Why Student Loans Never Go Away
06.25.21
“Sallie Mae sounds like a naive and barefoot hillbilly girl, but in fact they are a ruthless and aggressive conglomeration of bullies located in a tall brick building somewhere in Kansas,” wrote David Sedaris, America’s favorite humorist, in 1997. “I picture it to be the tallest building in that state and I have decided they hire their employees straight out of prison.”
When Sedaris first noticed Sallie Mae’s aggressive tactics, it had yet to reach the apex of its powers. Federal student loans could still be shed in bankruptcy (albeit, seven years after graduation), and they had yet to be grouped in the same consumer debt category as unpaid child support, unpaid alimony, criminal debt, and delinquent taxes. This would all happen just a year later.
Few could have foreseen that Sallie Mae, once a wholesome government initiative to help more kids to attend college, would soon morph into one of the most fearsome monopolies known to consumer borrowers. Fewer still could have predicted the “untamed beast” that would grow into the $1.8 trillion student loan portfolio now held by the federal government, a reality we are finally starting to grapple with today.
Just last week, many hoped the Supreme Court would offer some respite by clarifying the definition of “undue hardship” — currently the only circumstance eligible for bankruptcy relief of student loans — but it passed on the opportunity in favor of allowing the legislature to decide.
Why are student loans treated so punitively in bankruptcy? And how did the federal government effectively become the largest consumer bank in America? In this article, we discuss why student loans were stripped of standard consumer protections, how they became the favored policy tool for expanding higher education, and which policy options are being explored to reduce their outsized footprint today.
Why Does the Government Issue Most Student Debt?
When President Nixon first created Sallie Mae in 1972, it was in response to a dramatic market failure: the inability to invest in our own nation’s human capital. Student loans were not a burning political issue in the 1960s because few people went to college besides WWII veterans, the exceptionally gifted, and the exceptionally rich. In 1960, according to the US Census, fewer than 1 in 3 students graduated from high school, and a mere 6% of students obtained a college degree.
However, as the Cold War progressed, education was increasingly viewed as a powerful means to bolster national defense, increase international competitiveness, and combat domestic poverty. The problem was nobody wanted to pay for it. Even Milton Friedman, poster boy for free markets, was troubled at the private market’s failure to facilitate general education. “For whatever reason, an imperfection of the market has led to underinvestment in human capital,” wrote Friedman in 1962. “Government intervention might therefore be rationalized.”
Why did the private market fail us? Because students, by their very occupation, make for a terrible customer profile. Most college-bound students have no assets, no credit score, and no income for the first four years that they are requesting a loan. This makes student loans a particularly risky form of unsecured debt. On top of these unknowns, it’s also hard to predict a student’s future ability to pay. Returns on education are variable, depending on the institution, field of study, student performance, health of the economy, etc. As a result, lenders are unable to price risk and simply offer the same fixed cost to borrowers.
Rampant inflation further increased uncertainty of profits, and so the government intervened. Sallie Mae — originally a government-sponsored entity that would later privatize — encouraged banks, schools, and private lenders to make loans to college students in exchange for guaranteeing the loans or purchasing them in a secondary market. Essentially, Sallie Mae insured private lenders a profit, regardless of student default or repayment rates.
Why is (Most) Student Debt Nondischargeable?
As federal student loan debt increased, student loan protections were slowly stripped away by Congress over the course of nearly thirty years. Congress was initially concerned that student debtors would abuse the bankruptcy system by shedding their debts immediately upon graduating. The specter of the “hypothetical student loan debtor who graduates on Tuesday and files for bankruptcy on Wednesday,” as one judge describes it, shaped consumer bankruptcy reform. In 1978, the Bankruptcy Code was amended to prevent the discharge of student loans (without undue hardship) until five years after graduation.
Another concern was that the federal well would run dry. When a debtor defaults on a federal student loan, taxpayers foot the bill. Many Congressional members believed that reclassifying student loans as presumptively nondischargeable was the only means to “insure our youngsters in the future that loan money will be available to them as it was to past generations.” This is a marked departure from other kinds of federally guaranteed loans, including Farm Loans, FEMA loans, and SBA loans, all of which remain dischargeable in bankruptcy.
Nonetheless, in 1990, the bankruptcy code was amended again to extend the nondischargeable period to seven years. Meanwhile, Sallie Mae fully privatized in 1997 and began to aggressively lobby Congress to help bolster its acquisitional crusade. A year later, Congress passed the Higher Education Act (HEA), which exempted nearly all federal loans from discharge (and in 2005, it expanded the exemption to include private student loans). As one student debtor who appeared in bankruptcy court explained, “The judge told me not to come back unless I was in a wheelchair.”
Even disability, however, is no guarantee for discharge. In addition to disqualifying most student loans from bankruptcy, HEA expanded the powers of loan guarantors and collection companies. It allowed for the garnishment of wages, Social Security, and disability, a reality still faced by many student debtors today (in fiscal year 2019, the Department of Education recouped $4.9 billion from benefits due under government programs). HEA also allowed for exorbitant collection fees (up to 25%), tax seizure, suspension of state-issued professional licenses, and termination of public employment.
“It doesn’t make sense,” said David, a former chiropractor in Texas who now drives trucks in Amarillo after his medical license was revoked. “It’s almost like the government doesn’t want me to practice medicine — never mind that it’s the only way I can reasonably even have a shot of paying this mountain of money back!”
Perversely, legislation actually made it more profitable for lenders and guarantors when students defaulted rather than when they repaid. “At every reauthorization, we kept sweetening the deal for banks, sweetening the pot,” lamented Senator Ted Kennedy. Even today, thanks to accounting methods which categorize loans as profits rather than expenses, defaulted loans appear more profitable to the government since they result in a higher principal from accrued interest.
What Counts as Undue Hardship?
Today, student borrowers seeking bankruptcy relief must meet a legal standard called “undue hardship” to receive a discharge. However, circuit courts have a split standard for proving this, with tougher jurisdictions like Texas, Louisiana, and Mississippi using the onerous Brunner test, whereas more generous states like Missouri and Maine use the totality of circumstances test. The result, as reported by Congress’s think tank, is a confusing and arbitrary relief system where “inconsistency is the most consistent aspect of the standard’s application.”
What makes for a sympathetic debtor? It depends. Most courts agree that frequent cigarette smoking, dining out, expensive vitamins, and long-distance phone calls won’t win you any points, but other personal habits demand more scrutiny. Should a student debtor pay their student loan interest or donate to their ailing parish? Should a student debtor squirrel away every penny towards the principal or put away some for retirement? Should a student debtor be allowed to have children? Should a student debtor repay their loans if they learned nothing from their investment? (One marketing instructor showed films of “Batman” the whole class. The student’s loans were forgiven).
Each of these budgetary decisions is at the mercy of the individual court. Given their odds, and the additional fee incurred by the debtor to file an adversary proceeding, most student debtors opt not to file (less than 500 out of ~240,000 debtors apply). On a good year, 0.1% of student loan filers will receive a discharge.
Where to Find Relief
Following a number of investigations, Congress upended the traditional model of federal student loans — private loans backed by the government — and replaced it with direct federal lending to borrowers in 2010. It hoped to use the savings from third party subsidies to lower interest rates and provide more grants. Congress also expanded the alphabet soup of income-driven repayment systems (IDRs), which extended the possibility of debt forgiveness to more borrowers. Prior to the pandemic, nearly half of federal student loan debt was held by IDR programs, but most borrowers will not be forgiven for twenty to twenty-five years (and they will also face a hefty tax bill for forgiveness).
Some bankruptcy specialists recommend treating student loans as grants-and-taxes rather than debt. Under most IDR programs, the principal will never be repaid anyways. “If education finance were a tax instrument (a flow) rather than a debt obligation (a stock), it would not appear on consumer credit reports as a liability,” writes Adam Levitin, a professor of bankruptcy law at Georgetown. Many of student debt’s most painful consequences — negative amortization, default, ruined credit scores, etc. — could be avoided. Instead, recipients would “pay back” the grant through future taxes based on income.
Cancelling student debt is another idea that has gained popular support in recent years. However, unless a substantial amount of forgiveness is awarded per individual (+$30,000), most of the benefits would go to higher-income borrowers who hold higher levels of student debt. A singular debt jubilee would relieve the current generation’s pressures, but it would do nothing to lower the cost of college or prevent the same situation from happening twenty years from now.
The simplest option might be to restore bankruptcy protection to student borrowers, a Congressional item most recently proposed by Elizabeth Warren and Jerrold Nadler. At the very least, it could provide more targeted relief to those in default — some 9 million borrowers (or 15% of all student borrowers) — who are most in need of respite.
About Colbeck: Colbeck is a strategic lender that partners with companies during periods of transition, providing creative capital solutions to meet their evolving needs. You can reach the team at inquiries@colbeck.com.
