Student Loan Bankruptcy: Where are the checks and balances?

The sobering news today is that new filings for bankruptcies soared in 2009 coming in 32% higher than the previous year. So it appears that the more stringent bankruptcy codes passed in 2005, which made it more expensive and difficult to file bankruptcy, can't hide the enormous amount of economic stress that many people in this country are under.

While I hope to see more information about the specifics of these bankruptcies in the coming weeks, this steep increase does make me wonder how many of these filings are related to unaffordable student debt.

My interest in this topic was also directed somewhat by a statement that I recently came across on another site. The statement read something like this:

"Bankruptcy laws create a check on the activities of lenders."

Now I know it may sound naive but I found this to be a surprisingly novel and interesting thought. Most times when you hear about bankruptcy it is with some negative connotation, the implication being that the filing entity or person has failed in some way and now they will get away without having to pay what they borrowed. The borrower is often seen as the only offender.

However, the individual who made that post apparently grasped something that the writers of bankruptcy law, in their wisdom, must have also understood and taken into account. Namely, that the lender shares a significant burden of the responsibility involved in any loan or extension of credit.

The law therefore finds creditors to be responsible parties in the financial transactions they are involved in. This puts the onus on lenders to properly screen their borrowers and determine their eligibility for the loan based upon the borrower’s present and future ability to pay. Theoretically, the lender is supposed to assess the loan's risk based on the borrower's current assets and the potential future reward of the borrower's investment. If either of the borrower's qualifications is deficient then the loan is not supposed to be made.

If the lender determines the borrower's qualifications to be worthwhile then they usually make the deal. Both parties sign contracts, with good intentions, and off they go. Now I am not a banker but this is probably where the risk-reward ratio comes in and the interest rates are established.

If the lender makes a good risk and the borrower does repay he then makes a reasonable - and sometimes substantial profit. But if he makes a mistake and something happens that cannot be foreseen and the borrower cannot repay - then he may lose. This is where I fail to feel for the lender - it’s their business to make intelligent investments. It’s also part of the risk they accept.

As I see it, all bankruptcy law does then is to enforce the later outcome - which is to say the lender loses his investment in part or in its entirety when the borrower can't pay. And as anyone who has ever filed or witnessed a bankruptcy filing - bankruptcy law also punishes the borrower - through damaged credit scores and limits on future filings, neither of which makes for a light sentence.

However, these checks and balances are not present with student loans. The normal system is short-circuited presumably to make more loans available to students. Lenders are protected in many cases by a federal guarantee which obliges the federal government to cover these loans if the borrower can’t. The federal government then enforces payment by the borrower through all sorts of means, regardless of their ability to pay or lead a normal life. In the case of both public and private student loans - borrowers cannot file bankruptcy either. So, it has become essentially a win-win for lenders - they get paid, must get paid in most instances, even if the investment goes sour for the borrower.

While this may not have been the intention of our leaders when this system was first established it has become a problem for millions now. For the borrower of student loans, it seems - its do or die. Either the student loan debtor makes it and pays the loans back or they die and the loans don't get paid back. In the case of private loans – the loans are not discharged even at death - meaning lenders can go after spouses, parents and estates depending on the situation.

Ironically, student loans have therefore become one of the most risky investments anyone can make. At the end of the investment the student may not even have the piece of paper they invested in, may not be able to get a job with the investment they made and can be left with no hard assets to sell after the investment. Despite all this and more, they are forced to pay back even if the lender knew the investment was financially unsound because for them they never risked anything in the first place. While initially intended as a good and proper thing to do, the student loan finance system has backfired and is now enslaving generations of its citizens to financial profiteers.