The Student Loan Realities We Can't Ignore Anymore

An alternate view on student-loan payment performance data is challenging the prevailing narrative that tends to greatly downplay the problem.

In his recent Wall Street Journal column, Josh Mitchell correctly observes that after accounting for the fact that only half of all student loans are actually in repayment (the other half are deferred because the borrowers are still in school), nearly one-third are actually past due.

Yet as alarming as that metric may be, it doesn’t even factor in the loans that are in default (absurdly depicted as payments that are nine to as many as 12 months past due, versus three months for all other consumer and commercial obligations), temporarily accommodated (often with negatively amortizing forbearances) or permanently modified under one of the federal government’s relief programs (where an estimated 40% of borrowers under the Income-Based Repayment and Pay As You Earn plans fail to re-apply for continued relief between calendar years).

All that taken into consideration, the true level of distressed loans approaches 50%—nearly five times the delinquency rate for home mortgages at its post-economic-crash peak.

No wonder the chatter is intensifying. The question is, are we finally ready to do something about the problem? A good way to start is by grouping the myriad issues into two categories: cleaning up the mess we’ve made and preventing a recurrence.

Fixing the Problem

When a significant portion of any loan portfolio heads south, the reasons typically include poor credit underwriting or improper payment structuring on the front end, or faulty loan administration on the back.

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In the case of the student-loan program, it’s all bad.

Beginning with the loan-approval process, there’s a cure for sloppy credit underwriting. It’s called discharge in bankruptcy; a course of action that’s available for all types of consumer indebtedness except for student loans (absent undue hardship), which I’ll talk more about in a moment. But first, the Department of Education complains that not enough financially distressed borrowers are taking advantage of its various payment-relief plans and it holds the loan servicers responsible for that. However, as the saying goes, “Point a finger and there are three pointing back at you.” A good deal of the blame actually rests with the ED. After all, department officials pre-screened these companies, oversee the work they do, and devised the compensation plans the servicers are using to their advantage.

So, too, is the ED at fault for the fundamental design of the government’s relief plans, particularly how not all student loans are eligible for assistance or that the onus is on the borrowers to repeatedly apply for the support they continue to require.

Given the magnitude of this problem, the correct course of action is to refinance the entire portfolio of loans for terms of up to 240 months—rather than the standard 120—at interest rates that are financially justified as opposed to politically contrived, as was the case in 2013. Borrowers should also be entitled to penalty-free rights to pay down the principal or pay off their loans entirely as quickly as possible.

Until all that happens, the right to discharge student debts in bankruptcy should be restored. Doing so will motivate the government, its agents and the lenders, and investors who own discontinued Federal Family Education Loan program contracts (which represent slightly less than half of all the loans that are currently in repayment) to move more borrowers more quickly into more relief programs so that they may avoid bankruptcy altogether.

These borrowers, who by virtue of various Truth in Lending law exceptions have been relegated to second-class consumer citizenship, also deserve the same protections to which they are entitled for all other modes of consumer financing. So, too, should they benefit by the same exemption from taxes that have been granted to home mortgagors in the wake of the economic collapse, along with having their credit bureau reports reflect only their post-relief payment performance.

As for the loan servicers, the ED has had a heck of a time spinning all that bad press about many of its subcontractors’ objectionable practices. But since the department doesn’t disclose the details of its contractual arrangements with the companies that stand accused of misleading, overcharging and failing to funnel borrowers into the relief plans to which they are legally entitled, one might assume that it’s because it’s in these companies’ interests not to do so. Hence the need for reconstituting the department’s fee structure and the rules that govern that, all within the bright light of day.

For example, one way to remedy a runaway-delinquency problem is to remit servicing fees on a sliding scale: a little less for each month for the payments that fall 30, 60, 90 or more days past due. And because temporarily accommodated loans (i.e., in forbearance) do not appear to be characterized as delinquent during that period (which invites the potential for gaming the numbers) these loans should instead continue to be counted as past due until either the borrower becomes current with his payments or the contract is permanently restructured. Finally, in no case should any accommodation—temporary or otherwise—result in negative amortization (when the unpaid interest is added to the outstanding loan balance) because doing so only makes matters worse for the borrower later on.

Going Forward

Everyone agrees that the price of tuition has reached the point of unaffordability and the schools are doing all they can think of to remain competitive. Unfortunately, it’s a race to the bottom.

According to a recent survey conducted by the National Association of College and University Business Officers, many private colleges seem to be opting for a 47^th Street (New York City’s Diamond District) approach to the market where no one pays retail. The schools are reportedly discounting the price of their education products an average 46% and, perhaps, relaxing admission standards as well.

And then there are the facilitators.

Higher education financing continues to be readily available with little apparent regard for the borrower’s ultimate ability to repay his or her debt or, for that matter, the relative value of the product he or she plans on purchasing—two of the most basic, commonsense tenets of good credit underwriting. Couple that with the widespread loan-servicing problems of both government and privately originated loans—and it’s no wonder things have gone so terribly wrong.

So why haven’t we pulled the plug on this this reckless form of lending?

Well, if a consumer’s choice is between public- and private-education-related financing, the government wins. Not only are its fixed-rate loans less expensive and its terms and conditions more reasonable, but, most important, its relief programs are also more comprehensive and forgiving. The problem is that this does nothing to arrest the tuition-price spiral.

Perhaps a better way to go would be to consider what Germany has put into place—tuition-free, public higher education—which the U.S. can come tantalizingly close to accomplishing if it does these four things:

Refinance the existing portfolio of student loans so the payments become affordable.
Restructure all loan-servicing contracts to improve subcontractor accountability.
Sell the remediated portfolio and assign the underlying servicing contracts to the private sector (with the department acting as principal for that).
Redirect all the money it currently spends on higher education (originating and servicing loans, awarding grants and so forth) to funding tuition at two- and four-year schools that meet specific outcome-based eligibility requirements (such as program completion and gainful employment).

Will this cover every dollar of every cost at every college and university? No. Nor should it. Germany’s program, for example, funds only the price of tuition. Those students who qualify for admission to the nation’s public universities—a process that is arguably more rigorous than applicants experience in the U.S.—are responsible for room, board and other living costs. Consequently, many choose to attend universities that are close to home, partner up with other students to share the rent and take part-time jobs to pay the bills.

State-supported schools may be able to cover their overhead costs with this arrangement. Those that aren’t will have other decisions to make, as will their private-school counterparts, including merging with other institutions to eliminate wasteful redundancies and divesting noncore businesses such as residential housing and food services. The resulting cash can then be used to upgrade educational content and the systems that are needed for its delivery while reducing the cost of tuition.

What About Graduates?

There is one more matter to address.

If some form of tuition-free higher education actually comes to pass, what of the current and former student borrowers who, at last count, are saddled with more than $1.2 trillion worth of education-related debt? Certainly, there isn’t enough money to address their obligations too, that is, unless one was to consider an alternative source of funding.

Last year, the ED abruptly announced that it decided to drop the so-called cohort default rate (CDR) measurement from its prospective rating system—a move that still boggles the mind because loan repayment and gainful employment go hand-in-hand. But perhaps that metric can be utilized after all. What if the CDR was used as the basis for recovering from the schools a portion of the federal funding they received for the students who’ve proved to be overcharged or inadequately equipped to command the jobs that pay enough to cover their debts? Isn’t it time we held the schools to account, if only for the benefit of those who’ve been left holding the bag?

As you can see, there is more than enough blame to go around. But finger-pointing accomplishes nothing. Taking these politically and financially difficult steps will.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its partners.