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How to Fix the Broken Student Loan System

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As Washington slides ever closer to the fiscal cliff, financial vortex, or whatever will be the next term du jour, and our national focus finally shifts to fixing that which has heretofore been deemed “unfixable,” perhaps 2013 is the year we endeavor to fix our very broken student loan system.

In the first quarter of 1999, Americans owed $90 billion on student loans. It now exceeds $1 trillion. That’s not a bubble, dear friends, that’s a black hole.

The laissez-faire environment that fostered this extreme growth (1100 percent) has more in common with the repeal of the Glass Steagall Act or the zoning plan of the greater Houston area than it does with a properly functioning free market system.

The Confidence Game

Higher education has become a confidence game, with banks and slick marketing machines playing shill in a scam where the “mark” is the dream of American prosperity, parental aspirations and an army of kids conned into believing that an appreciation of Shakespeare will magically result in an appreciation of their net worth.

At the risk of sounding like Rick Santorum (which in my world is a fate far worse than death), just because there’s plenty of dough (for purchase at a premium), doesn’t mean everyone should go to college. Among those who are gifted in a college sort of way, the lack of financial literacy that prevails among prospective students is dangerous. Kids are not being prepared for the challenges of life — including the acquisition of a job, housing and all the rest — so much as they are being prepped for the rigors of witty banter at a cocktail party.

Throw Me the Money

We face a moral hazard. Money is too easy to get. Kids aren’t taught about the realities of the workplace. They get hard-to-market degrees, rack up a lot of debt and then can’t find jobs that pay enough to justify the expenditure. It’s deadly, too. The government farms out delinquent student debt to collection agencies — those boiler room guys who specialize in intimidation and relentlessness… The result: suffocating debt and an increase in suicide among jobless graduates.

You Want a Piece of Me?

Last week Congressman Tom Petri introduced a plan to tackle student debt. The Wisconsin Republican’s solution will be quite familiar to people from Commonwealth countries, including the UK, New Zealand and Australia. It allows automatic withdrawals from a borrowers’ paycheck (capped at 15% of a borrower’s income) to be managed directly by the Education Department and the Internal Revenue Service. In fairly short order, this practice would ease the demand for the services of collection agencies, saving an estimated $1 billion in commission payments that would otherwise go to those dastardly denizens of the deep.

“This doesn’t mean leaving taxpayers on the hook if a student borrows too much,” Petri told Bloomberg News. “It does mean providing much stronger protections against the kind of financial ruin that is all too prevalent in our current system.”

The problem here is that Rep. Petri’s heart is in the right place, but he’s missed the mark. The only thing that will prevent the financial ruin associated with the current system is to hobble the conditions that make it possible.

Seeking an Honorable Discharge

One of the fundamental problems is that since the law was amended in 2005, student debt cannot be discharged through bankruptcy.

That Bush-era modification of bankruptcy laws turned the basic precepts of debt upside-down. With most loans, a borrower with a low credit score pays a higher interest rate to compensate the lender for the increased risk of default. But there is almost no risk of default when it comes to a student loan, because bankruptcy very rarely results in the discharge of the debt. So, lenders can throw lots of money at mirror fogging degree-seekers, whether or not they are suited for their educational pursuits (or those pursuits will yield the return that justifies the expenditure), and the bank-friendly 2005 bankruptcy law guarantees they’ll get paid anyway. (If you’re thinking, “That’s not a credit market. That’s legalized theft,” you’d be right.) Petri’s proposal serves to further deepen that rut.

The Company Store

Colleges and universities charge higher and higher tuition each year because there is an endless flow of federal loans and federally insured private loans protected by bankruptcy laws that are so lender-favorable they’d make a Feudal baron blush. With these ironclad guarantees that loans will be repaid, institutions keep the money spigots open, which in turn gives schools zero incentive to cut costs while creating optimal conditions for tuitions to increase exponentially.

I agree with the Obama administration, it’s time to start treating student loans like any other type of debt and allow them to be erased by bankruptcy. That said, the administration’s recommendations, which came by way of the Education Department and the Consumer Financial Protection Bureau this July, only apply to 15% of the total outstanding debt — about $150 million in private student loan debt held by private lenders like SLM Corp.’s Sallie Mae and Wells Fargo. Why shouldn’t the other 85% be treated the same way?

Freeing the Market to be a Free Market

If the federal government and private lenders choose to make student loans, they should also accept the risks inherent in lending. Maybe that means creating academic benchmarks that qualify would-be college students for vocation-specific educational loans. That’s for them to determine. For sure it means stripping the immunity currently enjoyed by these institutions from borrower bankruptcies. The result of this simple change will re-introduce free market fundamentals, which will cause an adjustment to the cost of credit. Some students will pay higher interest rates on the money they borrow — but they will also be more careful about what sort of credits they use it for. They will also be pickier about where they spend that money. These factors should exert downward pressure on tuition.

Colleges have adopted a corporate model of competition, building condo-like dormitories and outrageous student centers, installing state-of-the-art technology and Nobel Prize-winning labs at schools where no Nobel-level faculty can be lured, even with teetering mountains of cash and prizes used to lure the next best thing. It’s the academic version of an arms race, and it will continue making college an engine for financial ruin for millions of young Americans until we, as a nation, start insisting on a reality principle — that there should be some relationship between expenditure and the return on investment for students.

Investing in Public Education

One way to do that is to bring price competition back to the higher education marketplace by investing more in public universities. States are slashing funding for higher education, forcing schools to plug the holes by boosting tuition. Re-funding public universities will make them less dependent on tuition for operating and capital costs — and with that more able to hold the line on tuition hikes; creating a more competitive environment.

The most effective way to tame student debt is a simple supply and demand approach. We need to slow the flow of money. Low interest rates fueled the mortgage boom. Cheap student loans are “funding” the indentured scholarship of lifelong student loan debt. Let schools use other sources of money, including endowments and alumni donations, to compete for market share by building lavish swimming pools or expanding into new disciplines.

Rep. Petri should be commended for advancing an idea that has already proven to be effective in the UK and elsewhere. The Commonwealth has another practice that would help our public universities reset the floor on college prices: national benchmarks that qualify students for a publicly-funded college education. In the absence of that sort of paradigm shift, we should at least consider going to the root of the problem. It’s not about debt collectors and new creative ways to keep debt-saddled graduates from committing suicide. It’s about addressing the conditions that made debt collectors and all the rest a reality.

Pretending the laws of supply and demand don’t apply to college education is a recipe for disaster. The marketplace is wiser than the boardroom (and makes Washington look positively brain dead). It’s time to return student loans to the discipline of the free market. Only then can tomorrow’s graduates enjoy the futures they’ve been promised.

This story is an Op/Ed contribution to Credit.com and does not represent the views of the company or its affiliates.

Image: SashaW, via Flickr

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  • Ralph Maddalena

    Why no discussion of the fact that many students knowingly borrow more than they “need” to support a lifestyle of overspending and partying while attending school? They also do this while fully expecting that they may never have to repay the loans despite what the current bankruptcy terms are. A little more research might reveal this is more prevalent than one might think.

    • Jofbow

      Ralph, I think your speculation is just that. There will always be the foolhardy… but you are wrong. There are groups on Facebook that students, parents, borrowers, and graduates of ALL ages belong to, and they are responsible, hard working, good Americans, duped by a predatory lending system, and a Bought Congress, that created legislation that favors their Wall Street Buddies, and money changers ( or haven’t you heard what’s going on with the big banks and the law suits — where have you been??).. and a Congress that removed consumer protections as this article does begin to touch upon…. . We need to FIX the broken system. And get the predatory, usurious practices out of the system. For you who are ill informed, Ralph hearsay doesn’t cut it. Read Alan Collinges book, on Student Loan Debt, and go to Forgivestudentloandebt.com, and StudentDebtCrisis.com, and Occupy STudent Debt, and Occupy Colleges, and go to Young Invincibles webb site, and you will see and hear the facts from those parents who were duped with Parent Plus loans that were predatory, deceptive loan plans, and hear first hand the truth of what Millions of Students, parents and families are going through because our Bought Congress over the past 25 years began to work for their special interests.. and Wall Street buddies, rather than for We The People. Ralph, get your facts straight before you talk for others. ListenToTheMillion, Robert Applebaums winning petition at the White House Webb site will prove you ill informed.

    • Kris Addix

      Please! My loans totaled 20k and now they total 57k after the compounding interest. Also as I look back you are asking an 18 year old that society does not even trust to drink yet, to sign a contract in perpetuity! Any other company that did this society would run their underwear up a flag pole. Tar and feather them then run them out of town…. How would and 18 year old know what they might make in the workforce? How would an 18 year old know how hard it is to pay off debt? Yet we ask them to sign their life away deep in debt. I have never met an 18 year old that didn’t say. I’m going to be… And do really great at….ask them if it is too high an amount. Right! Ask them at 35 if they took on more in debt load to take on… And the most likely would wince and sigh.

  • http://www.creditexpertllc.com Shelly

    Great article! In what I do I see quite a bit of ID Theft on Student Loans….I have to wonder of the $1 trillion….how much is ID Theft?

    • Jofbow

      Shelly, go to StudentDebtCrisis.org, Forgivestudentloandebt.com, and Alan Calafatos For Profit Facebook page, and Young Invincibles, and you will find out the FACTS. We have plenty of them to share, and links posted. We The Students have also submitted letters and information to the new Consumer Finance Protection Bureau that the Majority in Congress tried to crush, and basically booted out Elizabeth Warren — who is now Senator Elect, whom we backed 100% with our millions of members, and she is also serving on the Banking Committee… much to the dismay of the Crony Capitalist Bankers. Notice I said Crony… Banking is big business.. and we have allowed it to become corrupted… a major point the Occupy movement brought forth. Lots of facts for any of you to check out at these groups! When you want to know the TRUTH go to the source. WE need major educational reforms, from tuition charges, to lending reforms, to a modernization of the educational delivery system itself. The time has come! And ListenToTheMillion on Twitter……they are speaking loud and clear. Get the money out of politics and our educational system. Our Congress has legislated power to the Corps.. the banks and lenders are the Corps.. and Power Corrupts, and Absolute Power Corrupts Absolutely. We are going to change that………..students don’t want a free ride, they want freedom to chose a responsible way to become educated, without drowning in debt. I don’t think charging an average of $3,000 thousand dollars for a class is reasonable or responsible. It’s theft!

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