Guest Post: Obstacles or Excuses for Inaction?

[Editor’s Note: Last week, Treasury Secretary Henry Paulson said that he planned to expand the $700 billion bailout plan to aid private student loan providers. But what about the alarming number of financially distressed private loan borrowers who have fallen behind on their payments or are in default? Is there any help for them? In this post, consumer advocate Deanne Loonin takes a critical eye to lenders’ arguments for why they have been so unwilling to provide relief to these borrowers.]

By Deanne Loonin

Oscar, a 26 year old college graduate living in the Bronx, called our Student Loan Borrower Assistance phone line the other day. The first member of his extended family to pursue a higher education, Oscar took out both federal and private loans to pay for college. Earlier this year, he was laid off from one of two jobs he works to make ends meet. Since then, he has run intro trouble making payments on his private loans. He wants to avoid default, but is afraid he will have no choice, as his loan holder has repeatedly refused to work with him to ease his monthly payments.

“The loans were so easy to get,” he says. “So why is it so hard to get some help?”

Oscar is not alone. Defaults and delinquencies on private student loans are growing at alarming rates. This is hardly surprising given the predatory terms of many of these loans and the current state of the economy. So why are student loan providers so unwilling to offer financially distressed borrowers like Oscar the help they need to dig themselves out of trouble and avoid defaulting?

Here are the most common reasons lenders give for not offering relief, and ideas for addressing them:

• Securitization agreements: Some lenders say they can’t provide loan modifications, principal reductions or flexible repayment because the loans were securitized and the pooling and servicing agreements (PSAs) prohibit flexibility. But the securitization agreements we have seen do not expressly prohibit modifications. In almost all agreements, the bottom line instructions to the trustees are to act in the best interests of investors. This leads to the question, are loan modifications bad for investors? Not necessarily. Unlike mortgage loans, student lenders have no collateral to seize that can provide some return to investors. They can either work with borrowers to bring in revenue streams or sue and try to collect. We hope to gather more information on the cost of defaults, but we believe that in many cases it is more profitable for creditors and their investors to provide loan modifications. Most borrowers who are delinquent or in default really are in financial trouble. If the lender sues, there will be little or no assets or income that the creditor can legally seize. Collection efforts in many cases are simply much more expensive than the potential returns.

• Accounting problems: Lenders sometimes claim that they cannot offer work-outs such as principal reductions because of accounting rules that negatively impact their bottom lines. When lenders offer principal reductions to borrowers, they generally must recognize the written off amount as losses at least for a limited amount of time. These write-off requirements pose a disincentive for many creditors to reach settlements. We don’t know how big a barrier this is for student loan providers, but if it is, now is the time to request relief from Congress and federal agencies. Recently, some national organizations representing the financial-services industy have joined together with consumer groups to press federal officials to change the accounting rules to make it easier for banks to offer credit card work-outs to deeply indebted consumers . [So far these groups have been unsuccessful in their efforts but have vowed to keep pushing.] If the accounting rules pose a real problem for student loan companies, we can certainly take a similar approach.

• Moral hazard. It is likely that the loan modifications will be targeted at borrowers who are already delinquent or have defaulted on their private student loans. The supposed moral hazard is that this will encourage borrowers, who are current on their loans, to stop making payments. For the sake of argument, let’s assume that there are some consumers out there who are willing to damage their credit just so they can maybe get some principal reduction or other relief. In that case, yes, it is possible that the programs will be somewhat over inclusive. This seems like a small price to pay when the rewards are potentially so great for financially distressed borrowers and society as a whole. Loan modifications that provide real relief offer another chance to struggling borrowers to better themselves. Getting them back into affordable repayment plans benefits all of us – as borrowers in good standing are more likely to go back to school and pursue careers that will help them be productive members of society.

As we look for solutions to help struggling borrowers, we need straightforward answers from the financial community. Which obstacles are real? And which are simply excuses for inaction?

We would like to work with the financial industry to provide relief to borrowers, investors, and the economy. But ultimately, the incoming administration and Congress will probably have to intervene to require creditors to offer certain modifications and work-outs before placing private loan borrowers in delinquency and offer relief for those already in trouble. Any such effort should ensure that borrowers do not suffer tax consequences from the loan modification programs. For the government, such action will come with a cost — but it is literally a small price to pay compared to the cost of bailing out lenders, banks, and other industries. (This is where the real discussion of moral hazards should be focused).

Not all borrowers can be helped. Some will never be able to afford to repay their loans. Restoring a safety net, including bankruptcy rights, is essential for these borrowers. But a great many borrowers could get back into repayment if only their loan holders would work with them to modify loan terms or offer flexible repayment. The lenders who so aggressively courted Oscar a few years ago owe it to him and other struggling borrowers out there to give this a try.

Deanne Loonin is a staff attorney with the National Consumer Law Center and the director of the center’s Student Loan Borrower Assistance Project. She focuses on consumer credit issues generally and more specifically on student loans, credit counseling, and credit discrimination. She is the principal author of numerous publications, including “Paying the Price: the High Cost of Private Student Loans and the Dangers for Student Borrowers.” Her views are her own and do not necessarily reflect those of the New America Foundation.