A Bankrupt Argument

In 2005, Congress tucked into the bankruptcy bill a provision making it virtually impossible for borrowers to discharge private student loans. That provision -- which was added in a secret conference committee, received no public debate, and had no named Congressional sponsor --represents a glaring example of politicians serving corporate interests over regular people.

Momentum is building on Capitol Hill, however, to change the law before it does too much damage. Sen. Richard Durbin (D-IL) has introduced legislation that would reverse the 2005 statute for private loans, providing much-needed relief for borrowers who have found themselves in severe financial distress.

For most unsecured loans, the debtor who runs into difficulty can file for Chapter 7 liquidation or Chapter 13 reorganization, so a judge can sort out the appropriate treatment of the various loans. But there is a short list of debts that the law subjects to a different status, allowing for discharge in only the most extreme circumstances. The government, for example, makes it especially difficult for people to escape child support responsibilities, overdue taxes, and criminal fines. Federal student loans also can't be discharged. There is at least some justification for providing federal student loans that status: they are backed by taxpayer dollars, and they come with some borrower protections in cases of economic hardship, unemployment, death, and disability.

But there is absolutely no good reason that private student loans should be accorded any heightened status, much less the exalted category that competes with criminal fines, child support, and taxes.

The student loan industry, of course, is fighting Mr. Durbin's measure, warning that eliminating the exemption private student loans have from bankruptcy protection would ultimately hurt low- and moderate-income students. Without the absolute guarantee that the loans will be repaid, lenders, the argument goes, will be reluctant to lend non-federally guaranteed, private student loans to low-income borrowers. Without being able to obtain these loans, these students may not be able to afford to go to college at all.

Never mind that these are high interest loans with variable rates that go as high as 20 percent for the riskiest borrowers, who also tend to be those with the greatest financial need. Never mind that colleges are increasingly loading up poor and working class students with private loans, while devoting greater shares of their institutional aid dollars to attracting the "best and the brightest" students who also tend to be the most affluent.

The real question is whether the lenders claims are true. According to a new study by FinAid.org, a website about student aid, the answer is "No."

To tackle the issue, the study examines the FICO scores of Sallie Maes private loan borrowers before the passage of the 2005 bankruptcy legislation and after. The breakdown of FICO scores which measure the probability that a borrower will repay his or her debt, with the highest possible score being 850 are contained in the loan giants prospectuses for securitization.

Looking at Sallie Maes prospectuses from 2002 to the present, the study found that there was only a "negligible increase" of 0.2% in the "availability of private student loans to borrowers with low credit scores" after the new law went into effect. Only 7.5 percent of Sallie Mae's borrowers had FICO scores equal to or below 650 before the bill was passed, and only 7.7 percent had such scores afterwards. Surprisingly, the average weighted FICO score was 718 both before and after the bankruptcy legislation was approved.

In other words, allowing desperate borrowers to discharge their private loan debt through bankruptcy "is unlikely to result in a significant decrease in private student loan availability to prospective borrowers with low credit scores," according to Mark Kantrowitz, finaid.org's publisher.

Looks like the loan industry will have to go back to the drawing board and try to come up with better arguments to protect private loans' heightened status. Absent any compelling argument, Congress ought to swiftly and publicly consider Mr. Durbin's student loan borrower relief legislation.