On Private Loans and Bankruptcy

I spent more time rereading written testimony given to a subcommittee of the House Judiciary Committee to and thinking about this issue of how private student loans should be treated in bankruptcy. The crux of the matter seems to be an access issue vs. an equity issue.  On the access side, there are those who will argue that private loans will be more difficult to get if the rules are changed to make them fully dischargeable in bankruptcy.  On the equity side, are the consumer advocates who ask why private student loans seem to receive the same special consideration in bankruptcy as outstanding income taxes, alimony, maintenance and child support in not being fully dischargeable. 

Here are some answers to questions that I thought might further the debate: 

What happened to interest rates on private student loans after the provisions limiting the dischargeability of private student loans passed in October 2005? 

Despite the fact that the new legislation in 2005 would hypothetically improve the recovery rates of lenders since private loans would have limited dishargeability, the margins on private student loans went up after the new legislation passed. 

Here is weighted average loan margin information on private student loans that were securitized in 2004 and 2006 for two of the major private lenders and the simple average for those years:

First Marblehead

2004 securitizations: 
2004-1:  LIBOR + 4.31%
2004-2:  LIBOR + 4.70%
2004 Average:  LIBOR + 4.50%

2006 securitizations
2006-1:  LIBOR + 4.44%
2006-2:  LIBOR + 4.70%
2006-3:  LIBOR + 4.80%
2006-4:  LIBOR + 5.36%
2006 Average:  LIBOR + 4.83%
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Sallie Mae
2004-A:  Prime + 1.39%
2004-B:  Prime + 1.24%
2004 Average:  LIBOR + 1.32%

2006-A:  Prime + 1.96%
2006-B:  Prime + 2.10%
2006-C:  Prime + 2.30%
2006 Average:  Prime + 2.12%

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Did this change in the bankruptcy law increase lender appetite for taking on riskier borrowers?

It is hard to draw a cause and effect here since there were obviously lots of factors at play here including a very pliant secondary market for these private loans.  Having said that, it is worth noting that Sallie Mae's loans to the non-traditional (i.e. high-risk) borrower climbed almost 40% between 2006 and 2008, until they discontinued the program due to high default rates (footnoted in Lauren Asher's written testimony to subcommittee of House Judiciary Committee).  Also part of the increase in loan margins may have been driven by this increase in risk of the portfolio of borrowers.  In a bit of irony, private student loan volume this year, as estimated by SLA, is likely to be 20-30% below the volume in 2004-05 before the limited dischargeability of private loans in bankruptcy took effect.  Yes, believe it or not, lenders were making private loans at a time when they were fully dischargeable in bankruptcy.  I don't think it is too much of a stretch to say that this change in the bankruptcy code led to riskier underwriting which led to higher defaults which led inevitably to an investor strike in the secondary markets and this sharp decline in volumes. 

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How much would a change back to full dischargeability impact lenders and whether they choose to make private loans?

It would have been nice hear a lender answer this question directly (based on the Chronicle of Education's story today there is certainly no shortage of student loan lobbyists in Washington these days).  As it was, the attorney, J. Douglas Cuthbertson, who in the past has represented lenders but whose testimony was "that of a practicing attorney", provided this summary of the consequences of changing the bankruptcy code:

"Removing the exception to discharge for educational loans would tighten credit, decrease access to education, reduce responsibility and accountability, and drive lending into the public sector."

But would it really tighten credit beyond what has already happened in the last 12-18 months?

• First, this limited dischargeability in bankruptcy has not helped lenders as much as you might expect.   Sallie Mae's assumes a recovery rate of only 27% on defaulted loans, as found on page 61 of their latest 10-K.  This probably reflects the impact of the time value of money in that recoveries come several years down the road as well as settlements that they may make with borrowers to recover some portion of the defaulted loan.  It also indicates perhaps the dire financial straits that many of their private loan borrowers find themselves in that despite the best efforts of Sallie Mae collectors, they can't come up with much more than $0.27 on the dollar. 

• Second, lenders are already well-positioned if the day comes when private loans become fully dischargeable in bankruptcy.  Cosigners are an attractive feature for lenders as it provides two opportunities for them to collect.  Even if one of the borrowers were to file bankruptcy (in a full dischargeable scenario) lenders would have the opportunity to collect from the cosigner.  Sallie Mae is currently targeting cosigners on 90% of their SmartOption loans, while Discover recently stated publicly that 80% of their private loans had a cosigner. 

Even before this recent tightening of underwriting criteria, however, a significant percentage of private loans already had cosigners which would seem to mitigate any future change in the dischargeability of private loans:

• Even in 2007, before underwriting standards tightened, 82-84% of First Marblehead's private student loans had a creditworthy cosigner, based on a review of their securitization documents
• Sallie Mae's cosigner rates were in the 48-58% range in 2006-07 

Comments

[United States Bankruptcy Court]

Did this change in the bankruptcy law increase lender appetite for taking on riskier borrowers? I don't think so. While the averages moved as reported, the types of students who comprised those averages changed. Pre 2005, you had students with good credit who met relatively tough underwriting standards, and thus faced relatively low interest rates. Post 2005, lenders weren't as concerned, so they loosened standards, which resulted in a bunch of new higher risk loans. While they weren't dischargable, they were still more risky, thus they faced a higher interest rate. When these riskier loans were averaged in with the old low risk ones, it brought the average interest rate up. In other words, the type of students who could have borrowed pre 2005 did not see higher rates post 2005, but the average went up because it now includes lots of riskier students who couldn't have received loans before.

[John]

What no one is addressing is the fact that private student loan providers not only are protected from discharge in bankruptcy, but they also file a claim with the underwriter on the loan. The result is the underwriting insurance company on the loan then sends it to collections. This is exactly broadsided me and my bankruptcy attorney. Now I'm fighting a collection agency demanding payment on a student loan that I was never late or default in. In terms of bankruptcy, private loan companies are not only protected, but are kicking a person while they are down.

[hoa collections]

And now Sallie Mae is even being bailed out by you and me. Any justice in the world? Awaiting November; The Silent Majority will speak - Loud and Clear.