Opinion: Why Bankruptcy Protection for private student loans Failed

In breaking news, an amendment to the Higher Education Act reauthorization to reinstate some bankruptcy protection provisions for borrowers of private student loans was voted down on Thursday in the House of Representatives.

Backstory: in 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act altered the way in which courts treated private student loans. Prior to the BAPCPA, private student loans were treated as any other consumer debt and could be discharged (cancelled) in bankruptcy. After the BAPCPA, private student loans were exempted from discharge in bankruptcy, giving them equal footing with federal student loans.

Borrowers who took out private or federal student loans at any point who sought discharge of debts in bankruptcy would still owe the full balance plus interest of their student loans even in bankruptcy, and lenders could pursue a variety of options to collect on the debts, including garnishment of wages, seizure of income tax refunds, liens against property, and other debt recovery methods.

The amendment to the Higher Education Act would have offered students the ability to discharge private student loans after five years had passed since graduation, and loans from non-profit lenders would have remained exempt.

The failure of the amendment is an indicator of the times and part of the bigger picture. Right now, financial institutions are facing a sea change in consumers’ attitude towards debt. The recent episode of 60 Minutes featuring borrowers with the ability to repay a mortgage debt but choosing not to because of declining equity has rocked the lending industry to its core.

All lending is based on a simple premise: people who borrow money ought to repay it. If you loan someone money, even from an early age, you do so with an understanding and agreement that the borrower will give you back your money. With consumers simply walking away from huge loans, in some cases willfully defaulting (recent articles have highlighted that due to the huge number of foreclosures, borrowers who default on a mortgage can reasonably expect 6 - 12 months of free living in their property) or mailing in the keys to their houses. With no real equity or investment in their properties, simply defaulting and walking away from their obligations is relatively easy, and the stigma of bankruptcy has far less impact today than it did a generation ago.

Given this backdrop, plus the collapse of the credit markets due to bad mortgages, it’s no surprise that financial institutions would have lobbied very hard to preserve the current laws surrounding federal and private student loans with regard to bankruptcy. Any opportunity for financial institutions to retain any form of debt protection is something highly sought after right now, and student loans are the safest form of debt a bank can issue.

Federal student loans are guaranteed not only to be repaid, but also for banks to be guaranteed 95 cents on the dollar from the federal government, making them incredibly safe to lend to students. private student loans are guaranteed to be repaid because borrowers cannot obtain any form of debt discharge; even if the borrower stops paying and declares bankruptcy, they cannot forfeit the debt obligation.

Will the efforts by some advocates to add bankruptcy protection to federal or private student loans succeed? Not likely in the current environment. A change such as bankruptcy protection adds a great deal of risk to student lending, risk of the loan not being repaid, risk of the debt simply being cancelled by a court. Neither banks nor the federal government have any appetite for increasing risk to the financial system in the current market turmoil, and until the credit markets and mortgage problems work themselves out of the system, both financial institutions and the government are likely to remain highly risk averse.