3 ways Congress screwed up student loans

Congress has completely screwed up student loans.  First it ventured deep into the student loan business.  It issued loans to many Americans who would have been off better without them.  Then it made student loans almost impossible to discharge in bankruptcy.  Now many Americans are financially suffocating under the weight of loans the government encouraged them to take.

In a way, we can blame this all on Sputnik.  The Russians launched that silvery little satellite in October 1957.  That made Americans, lacking the capacity for such a feat, nervous.  Congress authorized the federal government to begin issuing student loans to encourage the study of science in the name of "national defense."

That was our first wrong turn, and it was wrong for many reasons:

• It created real financial risk in a business the government had no experience managing.  This became an even larger concern in later years.
• It began distorting the market for student loans by offering below-market prices (that's what "low-interest" means).  Who doesn't want the cheapest price.
• It used a tenuous legal justification.  Science has always been important to war.  Yet not in almost 200 years had Americans asserted a Constitutional power to issue student loans for science.  "National defense" wasn't a terribly compelling excuse for the government to dive into this financial market.

A few years later, Congress decided the federal government should make student loans available for all fields of study, not just science.  Further, it began guaranteeing many private loans.  But these were more wrong turns.  The government's financial risk increased rapidly as it issued more loans.  The market for student loans became completely warped.  And the already-tenuous legal justification was simply abandoned.  The government was now clearly operating outside the scope of the Constitution as it had been understood.  Yet the plan proceeded.

Over a decade later, Congress found itself concerned with the level of financial risk it had undertaken.  One response would have been to raise lending standards.  But that would have taken us back toward where we started.  So instead, Congress took another step down the wrong path.  It made government-issued student loans more difficult to discharge in bankruptcy.  Then even more difficult after that.  Then more.  And twice more after that, even making private loans non-dischargeable.  Now student loans are practically impossible to discharge.  And this is why predatory lenders exist.

It is generally foolish for a lender to issue a loan to someone it expects to have a rocky financial future.  If things get too rocky, that loan can be discharged in bankruptcy court.  However, a lender's calculus changes when bankrupcty proceedings can't touch their loans.  It might not matter if a loan can ever be repaid.  In fact, un-repayable loans might be more lucrative in the long term.  These un-repayable loans are what Congress made possible by making private student loans non-dischargable.  But Congress did that to protect the government from the financial risk it had assumed from private lenders by guaranteeing the student loans they issued.  In other words, Congress was trying to help students, and ended up creating a dangerous trap for them instead.

Thankfully, Congressionally-enabled predatory lending isn't something we need to worry much about.  Only 7.65% of outstanding student loans are privately issued, totaling $67.1 billion, and only 1.49% are currently in default.  That means even if we assume the worst case – that every dollar in default is the result of predatory lending – only roughly 1 in 1,000 student loan borrowers are victims.  That doesn't support a narrative of rampant predatory lending.  So is there any merit to the story that students are being issued loans they can't repay?

It turns out brainless government lending, not predatory private lending, is the real problem.  First, federal loans dwarf private loans.  There is over $1.4 trillion in outstanding government loans, 21 times more than private.  Second, the default rate is far higher.  Currently 11.2% of federal student loans are in default, 7 times the rate of private.  If we again assume the worst case – that every dollar in default is the result of brainless lending – roughly 1 in 10 student loan borrowers are victims.  Over 4.3 million Americans.  That's 100 times bigger than worst-case predatory lending.  If there is a narrative here, it's about rampant brainless lending.

So how do we fix student loans?  It depends on how much you want to fix.  Let's start with small, partial fixes and work our way up to fixing everything:

1. Slightly improve accountability:  Make private student loans dischargeable again, like they were before 2005.  The justification for making them non-dischargable was that many were guaranteed by the government.  But guaranteed loans ended in 2009.  Maybe private loans won't have those nice below-market rates, but they will be dischargeable if you find yourself in bankruptcy.  That seems like a fair trade.  And it would slash predatory private lending (what little may actually exist).
2. Substantially improve accountability:  Make all student loans dischargeable again, like they were before 1978.  This would slash predatory private lending like option 1, and also witless government lending that has the same disastrous effects.  Both private lenders and the government should be responsible for performing due diligence, and refusing to make loans to people who can't afford it.  And both private lenders and the government should be held accountable if they do make bad loans.  On the government side, that means making interests rates high enough so the scheme breaks even.
3. Fix accountability:  Make all student loans dischargeable and keep the federal government out of the student loan business, like before 1958.

Obviously a fix is better than a band-aid, but any of it would be progress.

Major Congressional actions affecting student loans:

• National Defense Education Act of 1958 – Introduced low-interest loans available to science and engineering students through the National Defense Student Loan program).
• Higher Education Act of 1965 – Introduced low-interest loans available to all students through the Federal Direct Student Loan Program, and guaranteed loans available to all students through the Federal Family Education Loan Program.
• Bankruptcy Reform Act of 1978 (the "Bankruptcy Code") – Overrode the Federal Bankruptcy Act of 1938.  Made student loans issued by government and schools non-dischargable.  Made other student loans non-dischargable unless there was undue hardship or there had been at least five years of repayment.  
• Bankruptcy Amendments and Federal Judgeship Act of 1984 – Made student loans issued by non-profit lenders non-dischargeable.
• Crime Control Act of 1990 – Extended the five year rule to seven years.
• Higher Education Amendments of 1998 – Abolished the seven year rule.  (Made undue hardship the only exception for non-dischargable loans.)
• Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 – Made private student loans non-dischargeable.
• Student Aid and Fiscal Responsibility Act of 2009 – Ended guaranteed loans through the Federal Family Education Loan Program in favor of the Federal Direct Student Loan Program.  (Note: This helps taxpayers, but not students.)