What are the stated downsides of allowing to default on college loan debt?

Question

There are political positions in USA who advocate that people should be able to default on college loan debt (with the status quo being that it's very hard if not impossible to do so right now).

What are the reasons (stated downsides) that proponents of the status quo posit as a reason not to allow to default on college loan debt?

The answers need to:

1. ideally, cite scientific/economic studies that are being used to back up any arguments

2. barring that, cite who publicly used any specific reason/argument

As an answer noted, the main context for this is federally backed loans during personal bankruptcy.

Answer 1

First, let's define our terms. People certainly can default on their student loan debt now. To default on a debt is to stop paying it. Then the debt goes into collections. What you presumably want to know is what is the difficulty with easier discharge of student loan debt in bankruptcy. The current rate of discharge for student loans is about 40% (study) of requests.

Todd Zywicki posted on the Volokh Conspiracy:

But that would be the effect–you wouldn’t be able to borrow money to go to college any more. As my old friend Marcus Cole ably explained to the Senate a few weeks back when this issue was proposed. The problem, of course, is that the moral hazard and adverse selection problems here are extreme: when most people graduate from college they are massively insolvent.

The point here being that nearly every student is in deep debt at the end of college and has no tangible assets that can be seized. So every student is in a situation that would be helped by a discharge bankruptcy. Contrast that with a mortgage, where debt may be high but at least there is a property that can be seized against the debt.

To make this worse, we have the adverse selection and moral hazard problems. These mean that people who intend to declare bankruptcy can borrow more money than people who don't. People who don't can only borrow as much money as they can reasonably pay back. People who do can borrow as much as they need (moral hazard). After all, it's not like they're planning on paying it back.

Under these circumstances, there is no incentive to offer loans. The largest loans will default and discharge in bankruptcy. Since the principal is much higher than the interest rate profits, this means that such loans lose money. So the banks raise interest rates. This makes the loans more expensive to pay back, causing legitimate borrowers to withdraw. But those not intending to pay the loans don't care and stay (adverse selection).

The Brookings Institution published an argument by Rajeev Darolia that mischaracterizes this position:

If private student loan debtors were behaving opportunistically pre-policy, we would have expected a sharp relative decline in bankruptcy filings after the 2005 provision impeded their alleged opportunistic behavior, as compared to debtors whose incentives were not directly affected by the nondischargeability provision. Yet, we do not find evidence of such a reduction.

However, that's not what they say. They don't say that bankruptcy was a problem. What they say is that the threat of bankruptcy was the problem. If true, we'd expect to see loan amounts increasing after 2005. And according to the NYU Journal of Law and Liberty Blog, that's what we do see:

According to the Consumer Financial Protection Bureau, in 2013, student loan debt was over $1.2 trillion: now, the number is likely much higher. Student loan debt has ballooned since 2008, and is the only type of consumer debt that continues to go up, rather than down. Not only that, but delinquency has doubled over the last six years. Roughly a quarter of all student debt is at least three months in arrears.

Of course, something else happened in 2008 that might cause more people to seek debt and more people to struggle with paying it. Teasing out the separate effects might take longer.

Answer 2

Allowing defaulting on student loans changes the risk profile of the loans, which primarily affects the interest rate. Currently rates are artificially low on what is essentially an unsecured (no collateral) loan, if student loans were dischargeable in bankruptcy then their interest rate would be closer to that of credit cards. This would also cause a lot of loans to simply not be offered, or require a parent to cosign that has good credit/high income. Loans that are offered would also be significantly smaller than what is offered today as less money means less risk and higher interest means payments have to be higher as well. This would restrict the access lower income people have to student loans, which is contrary to one of the primary goals of the program of granting access to the less privileged.

Not being able to default on student loans is also less problematic for those that have only modest loans that can be payed over a reasonable period. The majority of those with student loans would fall into this category. They are currently benefiting from not being able to default by paying a lower interest rate than other types of unsecured debt. Allowing defaults would cause future and current borrowers with adjustable rates to essentially be punished with higher interest rates to offset the minority of defaulting borrowers.

Some student loans are also backed by the federal government, so if the borrower is allowed to default then the government is responsible for paying the loan, which puts the burden on all taxpayers due to the poor decisions of a single person. The federal government also can't default on its guarantee without catastrophic results for its own borrowing.

Allowing defaults on non-guaranteed loans, could potentially create another situation similar to the mortgage crisis. Student loan debt is also sold in securities which are rated as more secure based on the difficulty to discharge them. allowing default would make these assets far more risky than they previously were, which causes them to be devalued, which may result in losses across a wide section of the economy and particularly hitting risk averse sectors. This wouldn't be as catastrophic as the mortgage crisis, but it could have an exaggerated affect on retirement incomes for the elderly as they are generally advised to invest in lower risk assets.

Allowing loans to be discharged is also a major change to how the student loan contract works, and it's a reasonable assumption that any change in allowing defaults will be accompanied with other changes. What exactly might change is unclear, but there are a lot of possibilities and they can apply retroactively. Lenders aren't going to simply accept the entirety of these losses, there will be some level of compensation payed by the public at large.

Answer 3

The downside of allowing defaults is that it encourages creation of more bad loans.

Normally, a lender would go out of business if they made too many loans that could not be repaid. However, when the government secures the loans, then there is no such market force at work to prevent further bad lending.

Without market forces to stem the creation of bad loans, political forces must be used. Disallowing loan forgiveness is one such political force. It increases the risk to the loan recipient which increasing their incentive to ensure for they'll be able to repay, and hopefully, ultimately, fewer people will take out loans they cannot repay.

Unfortunately, political incentives don't work as well as market forces as evidenced by the massive level of student debt. None the less, that's the rational for not forgiving government backed student loans.

Answer 4

What are the reasons (stated downsides) that proponents of the status quo posit as a reason not to allow to default on college loan debt?

The people reaping the massive benefits/profits from the current arrangement will of course resist changing it.

It doesn't really matter what self-serving reasons they might "posit".

Here's some self-evident truth to consider:

• If loans can't be discharged in bankruptcy, it makes the creditworthiness of borrowers much less of a concern, which results in many more loans being made, which results in price inflation in whatever is bought with the loaned money.

In a nutshell, banks and universities absolutely love the fact that (US) student debt can't be discharged in bankruptcy.

You may have noticed tuitions skyrocketing, vast hordes of "administrators" being paid obscene salaries, fancy new campuses getting built, and so on.

Universities have been spending money like they're Saudi Princes or something.

Who do you think benefit from the current arrangement? Is it universities and banks, or is it the college graduate baristas with advanced degrees and mountains of debt?