Lawmakers Introduce Bills to Change Student-Loan Bankruptcy Policy

April 22, 2010

Valisha Cooks thought that attending the University of Phoenix would improve her financial future. Ms. Cooks instead graduated with $41,000 in federal loans and $36,000 in private loans and soon began racking up medical bills after a difficult pregnancy She filed for bankruptcy, but that did nothing to abolish her private student loans. A collection agency is asking her to pay $627 a month—an amount she says she cannot pay in full.

"When I took out private student loans, I had no idea that I was condemning myself to a lifetime of ruined credit, harassment by collection agencies, and the hopelessness of endless debt," Ms. Cooks, a program assistant at the University of California at Los Angeles, told members of a subcommittee of the House Judiciary Committee during a hearing Thursday on the issue of discharging private student-loan debt in bankruptcy.

Lawmakers introduced bills in both the U.S. House of Representatives and the Senate this month that would allow borrowers like Ms. Cooks to more easily expunge their private student-loan debts through bankruptcy. Under current law, private student loans cannot be discharged unless borrowers can prove that repaying the loans would be an "undue hardship," a legal standard that has been applied inconsistently over time.

Help With Private Loans

By comparison, mortgages, credit-card balances, and even gambling debts can be excused without showing undue hardship. The bill would end the undue-hardship standard for private student loans, allowing those debts to be dismissed through the same process as most other forms of private debt.

Rep. Stephen I. Cohen, Democrat of Tennessee and sponsor of the House bill (HR 5043), said at Thursday's subcommittee hearing that the legislation would provide a critical safety net for individuals struggling because of unforeseen financial circumstances.

Supporters of the legislation say it would restore fairness to the bankruptcy system by treating private student loans like other types of private debt. Rep. Hank Johnson, Democrat of Georgia, said private student loans taken out by well-meaning students eager to get a college education should not be lumped into the same class as other debts that cannot be easily erased through bankruptcy, such as child support and alimony.

Under the bill, borrowers would still be required to repay federally subsidized loans after filing for bankruptcy, but supporters of the measure drew a distinction between those federal loans and private loans. Private loans lack the protections provided by federal loans, such as caps on interest rates. Those rates can reach double digits for private loans—double or triple the rates for federal loans.

"Private student-loan borrowers are often unable to work out terms that ensure a reasonable and fair payment schedule," said Representative Johnson. in contrasting the two types of loans.

Republicans' Concerns

But the legislation faces some Republican opposition. Rep. Trent Franks, Republican of Arizona, said the legislation would "discourage private lending and encourage abuse of the bankruptcy system."

John A. Hupalo, managing director of a group specializing in student-loan finance at Samuel A. Ramirez & Co., a securities firm specializing in student-loan finance, warned that interest rates for all borrowers of private student loans would have to rise to compensate for the increased risk that borrowers would eliminate their private-student loan debt through bankruptcy.

The introduction of the bill follows the passage of the student-loan overhaul in March (HR 4872), which ended the bank-based distribution of federally subsidized student loans. Representative Franks said the new bill would "have the effect of shrinking an already depressed private student-loan market."

Supporters of the bill dismissed the idea that the legislation would drastically alter the ability of private companies to conduct student-loan business. Until a 2005 change in the bankruptcy code, private loans could be eliminated through bankruptcy. Private lenders then argued that the change in the policy would allow them to offer loans to a broader spectrum of students, including those with lower credit scores.

But supporters of the new bill worry that private lenders are making loans to some students who are likely to default. Deanne Loonin, a lawyer for the National Consumer Law Center, a nonprofit group, likened some private loans to subprime mortgage lending. She pointed out that in both cases, loans have been offered to people with little ability to repay.

Members of Congress have made several attempts to change the bankruptcy law since 2005. In 2007, Sen. Richard J. Durbin, Democrat of Illinois who introduced the Senate version of the bill (S 3219), offered similar legislation, but it was never voted out of committee.

The prospects of the new bills are unclear, but passing such a controversial measure could be a challenge for Democrats in an election year.