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Student Loan Reality Check: Are Lenders the Problem?

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The Consumer Financial Protection Bureau published its annual student loan ombudsman report, and the news isn’t good.

Cash-strapped borrowers are still having trouble restructuring and modifying the loans they’ve been unable to pay. Even many of those who have the money are being plagued by delayed and misapplied remittances that often result in unwarranted late fees, credit-bureau rating dings and added interest. Borrowers also reported miscalculated early payoff quotes, difficulties verifying payment histories online and, if that weren’t enough, unauthorized changes to monthly payment amounts and loan durations.

As usual, the CFPB weighed in with a series of recommendations.

The bureau is urging banking regulators to find ways to encourage more payment-relief measures without subjecting lenders to the harsh accounting and loss-reserve requirements typically associated with troubled debt restructures. (Lenders have cited this concern as a leading reason for their reticence to work with distressed borrowers.)

The CFPB also wants the financial services industry to establish a universal set of loan servicing standards governing turnaround times for error and dispute-resolutions, the timely and accurate applications of remittances, and more prompt notifications when loan contracts are transferred from one servicer to another.

I don’t know about you, but I would have liked to have read a more forceful response.

What Should Be Done

Take for example the issue of loan restructures and modifications. With certain limitations, all Direct and FFEL loans are eligible for the various government relief programs. Loan servicers should therefore be compelled to make this known to all borrowers—particularly those whose remittances are delinquent at any level.

With regard to the aforementioned troubled debt restructures issue, let’s not mince words: lenders are responsible for the credit decisions they make. If a borrower’s weakened financial condition necessitates a restructure (reduction or suspension of payments for a period of time) or modification (where principal and interest are permanently adjusted), the loan is indeed troubled and should be acknowledged as such.

Forcing lenders to fess-up to that reality would also encourage them to be more proactive, especially if the default trigger for government-backed loans were made to coincide with that of all other types of consumer lending activity.

As for the payment misapplication and incorrectly calculated payoff quotation matters, these can happen from time to time—but they should not happen to the extent that’s been reported. Not only should lousy customer service not be tolerated by companies wanting to stay in business, but it should also be penalized by the Department of Education (which does the majority of the loan servicing-subcontracting), because these failures can lead to defaults that the government will then be called upon to cover.

And as it pertains to the forced payment-adjustment issue, it’s hard to understand how a two-sided agreement can be materially altered without both parties consenting to that change. But instead of saddling borrowers with the costly and time consuming effort of challenging improper servicer conduct in court, the practice should be outlawed, pure and simple.

The Biggest Issue

All that said, what disappoints me more than anything, however, is our apparent unwillingness to address the single greatest impediment to resolving the student loan crisis: the roughly $500 billion of education debt that’s controlled by private lenders and their investors (approximately $300 billion of FFEL loans, plus more than $150 billion of private loans). Simply put, their interests are at odds with those of borrowers and the taxpayers that stand behind three-fifths of these obligations. Why? Because loan restructures and modifications affect investment rates of return: Even when interest rates and principal amounts remain static, investors would still be impacted when loan durations are extended and like-term opportunities yield more.

The remedy is straightforward: not only should these loans find an expedited way out of private hands and into the government’s programs, the DOE should also take control of its own destiny going forward.

Rather than taking on more debt to fund its programs or permitting middlemen such as Sallie Mae to sell (via securitization) government-backed loans to the investment community at a profit, the DOE should run its own loan-selling activity. After all, a guaranty is a guaranty whether it’s offered directly or through an intermediary. Moreover, the elimination of this added layer of cost—which investors would naturally view as a yield-enhancing opportunity—should be used to extract an important structural concession: the right to truncate or extend the durations of any or all the securitized loans it securitizes. The government would then be in a position to direct its subcontracted loan servicers to expeditiously transact the restructures, modifications and accelerated repayments its borrowers require.

The only incremental taxpayer exposure would come from the losses that may arise from the private loans that flow into the program. Fortunately, that risk can be mitigated by giving the originating lenders a choice: remain contingently liable for any losses that result from the credit decisions they’ve made, or accept a discounted payoff amount upfront for the loans that exit their portfolios. An added inducement to facilitate these transfers would be to permit the discharge of privately held student loan debt in bankruptcy court.

How Schools Can Help

Finally, the schools should also be held financially responsible for losses stemming from costly programs with poor outcomes—and not just by curtailing future levels of financial aid. Colleges and universities should be compelled to return a portion of the money they’ve already received. Cohort default rates (which encompasses the loans defaulted on by students who are out of school only a year or two) can be used in the calculation of those values.

Look, there’s more than enough blame to go around for this $1.2 trillion mess. What matters most at this critical point in time is how we get out of it—certainly not by stonewalling requests for payment restructures, drop-kicking borrowers from one servicer to the next, carelessly attending to routine administrative matters and turning a blind eye to intermediaries that skim profits at borrower and taxpayer expense.

And, let’s not forget about the hard decisions that must also be made to reform higher education (including several suggestions you can read about here)—until that happens, for every problem loan that’s resolved, you can count on a new one taking its place.

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