Lending Bankrupt Students a Hand

It is a great shame of the American financial system that we do not allow student loans to be discharged in bankruptcy.

Giving students a clearer financial picture.

Photographer: Kathryn Scott Osler/The Denver Post via Getty Images

It is a great shame of the American financial system that we do not allow student loans to be discharged in bankruptcy.  There's no logic to it: "Well, you can't pay all your other debts, but apparently, you can pay this one, even if it's larger than all the others." Its exclusion from the bankruptcy code, like the rules surrounding taxes, are a bit of special pleading from the government, an assertion that government obligations are somehow immune from the rules surrounding other sorts of debt.

As part of changes to the federal student loan program, the Barack Obama administration will be looking at relaxing the restrictions on bankrupting student loans. This is a change we should be looking at. But it has to be done the right way.

The first problem with allowing easy bankruptcy of student loans is that these loans are made without regard to the borrower's credit history or their likelihood of repayment. As long as you're using your loans for an accredited program, you can borrow. This is possible because the loans are guaranteed by the government. The potential for abuse is obvious: If you make student loans easy to get and easy to bankrupt, the government is going to lose a lot of money.

There's a reason that we make such loans without credit history information, of course: At 18, when a typical student enrolls, they don't have much of a credit history. But credit histories are relatively recent, and banks still managed to make the loans before. (For that matter, the Federal Housing Administration still manages to make mortgages to people with bad credit reports.) The way you could change this is by underwriting: looking closely at the student, the institution they are attending and the major they are choosing to get an estimate of whether they are likely to repay before you make the loan.

Of course, this sort of underwriting would send shock waves through the world of higher education. Students at institutions with high default rates probably wouldn't be able to get loans, and students majoring in less vocationally focused programs would also have difficulty. Though this would be bad in individual cases, I think in aggregate it would be better for everyone: Students should not be encouraged to take on debt when they have a high probability of defaulting. In fact, I think one of the major benefits of allowing loans to be bankrupted is that it would encourage lenders, and the government, to be more discriminating about the loans they make. But the schools would freak out, and their lobbyists would descend on Washington with the righteous fury of a thousand suns.

At the very least, however, we could contain some of the damage by imposing a time limit on your ability to bankrupt loans -- say, no bankruptcy until you've been out of school for 10 years. This would at least discourage the tactic that caused legislators to enact the student loan exception in the first place: that of taking out huge loans to attend professional school, then declaring bankruptcy as soon as you graduate.

How we structure the program is one concern. How we enact it is another. The rules governing the bankrupting of student loans are written into the bankruptcy code. Loans have been made, and subsequent student loan programs designed, with those rules in mind. If the president wants to make a substantial change, he should go to Congress and get one passed, rather than relying on the sort of creative assertions of executive power that he has become so fond of in recent years.

Frankly, I doubt he could get such a rule through Congress, not because our legislators are student-hating misers, but because the Congressional Budget Office is likely to score any such proposal as costing a lot of money. Nonetheless, this is the route the proposal should go. Exempting student loans from bankruptcy was bad law. But we are a nation of laws, and even the bad ones must be changed, not ignored.