Are You There, SCOTUS? It’s Me, Tetzlaff. The Harsh Bankruptcy Discharge Rules Are Not Protecting The Integrity Of The Federal Student Loan Program
It's time for the courts or for Congress to act, according to columnist Shannon Achimalbe.
Last week, I explained the circuit conflict over how courts interpret the “undue hardship” standard when deciding whether to discharge student loans in bankruptcy. I then argued that this should be the basis for the U.S. Supreme Court to grant certiorari and settle the conflict once and for all.
The court that created the (in)famous Brunner Test for discharge stated that student loans must be “a very difficult burden to shake off” in order to maintain the integrity of the guaranteed federal student loan program. But does a strict interpretation of undue hardship for the entire life of the loan serve this purpose?
It should be noted that Brunner was decided in 1985, when student loans were nondischargeable in bankruptcy for five years after graduation. The plaintiff in Brunner filed bankruptcy seven months after graduation. The court understandably wanted the debtor to work harder, stop acting entitled, and network during the five-year waiting period.
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Today, it is no secret that total student loan debt exceeds $1.2 trillion. The Consumer Financial Protection Bureau reports that one in four student loan borrowers are currently in default or struggling to stay current on their loans, despite the availability of income-driven repayment options for the vast majority of borrowers.
The student loan business has grown significantly and has contributed to the growing debt burden among young people. But it appears that not all of the money generated from repayment is not going back to the federal government, as I will explain below.
The good loans are refinanced away from the federal government to private banks.
In recent years, the interest rate of most federally backed student loans ranged anywhere between 5% to 8.5%. This is unusually high considering that interest rates for other loans were at their lowest in decades. Regardless, most students applied for federal loans because they were easy to obtain, and income-based repayment (IBR) and deferral options were available in case of unemployment and underemployment.
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But those who are able to pay off their loans within the repayment period or do not qualify for IBR are stuck with paying relatively high interest rates. So now comes the private student loan market. Banks and startup online lenders such as SoFi and CommonBond are targeting these well-off graduates by offering refinancing at lower interest rates.
Of course, these companies don’t offer these interest rates to just anyone. According to this article, more than half of SoFi’s borrowers earn at least $100,000 a year and have an average FICO score of 774. CommonBond CEO David Klein points out that his average customer has a credit score north of 760 and makes $140,000 a year. Their target clients appear to be graduates of prestigious institutions.
So that explains why my refinancing application was denied. Repeatedly.
What ends up happening in the long run is that the federal government’s student loan portfolio will be stuck with the defaults, the IBR/PAYE lifers, and the rest of the financial lepers. While the government gets its loan money back plus modest interest and future net interest tax revenue when its good debtors refinance out, I suspect it will not be enough to offset the loss from the bad debtors.
SLABS that may be too big to fail.
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Not only are student loan lenders fighting over the good debtors at the expense of the federal government, they are also seeking to profit immensely by selling the loans wholesale through the use of Student Loan Asset-Backed Securities or SLABS.
Here is a good, concise explanation of how SLABS work from a Business Insider article:
SLABS consist of student loans that have been refinanced and packaged into a large offering. That offering is then cut into pieces and sold to institutional investors, like hedge funds and pension investments.
For years, SLABS have been advertised as a strong investment vehicle. Why? Because most of the borrowers have strong credit. Another big selling point for investors: Unlike normal consumer debt, student loans are almost impossible to discharge in bankruptcy.
According to Business Insider, in 2015, SoFi has already placed $700 million in SLABS. The company expects that figure could rise to $2 billion by the end of 2015. Quarterly SLABS are expected to commence in 2016 and SoFi CEO Mike Cagney says SoFi can sell $4 billion in asset-backed securitizations in 2016. Last year, CommonBond executed the securitization of $100 million of student loans.
So it appears that a good portion of the student loan repayment income will be used not to maintain the solvency of the federal student loan system, but instead to make somebody else richer. And if SLABS are sold to pension funds (particularly to government pension funds), then protecting its solvency can be a new reason for Congress and the courts to maintain strict nondischargeability rules for student loans. Not only will this create strife between the generations, but this will in effect turn student loan payments into a secret tax on the young.
The Supreme Court justices will meet on January 8, 2016 to determine whether to grant certiorari in the Tetzlaff case. I and many others strongly urge them to do so. Granting certiorari alone does not change policy. It is merely starting a debate — a debate that is much overdue. A reasonable person would question whether the strict interpretation of the undue hardship rule serves more to improve a private investor’s rate of return as opposed to keeping a debtor responsible for his debts and maintaining the solvency of the federal student loan system.
Defenders will argue that easing bankruptcy rules will result in a wave of recent graduates lining up in bankruptcy court, getting their student loans discharged and then using their paychecks to spend lavishly. While this sounds like a moral hazard (and an economic stimulus), I seriously doubt this will happen. Filing bankruptcy is still generally frowned upon by society. Filers will be unable to buy anything on credit for a few years, usually in the prime of their lives. If they aspire to be professionals, then a bankruptcy can jeopardize their chances of getting licensed. As more employers are conducting credit checks, a bankruptcy will adversely affect a person’s ability to get a respectable job. Finally, the financial stigma of a bankruptcy will make it harder for a young person to get married and start a family.
What easing bankruptcy rules will do is give seriously delinquent debtors a stronger negotiating position against aggressive collection agencies. By playing the bankruptcy card, the debtor can convince the creditor to provide more favorable payment terms rather than ignore phone calls and letters as they tend to do in these situations. So this may incentivize those with seriously delinquent debts to rehabilitate themselves and work out a long-term solution.
I would like to propose the following solution for determining undue hardship in future student loan bankruptcy cases: If the debtor files bankruptcy within the first five years after graduation, all jurisdictions must apply the strict Brunner test, just as the court did back then. If the debtor files bankruptcy five to ten years after graduation, courts should apply the more lenient totality of the circumstances test. For physicians and certain health-care professionals, graduation happens when they finish their final residency or fellowship training.
I would also like to propose a new solution for people who are filing bankruptcy more than 10 years after graduation and for debtors with special circumstances such as senior citizens with minimal income, people with terminal or disfiguring illnesses, or cases where debtors can prove that their schools have misled them about salaries and employment prospects. In these cases, the court should apply the undue hardship standard similar to what is stated in Section 524(m)(1) of the bankruptcy code. This standard is endorsed by Bankruptcy Judge Michael B. Kaplan. In this case, undue hardship is defined as a situation in which a debtor’s monthly net income simply is not enough to permit payment of the specific debt.
There are some who suggest that the student loan bubble has become “too big to fail” and forgiving loans will trigger a financial crash. That is unpredictable and debatable. But assuming the worst, I say let it come. Most likely it will be the final catalyst for student loan finance reform.
One final thought. If cert is denied and the status quo continues, I’m afraid that young people with massive student loan debt will have no one to turn to for help.
Except for one man. A man running for President of the United States who is considered by many to be an electable candidate.
This man understands and has benefited from the bankruptcy laws. So he is likely to be sympathetic to the plight of the distressed debtor and push for student loan discharges in bankruptcy. And this man sounds serious about purging the country of murderers, drug dealers, rapists, and terrorists. Some may call him a racist with a bad mullet and a loud mouth. But he’s only in office for four years, eight at most. What damage can he really do in that relatively short time frame?
Think about it.
Shannon Achimalbe was a former solo practitioner for five years before deciding to sell out and get back on the corporate ladder. Shannon can be reached by email at sachimalbe@excite.com and via Twitter: @ShanonAchimalbe.
