Government Profiting on Defaults
Alan Collinge, firstname.lastname@example.org (202) 594-1120
Suppose it was discovered that B of A, JP Morgan Chase, and other banks had actually been making, not losing money on defaulted subprime home mortgages. Now, suppose further that it turned out that Fannie Mae had a similar perverted financial motivation. Finally, suppose that even the Federal Housing Administration actually realized a net profit on defaulted subprime home loans. This is, in fact, precisely analogous to what is happening, and has been happening for years for defaulted federal student loans- which comprise the large majority of all student loans, nationally.
Supplemental materials in the president’s 2009, 2010, 2011 budgets (and prior) show that for every dollar paid out by the federal government for defaulted Federal Family Education Loan Program (FFELP) student loans (which comprise a large majority of all outstanding student loans), the Department of Education recovers $1.22 (we assume this is before collection costs, and the government’s “cost of money”) . For Direct student loans, this recovery rate is about $1.10 for every dollar in default.
Compare this recovery rate to that for defaulted credit cards, which is usually about 10 cents on the dollar, and one can see that defaulted loans are clearly not costing the Department of Education money. In fact, it appears strongly that the reverse is true. Comparison of the defaulted student loan recovery rate with those for other federal loans shows a hugely exaggerated rate for student loans, and only for student loans.
Comparing defaulted student loan collections to typical, industry standards
Consider the case of generalized defaulted bank loans. Dermine and Neto de Carvalho (2006) found that these loans incurred, on average, a recovery cost of about 2.6% of the amount recovered. So for example: Recovering $122,000 in defaulted bank loan debt costs about $3,500.
It is important to note that for general bank loans (ie home loans, car loans, property loans, etc), recovery typically involves the seizure of physical property pledged against the loan- property that must be handled, stored, and ultimately liquidated by the bank. This, combined with the various legal and administrative costs that accompany such recovery action is a significant cost that does not exist for unsecured debts, such as student loans.
Consider also that student loans are not dischargeable in bankruptcy. Nor are they subject to statutes of limitations, state usury laws, or even Fair Debt Collection Practices when the collection entity is a non-profit, government-sponsored (or government) entity. The student lending system can take a borrowers wages, income tax returns, Social Security and Disability income, and can also put pressures on a borrower that no credit card company could bring to bear, such as termination/exclusion from public employment, denial of security clearances, exclusion from practicing in a state licensed profession through administrative suspension, and others.
Applying the Dermine/Carvalho standard to federal student loans yields the following:
Net Recovery for FFELP Loans = 118.5%
Net Recovery for Direct Loans = 107.1%
Therefore, it is clear that the federal government is profiting on defaulted FFELP student loans as well as defaulted Direct student loans. This is a defining characteristic of a predatory lending system.
The perverted financial incentives and bad faith that this fiscal dynamic creates have been key enabling factors that explain the inflation we see in the cost of college, the extremely high default rates, and the rampant abuse of- and profiteering from borrowers. These have all accelerated in more recent years as student debt has exceeded $1.5 Trillion, and the student loan companies have lost their interest revenue streams to the federal government under the Direct Loan Program. Now that they can only make money by servicing loans and collection on defaults, this makes defaults even more attractive for them due to “loan rehabilitation”, and the 16% commissions that they make on rehabilitations.*
The Founders called for uniform bankruptcy laws ahead of the power to raise an army, declare war, and raise an army in Article I, Section 8 of the U.S. Constitution. The student loan violation validates the wisdom of these men.
Congress must correct this blatant, unconstitutional injustice if the lending system is to maintain any credibility with the public and the lending system is to maintain any legitimacy. The first step that must be taken is the repeal of 11 USC 523(a)(8), which will restore uniform bankruptcy rights to all student loans, as they exist for every other loan in the nation.
*According to Moody’s, rehabilitated loans default at 3-4 times the rate of other loans. This indicates that the majority of rehabilitated loans default a second time. This is incredibly harmful to the borrowers.