Student loans, along with mortgages and car loans, have become one of the three largest sources of credit, exceeding credit-card debt. This growth in student debt appears to have caught regulators unprepared. Compared with mortgages, auto loans and credit cards, student loans are loosely regulated, and that regulatory weakness is particularly threatening to consumers because they can’t discharge their debts through bankruptcy and escape lenders who are causing them harm.
Borrowers — and the economy at large — are suffering as a result. Every borrower in default has a damaged credit record, which increases the cost of buying a home or car and can result in lost job opportunities. Many landlords won’t rent to someone with a bad credit record.
The parallels with the mortgage crisis are striking. In both cases, the companies managing the loans have been slow to devise loan forgiveness plans for borrowers who run into trouble, hurting both the borrowers and the broader economy. In both cases, it often isn’t clear who even owns the underlying loans, further slowing efforts to restructure them.
I’ll start with the first of these problems: that so few distressed borrowers are getting help. You may remember HAMP — or the Home Affordable Modification Program — which began in 2009 to allow borrowers struggling with their mortgages to remain in their homes. HAMP relied on mortgage servicers to restructure the loans, and the results were extremely disappointing. The goal was for four million borrowers to enroll in HAMP, but in the program’s initial year only half a million homeowners had their loans successfully modified. As of March 2014, the total was 1.3 million.
Fast-forward five years, and the same dynamic is at work. Federal overseers are pressing student-loan servicers to restructure repayment plans, so that borrowers can avoid default. Lenders are dragging their feet, and the number of borrowers in more forgiving repayment plans is much lower than the number of borrowers in distress and default. The Consumer Finance Protection Bureau has documented that in many cases loan servicers are unresponsive to borrowers who want to restructure their payments. Paperwork is lost, resulting in missed deadlines and missed opportunities for relief. Again, we see that it is risky to rely on lenders to carry out a task that would clearly benefit borrowers.
This is unsurprising. Student loan servicers have little incentive to prevent borrowers from defaulting, because the servicers either don’t own the underlying loans or, if they do, face few costs if a borrower defaults. Restructuring a borrower’s payments and preventing default requires effort, and the beneficiary of this effort is the government and the student — not the servicer.
The problem is particularly obvious in the Direct Loan program, in which the federal government owns the student loans and pays servicers a fee to interact with borrowers. Here we have a classic “principal-agent” problem, with the agent (the servicers) having little incentive to act in the best interests of the principal (the federal government). Carefully written contracts are required to make such relationships work well; an entire field of economics, mechanism design, is devoted to studying these contracts. If the principal can’t get the incentives right, in some cases she should just do the job herself. In this case, that would mean the federal government collecting payments on the loans it makes. Taxpayers would most likely come out better in that situation.
In another echo of the mortgage crisis, “robo-signing” is making a comeback, this time in student loans. Robo-signing refers to a practice in which bank employees signed blizzards of documents selling mortgages to another investor without properly verifying who actually owned them. This impeded the restructuring of distressed mortgages, since no one was sure who had the legal standing to alter a loan’s terms. Student loans, like mortgages, are traded in a secondary credit market. Robo-signing is cropping up in these trades, with staff members signing off on the transfer of ownership of a huge number of student loans in a single trade. The National Consumer Law Center has documented that this has created difficulty for borrowers in distress trying to restructure their loans.
Consumer protection is particularly important in the context of student loans, because borrowers have few ways to escape an unhelpful servicer. Borrowers don’t choose their servicers; they are assigned by the owner of the loan, whether that’s the federal government or a private bank.
Even bankruptcy doesn’t sever the tie between a borrower and a lender, since student loans survive bankruptcy. Legally, federal student loans have long been presumed to do so. Since 2005, even private loans (which, unlike federal loans, typically require a co-signer) are presumed to survive bankruptcy. Student lenders and servicers therefore have a captive customer.
Most students can repay their loans without running into major problems. But the number who do struggle is significant, and the struggles can come to dominate their financial lives. As with mortgages, credit cards and auto loans, students loans keep our economy ticking. They make it possible for millions of students to invest in education. But when they don’t work well, they create major problems for borrowers and for the economy at large.
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