Tuesday, December 27, 2016

Discharging Student Loans in Bankruptcy

There's no shortage of articles warning of an impending student debt crisis in the U.S. News organizations are quick to remind us that student debt now represents a larger portion of overall outstanding debt than credit cards and auto loans. So I dug into it a little bit...

It's over $1 trillion, and all the reports warn of the potential damage it can do if a large swath of the country is buried under debt -- sacrificing other forms of consumption to go towards digging out of the hole.

It's not hard to imagine why student debt loads have increased so dramatically. If there's one theme that's been pounded into our collective heads regarding education, it's that it is the primary tool to realize economic/social class mobility. If there's another theme, it's that college keeps getting more and more expensive. Put those two themes together, and you have a recipe for increasing student debt, but with a critical catalyst that I'll get to shortly.

As the parent of two young children -- that college prices are exploding has me concerned. The raw increase in college costs has been pretty extraordinary, just one data point:

This fall, Harvard's annual tuition and fees (not including room and board) will set you back $45,278, more than 17 times the 1971-72 cost. If annual increases had simply tracked the inflation rate since 1971, next year's tuition would be to just $15,189.

I know it's Harvard, but what can I say? I'm setting my expectations for my kids very high! Although by the early 2030's when they'll be looking to go, who knows if I'll be able to afford what it costs.

Let's set my own finances aside, and come back to what's driving the increase in college costs. Much is made of colleges building amenities and features that range from the merely opulent to the truly fantastical. Climbing walls in state-of-the-art fitness centers, dorms with private bathrooms, and iPads as far as the eye can see. That's a line of thought that gets buy-in and nodding from liberals and conservatives. Then there's another focus on increase in administrative staff -- more frequently raised by conservatives -- because to attribute the cost increases to nest-feathering bureaucrats who happen to tilt liberal fits well with the conservative view of the world. With that said, it's very likely true to some degree as well.

But I was curious if another structural force could be at work to drive increasing college costs and resulting debt obligations. That's the inability of borrowers to discharge educational debt in bankruptcy.

Unlike other forms of debt -- student loan debt doesn't disappear if you try to declare bankruptcy. It doesn't get discharged. It stays there forever.

And this isn't some historical artifact, the major legislation which drives it dates back only about ten years ago:

Before 1976, all education loans were dischargeable in bankruptcy. That year, the bankruptcy code was altered so loans made by the government or a non-profit college or university could not be discharged during the first five years of repayment. They could, however, be discharged if they had been in repayment for five years or if the borrower experienced “undue hardship.” Then, the Bankruptcy Amendments and Federal Judgeship Act of 1984 made it so all private student loans were excepted from discharge too.

Two decades of further tweaks to the bankruptcy code ensued until 2005, when Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which made it so that no student loan — federal or private — could be discharged in bankruptcy unless the borrower can prove repaying the loan would cause “undue hardship,” a condition that is incredibly difficult to demonstrate unless the person has a severe disability. That essentially lumps student loan debt in with child support and criminal fines — other types of debt that can’t be discharged.

So we treat student debt in the same way we treat criminal fines or child support -- you can't get out of it, pretty much under any circumstances. Although there are some measures like repayment programs that try to make it easier -- it's not a stretch to say it's extremely difficult and unlikely you'll escape from student loan debts if you're unable to pay them back.

If we think through the impact of that legislation -- I'd argue you can draw a pretty clear line to an ever-increasing debt load for students in the U.S. Thinking about it logically, the bankruptcy legislation eliminated a major cost for student debt issuers. With the threat of bankruptcy discharge off the table, financial institutions would be much more liberal in doling out money, as they're no longer left holding the bag if a student can't pay. Now it doesn't matter if a student can't pay, the debt stays with them, and while it's clearly not as financially beneficial to a bank vs. paying back a loan on schedule, they maintain the means to get theirs even if it takes decades and essentially throws the student into a practical debtors prison.

Looking through some research to find evidence of this thought - I came across an NBER paper summary which explains exactly the phenomenon I assumed existed:

The answer is that by making it harder for consumers to escape their debts, the new law dramatically reduced lenders' losses from default and bankruptcy. As a result, they started lending more, even to consumers with bad credit. Credit card debt increased more quickly during the past two years than at any time during the previous five years.

Consumers should have responded to the new harsher bankruptcy law by borrowing less, which would have lowered their risk of getting into financial distress. But not all consumers behaved in this rational way. Instead, many behaved shortsightedly and took advantage of the greater availability of credit to borrow more than they could easily handle --- ignoring the risk of financial distress. (Economists refer to this shortsighted behavior as "hyperbolic discounting" - consumers who are hyperbolic discounters intend to start paying off their debts immediately, but each month they consume too much and end up postponing repayment until the following month. So their debts steadily increase.)

The new bankruptcy law exacerbated the problem of shortsighted consumers borrowing too much, because it prevented many of them from using bankruptcy to limit their financial distress. Many consumers in financial distress are unable to file for bankruptcy under the new law, because they cannot afford the costs of filing, cannot meet the new paperwork requirements, or are ineligible. This means that their debts will not be discharged and they will remain vulnerable to creditors' collection calls and to wage garnishment that may take funds they need for basic necessities. Because of the new bankruptcy law, consumers can end up in deeper financial distress than would have been possible before 2005.

This paper is about credit card debt, not student loan debt, but the principle is the exact same. Eliminate the potential write-off cost of default from the lender, and not so surprisingly, they lend more!

Reading more on the legislation ticked me off a little further -- especially given that support for the 2005 bill turned out to be bi-partisan, passing with over 70 votes in the Senate and over 300 in the House. Even Joe Biden voted for it (I assume because Delaware has some big interest in the credit card business), although Obama notably didn't.

If we're interested in reducing the amount of student debt borne by borrowers -- I'd advocate for allowing bankruptcy protection for borrowers. I'm not persuaded by the argument that loosening the rules will create tons of strategic bankruptcies by fresh Yale grads with Art History degrees. Bankruptcy, although it would help reduce debt loads, still has very real costs in terms of credit score impact that aren't easy to walk away from. The more persuasive counter-argument, is that allowing students to declare bankruptcy will tighten lending exactly for the group of prospective students -- those without much financial means -- that need it most.

I think that's probably true, but only to a point. I think it could dramatically reduce lending to students aiming to attend for-profit institutions, the same ones with pretty dubious records of leading to gainful employment in a given field. I also think that's probably a good thing. You wouldn't want to keep someone from being able to borrow to get an education that would dramatically help their career prospects -- but you would want to keep someone from being able to borrow to attend a crappy online college that can't help them get a job. If you were truly worried about the latter, I'd argue maybe you allow bankruptcy filing for borrowers attending for-profit colleges, but not for non-profit ones. Given that for-profit students make up 35% of all loan defaults, it would at least be a start