Assessing Damage of Private Loans

WASHINGTON -- In a sweeping study of the private student lending market released today, a new federal consumer protection agency compares private loans to subprime mortgages and urges Congress to consider letting borrowers discharge such loans in bankruptcy.

The study, months in the making, touched a nerve as the Consumer Financial Protection Bureau began gathering information about private loans and concern grew about student debt. Almost 2,000 people -- borrowers and their family members, as well as representatives of banks, research groups and higher education organizations -- wrote in to describe their experiences with student loans and to urge the bureau to act.

The result was a report examining the varied private student loan market, which makes up less than 15 percent of all outstanding student debt but is often criticized because its loans offer fewer protections than their federal counterparts. The consumer protection bureau found that loans made just before the financial crisis were among the riskiest, made to students with low credit scores and often without co-signers or involvement from their colleges’ financial aid offices. A majority of those students had not exhausted their federal borrowing options beforehand.

“Our findings reveal that students were yet another group of consumers that were hurt by the boom and bust of the financial crisis,” Richard Cordray, the bureau’s director, said in a conference call with reporters Thursday afternoon. “Too many student loan borrowers were given loans they could not afford and sometimes for more money than they needed. They are now overwhelmed by debt and regret the decisions they made.”

In response, the bureau recommends requiring colleges to become more involved when students take out private loans. The report also urges regulators to look into providing additional protections to private loan borrowers that mimic some features of federal loans, such as forbearance, deferment or income-based repayments. And while stopping short of calling on Congress to once again allow borrowers to discharge private student loans in bankruptcy -- which was outlawed in 2005 -- the report’s authors indicated they found few reasons not to do so.

But the agency also found that some of what it considered the worst practices of the private lending industry have ceased. Between 2005 and 2008, private student lending boomed, increasing from about $7 billion to over $20 billion in 2008. At its peak, private lenders made loans to students with low credit scores and no co-signers, often allowing borrowers to take out loans that far exceeded the cost of attendance at their colleges.

Source: Consumer Financial Protection Bureau

But since 2008, driven in part by new regulations and in part by the recession-driven tightening of the financial markets, there has been a “flight to quality,” the agency found: more loans began requiring co-signers, and nearly all loans in 2009 required colleges to certify that students needed to borrow.

“While these are more prudent trends, borrowers who took out loans at the height of the boom are still suffering from those excesses,” Cordray said.

In response to that concern, the report delves into the arguments against allowing student loans to be discharged in bankruptcy: that it would reduce access to the loans or make them prohibitively expensive. The report’s authors argue that student loans have little in common with other forms of debt that can’t be discharged, such as child support or tax liens. Even federal student loans, also not dischargeable in bankruptcy, are not comparable, they said, because those represent a debt to the federal government and, by extension, to taxpayers.

Eliminating bankruptcy protections did not directly lead to lower interest rates or wider access to credit, the report’s authors argued. Changes to bankruptcy law would also make it more difficult for borrowers to abuse the privilege by declaring bankruptcy to avoid repayment -- although the report also said there was little evidence of such abuse before the change. Congress need not entirely restore bankruptcy protection, the report went on to say, but should consider adding more flexibility for borrowers suffering from economic hardship.

An increasing number of borrowers have opted to file for bankruptcy even though their loans cannot be discharged, perhaps to reduce their payments, although bankruptcy proceedings do so only temporarily. (The entire balance of the loan must eventually be repaid.)

“If Congress concludes that the 2005 changes did not meet their overall policy goals, it would be prudent to consider modifying the code in light of the impact on young borrowers in challenging labor market conditions,” the report’s authors wrote.

Simply by laying out more information about private loans -- including borrowers’ characteristics and the loans’ typical interest rates -- the report is important, said Deanne Loonin, an attorney with the National Consumer Law Center and director of its Student Loan Borrower Assistance Project. Loonin said she appreciated the focus not only on bankruptcy protection but on other steps that regulators could take, perhaps without Congress, to ease the burden of loans for borrowers in default.

“They’re not focusing on bankruptcy as the only way to provide relief,” Loonin said. “There are other possibilities that are more within the CFPB’s jurisdiction to get regulators to pressure the lenders to provide modifications or that sort of thing.”

The agency also recommends mandating college certification of private loans, which requires a financial aid office to get involved before a student signs a promissory note. Certification makes it more difficult for students to borrow far in excess of the cost of attendance, and also gives colleges an opportunity to discuss federal alternatives to private loans. About 90 percent of loans currently are certified by colleges, but there is no federal requirement in place -- although it was considered when the law that created the financial protection bureau was enacted.

“There’s a window of opportunity to put protections in place before we enter another cycle,” said Lauren Asher, president of the Institute for College Access and Success, arguing that the market for private student loans is likely to rebound eventually. “The strong case for improved bankruptcy protections and school certifications really is important.”

Reactions to the report varied among lenders. The Consumer Bankers’ Association criticized the financial protection bureau for avoiding the “elephant in the room” by focusing only on private lending, a narrow slice of the overall student loan market. “Today, private loans are carefully underwritten and borrower disclosures are much more comprehensive than those given with federal student loans,” the group said in a statement.

State lending agencies and nonprofit lenders came in for less criticism in the report; the consumer protection bureau praised such lenders for having lower interest rates and more flexible loan terms over all. The Education Finance Council, a group of such lenders, praised the report for differentiating between various types of lenders. “This report proves that not all private student loans are bad,” the group said in a statement.

The report now goes to Congress and Education Secretary Arne Duncan. But regardless of the outcome, many who work with indebted students argue that the report’s work to increase available information about private loans and student borrowing is a step forward.

“It does shed important light on a market that has really operated in the shadows,” Asher said.