student loans would accomplish nothing more than creating “a one-time, unjust transfer from innocent lenders who did nothing more than give money to people in the hopes of being repaid someday.”9
The Bills would also impact lenders who securitize their private student loan portfolios. Rating agencies look to several collateral characteristics when rating a pool of student loans for securitization, including:
school type (e.g., graduate vs. undergraduate vs. vocational),
co-signature status (i.e. whether or not there is a creditworthy co-signer on the loan),
repayment option (e.g., immediate vs. deferred), and
origination channel (e.g., directly to student or through schools).10
The primary risk in private student loan securitizations, though, is credit risk because private student loans are not guaranteed by the U.S. Department of Education. Instead, private student loans are underwritten like traditional unsecured consumer loans by focusing on the credit history of the borrower. Recovery rates are currently higher for private student loans than other unsecured consumer loans because, as opposed to typical consumer debt, e.g. credit cards, that can be dischargeable in bankruptcy, private student loans are non-dischargeable. The Bills, by providing borrowers the ability to discharge their private student loans, could increase the credit risk for private student loan securitizations, which would impact a securitization’s yield, rating, and collateralization requirements, among others.
The Bills are currently in their respective committees, but it is unclear whether the Bills will be passed. The CFPB’s report has generated more popular support on the issue than in the past. S. 114 has received seven co-sponsors, HR 532 has received 14 co-sponsors, and Sallie Mae, the largest private student lender, “supports 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.”11 On the other hand, Senator Durbin authored similar pieces of legislation in at least three previous sessions of Congress. Legislation similar to the HR 532 has also been introduced at least five times in the House. None of those bills were successful.