Why Is Student Debt Exempt from Bankruptcy?

Megan McArdle suggests that allowing student debt to be discharged in bankruptcy along with all other debt would be a good idea if done right.

student loan bubble

I realize there are arguments that we should not even allow bankruptcy. It seems to be a way of getting away with not paying the people to whom you owe money.

The only reasonable answer to that accusation is that, if people can’t pay back a loan, then we should acknowledge that they never will repay a loan. Bankruptcy can be abused, but it is a reality whether or not the law allows for it.

(A much more sane way of making loans would be to always demand collateral. That way, if someone could not repay the debt, they simply would lose the property they had signed over. Of course, that way not everyone would be able to get a loan. But isn’t that the point?)

But current bankruptcy law does not permit student loans to be included in the debt that can be discharged. Economic blogger Megan McArdle suggests that the Obama Administration is right to suggest that this should be changed. But she makes some comments about it that are illuminating. Especially this:

There’s a reason that we make such loans without credit history information, of course: At 18, when a typical student enrolls, they don’t have much of a credit history. But credit histories are relatively recent, and banks still managed to make the loans before. (For that matter, the Federal Housing Administration still manages to make mortgages to people with bad credit reports.) The way you could change this is by underwriting: looking closely at the student, the institution they are attending and the major they are choosing to get an estimate of whether they are likely to repay before you make the loan.

Of course, this sort of underwriting would send shock waves through the world of higher education. Students at institutions with high default rates probably wouldn’t be able to get loans, and students majoring in less vocationally focused programs would also have difficulty.

This made me realize my conception of the motive for denying bankruptcy protection to student debtors was probably backwards. I had assumed that the reason a student couldn’t declare bankruptcy on his loans was because the banks wanted to be able to hang onto the student forever. But now I realize the point is not to hook the student so much as to fool the lenders and to keep the tuition bubble inflating. The point of denying bankruptcy is to put forward the fiction that such loans will always be repaid. Therefore, there is no need to investigate a student’s creditworthiness. Nor is there any need to evaluate the student’s major or choice of school as an investment.

As soon as you allow the possibility of bankruptcy into the picture, then you encourage lenders to be cautious about which students they loan money to. And, as McArdle says, this could “send shock waves through the world of higher education.”

It is all about protecting the bubble.