REFORMING THE STUDENT DEBT MARKET: INCOME- RELATED ...vjspl.org/wp-content/uploads/2019/02/511-546.pdf · Student Loan Debt, 53 SANTA CLARA L. REV. 329 (2013) (discussing the social

REFORMING THE STUDENT DEBT MARKET: INCOME-RELATED REPAYMENT PLANS OR RISK-BASED LOANS?

Alexander Yi*

ABSTRACT

This Note examines the income-related repayment plans that have been promoted in some circles as an alternative to the current student debt infrastructure. It argues that these types of repayment plans have major flaws and that introducing risk assessment in distributing student loans is a preferable policy solution.

This Note begins by looking into the current problems stemming from the current student debt system, which provides easy access to loans but sets stringent requirements in their discharge. It then discusses the various income-related repayment programs that have been adopted at the federal and proposed at the state level, and maintains that they may produce perverse consequences. Rather than an income-related program, this Note proposes its own solution: (1) distributing loans based on a borrower’s risk profile and (2) setting a period in which student loans cannot be discharged. It argues this proposal is superior to an income-related plan because it leads to a sustainable student debt market that improves the lives of its participants.

CONTENTS

Abstract ................................................................................................. 511Introduction .......................................................................................... 512I. Student Debt in Its Current Framework ............................................ 515

A. Obtaining Student Loans ............................................................. 5161. Obtaining Federal Student Loans ............................................. 5172. Obtaining Non-Federal Student Loans ..................................... 519

B. Discharging Student Loans .......................................................... 5211. The Brunner Test ...................................................................... 5232. The Totality of the Circumstances Test .................................... 524

C. The Failure of the Current Student Debt Framework .................. 526II. Income-Related Repayment Plans ................................................... 528

A. Federal Income-Related Repayment Plans .................................. 528B. State Income-Related Repayment Plans ...................................... 531

1. Adverse Selection ..................................................................... 5322. Incentive to Waste and Disincentive to Monitor ...................... 534

* J.D. Candidate 2014, University of Virginia School of Law. I would like to thank Professor Edmund Kitch for his valuable insights in the writing of this Note and the editors of the Virginia Journal of Social Policy and the Law for their thoughtful comments and suggestions.

512 Virginia Journal of Social Policy & the Law [Vol. 21:3

3. Less Responsiveness to Labor Market Demands ..................... 535III. Proposal: Risk-Based Student Loans and Bankruptcy Code Revision ................................................................................................ 535

A. Benefits of a Risk-Based Loans Policy ........................................ 536B. Developing a Risk-Based Loans Program ................................... 538

1. Cohort Default Rate and Gainful Employment Rate ................ 5382. Employment Prospects of Borrowers ....................................... 5393. Challenges to Developing a Risk-Based Loans Program ......... 5404. Possible Solutions to Challenges .............................................. 541

C. Amending the Exception to Discharge in the Bankruptcy Code .. 5431. History of Section 523(a)(8) of the Bankruptcy Code.............. 5432. Amending Section 523(a)(8) Back to Its Original Language ... 5443. Revised Section 523(a)(8)’s Regulation of Lender Behavior ... 545

IV. Conclusion ...................................................................................... 545

INTRODUCTION

A fundamental purpose of student loans is to assist borrowers, who may not have the resources, finance their education.1 Implicit in this goal is the presumption that providing student loans has a net positive effect as society benefits from the socioeconomic mobility and the skilled workforce that result from greater access to higher education.2 But while the expansion of student loans has led to increased enrollment in higher education,3 it has not necessarily led to improved employment prospects or greater social mobility. Borrowers are graduating with more student

1 See Higher Education Act of 1965 § 421, 20 U.S.C. § 1071(a)(1)(B) (2012) (“The purpose of this part is to enable the Secretary. . . to provide a Federal program of student loan insurance for students who do not have reasonable access to a State or private nonprofit program of student loan insurance. . . .”); Department of Education Organization Act § 102, 20 U.S.C. § 3402(1) (2012) (“Therefore, the purposes of this Act are . . . to strengthen the Federal commitment to ensuring access to equal educational opportunity for every individual. . .”); Ensuring Continued Access to Student Loans Act of 2008, Pub. L. No. 110-227, 122 Stat. 740, 740 (“An Act to ensure continued availability of access to the Federal student loan program for students and families”). 2 For a more in-depth discussion on the normative and historical goals of wider access to higher education, see Jonathan D. Glater, The Other Big Test: Why Congress Should Allow College Students to Borrow More Through Federal Aid Programs, 14 N.Y.U. J. LEGIS. & PUB. POL’Y 11 (2011); Lani Guinier, Admissions Rituals as Political Acts: Guardians at the Gates of Our Democratic Ideals, 117 HARV. L. REV. 113 (2003). Professors Glater and Guinier offer rationales of facilitating and broadening access to higher education, which some could view as outweighing the financial losses associated with nonpayment of student loans. 3 Fast Facts, NATIONAL CENTER FOR EDUCATION STATISTICS, http://nces.ed.gov/fastfacts/display.asp?id=98 (last visited Mar. 16, 2014) (finding that enrollment in degree-granting institutions increased 11% in the decade between 1991 and 2001 and 32% between 2001 and 2011).

2014] Reforming the Student Debt Market 513

debt, but they are having greater difficulty in applying that education to productive use.4 After graduation, many of them find themselves unemployed or taking on jobs that are below their education and skill level.5 Meanwhile, they are on the hook for perhaps an enormous amount of student loans that they will struggle to repay based on their current income.

The problems associated with the current student debt framework have not gone unnoticed,6 and already we see signs of forthcoming changes. Financing education through income-related repayment plans7 has become a front-runner among competing alternatives to the current student debt system. The basic idea of income-related plans involves graduates paying back lenders based on a percentage of their earnings rather than the amount they borrowed to finance their educations. Under this system, the amount that a borrower owes after graduation does not have to equal the amount borrowed to pay for his education.

The concept of borrowers paying what they earn and not what they consume is not a new idea. In 1955, Milton Friedman discussed the possibility of an educational capital market where people purchased

4 Heidi Shierholz et al., ECON. POLICY INST., BRIEFING PAPER NO. 340, THE CLASS OF 2012: LABOR MARKET FOR YOUNG GRADUATES REMAINS GRIM, 11 fig.I (2012), available at http://www.epi.org/files/2012/bp340-labor-market-young-graduates.pdf (showing an increase in unemployment and underemployment among young college graduates from 1994 to 2012). 5 See id.; JESSICA GODOFSKY ET AL., JOHN J. HELDRICH CENTER FOR WORKFORCE DEVELOPMENT, RUTGERS UNIVERSITY, UNFULFILLED EXPECTATIONS: RECENT COLLEGE GRADUATES STRUGGLE IN A TROUBLED ECONOMY, 8 fig.6 (2011), available at http://www.heldrich.rutgers.edu/sites/default/files/content/Work_Trends_May_2011.pdf (indicating a rise in the compromises that graduates accepted to obtain their first job). 6 See, e.g., Daniel A. Austin, The Indentured Generation: Bankruptcy and Student Loan Debt, 53 SANTA CLARA L. REV. 329 (2013) (discussing the social and economic consequences of an “indentured class” of student borrowers); Katheryn E. Hancock, Student Article, A Certainty of Hopelessness: Debt, Depression, and the Discharge of Student Loans Under the Bankruptcy Code, 33 LAW & PSYCHOL. REV. 151 (2009) (examining the mental health issues related to bankruptcy proceedings involving student debt); Andrew Woodman, Note, The Student Loan Bubble: How the Mortgage Crisis Can Inform the Bankruptcy Courts, 6 ALB. GOV’T L. REV. 179 (2012) (comparing the housing bubble before the 2007-08 financial crisis to the current conditions of the student debt market). 7 These programs in which payment varies based on what a graduate earns are also referred to as “income-based repayment plans.” This Note, however, exclusively uses the term “income-related repayment plan” in order to avoid possible confusion with the federal program also titled “Income-Based Repayment Plan.”


equity interests in human capital.8 Two decades later, Yale University experimented with the idea through its Tuition Postponement Option.9 And since the 1990s, the federal government has introduced repayment plans based on the future earnings of borrowers.10 What is new, however, is the enthusiasm with which state and federal legislatures have pushed these programs as well as the attention they have received from policy experts and the media. Since 2007, the federal government has instituted two income-related plans as well as continuing to offer its older programs.11 Similarly, states have recently begun to develop their own income-related plans.12 They have introduced pilot programs to assess the feasibility of income-related repayment plans with the hope of replacing the current student loan infrastructure entirely.

This Note looks into the viability of these income-related repayment plans. It discusses the income-related plans that have been adopted at the federal level and proposed at the state level, and it argues that they have various downsides that prevent them from being sustainable without the benefit of external aid. This Note proposes, as other papers have argued,13 that the federal and state governments should adopt a market-based approach by incorporating risk assessment into their student loans.

This Note adds to the discourse already laid out by framing the student debt problem as the product of an inconsistent policy in which borrowers have little difficulty in obtaining financing but are severely constrained when they try to discharge their debts. It finds that this easy-borrow/difficult-discharge policy is harmful to borrowers and lenders alike and, accordingly, proposes that the threshold of borrowing be

8 See The Role of Government in Education, in ECONOMICS AND THE PUBLIC INTEREST 123, 135–37 (Robert Solo ed., 1955). 9 See E. G. West, The Yale Tuition Postponement Plan in the Mid-Seventies, 5 HIGHER EDUC. 169 (1976); William M. Bulkeley, Old Blues: Some Alumni of Yale Realize That They Owe College a Lasting Debt, WALL ST. J., Feb. 23, 1999, at A1. 10 See Income-Contingent Plan, OFF. OF FED. STUDENT AID, U.S. DEPARTMENT OF EDUC., http://studentaid.ed.gov/repay-loans/understand/plans/income-contingent (last visited May 19, 2014); Income-Sensitive Plan, OFF. OF FED. STUDENT AID, U.S. DEPARTMENT OF EDUC., http://studentaid.ed.gov/repay-loans/understand/plans/income-sensitive (last visited May 19, 2014). 11 See Income-Based Plan, OFF. OF FED. STUDENT AID, U.S. DEPARTMENT OF EDUC., http://studentaid.ed.gov/repay-loans/understand/plans/income-based (last visited May 19, 2014); Pay as You Earn Plan, OFF. OF FED. STUDENT AID, U.S. DEPARTMENT OF EDUC., http://studentaid.ed.gov/repay-loans/understand/plans/ pay-as-you-earn (last visited May 19, 2014). 12 See infra notes 147, 150. 13 See Michael Simkovic, Risk-Based Student Loans, 70 WASH. & LEE L. REV. 527 (2013); Peter Zuckerman, Note, Ending Student Loan Exceptionalism: The Case for Risk-Based Pricing and Dischargeability, 126 HARV. L. REV. 587 (2012).


raised while the bar from discharge be lowered. In more specific terms, it offers the following solution to the student debt problem: first, distribute student loans based on a borrower’s risk profile; second, amend the bankruptcy provision relating to student loans so that they are automatically dischargeable except during the early years of the repayment period.

Such a proposal is likely to result in a decrease in the distribution of student loan money and consequently a decline in enrollment. As interest rates become correlated to borrower-risk, certain students will be priced out and will be unable to finance their education. Revamping bankruptcy law may also lead to a drop in dollars and in enrollment. Without the exception to discharge protection, the prices of student loans would have to be raised in order to incorporate the added risk of nonpayment through bankruptcy discharge. While imperfect, a risk-based loan policy is still a vast improvement to the system in place now. Students under the current debt market are permitted to borrow more than they can repay, and the result oftentimes is insolvency for these borrowers. In contrast, risk assessment of student loans offers a sustainable framework where student financing is allocated efficiently and incentives are appropriately aligned. Thus, while the doors to higher education will not be as widely open under a risk-based framework, financing an education will no longer be the bait-and-switch that it is for many students today.

Part I of this Note briefly describes the size and growth of the current student debt market and discusses the requirements of obtaining and discharging student loans. It shows the disparity and the negative consequences that stem from the current student debt policy of easy-borrow/difficult-discharge. Part II examines income-related repayment plans that have been adopted at the federal and state levels. It argues that income-related plans produce perverse consequences, and can work only if policymakers intend to continue contributing money into these programs. Part III proposes that incorporating risk assessment into student loans and revising the Bankruptcy Code form a better alternative to improving the student debt infrastructure, and suggests how such a proposal could be implemented.

I. STUDENT DEBT IN ITS CURRENT FRAMEWORK

The student debt market has grown enormously in recent history. The level of outstanding student debt has surpassed a trillion dollars,14 almost double what it was in 2007 when the amount of outstanding

14 FED. RESERVE BANK OF N.Y., QUARTERLY REPORT ON HOUSEHOLD DEBT AND CREDIT 2 (Nov. 2013), available at http://www.newyorkfed.org/research/national_economy/householdcredit/DistrictReport_Q32013.pdf (reporting that there are $1.027 trillion dollars in outstanding student loans as of September 30, 2013).


student loans was $550 billion.15 The dramatic increase in the level of outstanding student debt can be attributed to increases in enrollment and higher costs of education. In the 2010–11 academic year, total enrollment in public institutions was over 15 million.16 This is a 16.3% increase from 2005–06 and a 28.8% increase from 2000-01.17 Similarly, tuition and fees have increased significantly across the board. A student in 2011 would have had to pay 30.8% more to attend a public two-year institution,18 42% more to attend a public four-year institution,19 and 27.8% more to attend a private nonprofit four-year institution than a student in 2006.20

A. OBTAINING STUDENT LOANS

Because the federal government is the source of the vast majority of student loans,21 student loans can be divided into those coming from the federal government and those that do not. Federal loans composed ninety-three percent of the $113.4 billion in educational loan money that was distributed in the 2011–12 academic year.22 And historically the brunt of student debt has been borne by the federal government. In the last two decades, federal loans have made up seventy to ninety percent of the student loan market.23 Non-federal loans, which include those made by states and private institutions, have traditionally been an afterthought in the student debt arena, except from the 2005–06 to 2007–08 academic years when they composed around a quarter of the total

15 Private Student Loans: Regulatory Perspectives: Hearing Before the S. Comm. On Banking, Housing, and Urban Affairs (2013) (statement of Todd Vermilyea, Senior Associate Director, Division of Banking Supervision and Regulation, Board of Governors of the Federal Reserve System), available at http://www.federalreserve.gov/newsevents/testimony/vermilyea20130625a.pdf. 16 See JENNIFER MA & SANDY BAUM, COLL. BD. ADVOCACY & POLICY CTR. TRENDS IN TUITION AND FEES, ENROLLMENT, AND STATE APPROPRIATIONS FOR HIGHER EDUCATION BY STATE 14 tbl.6 (July 2012), available at https://trends.collegeboard.org/sites/default/files/analysis-brief-trends-by-state-july-2012.pdf. 17 See id. 18 See id. at 8 tbl.1. 19 See id. at 9 tbl.2. 20 See id. at 10 tbl.3. 21 See Kelly D. Edmiston et al., Student Loans: Overview and Issues (Update) 4 (Fed. Reserve Bank of Kan. City Research, Working Paper No. 12-05, 2013); TRENDS IN STUDENT AID 2012, COLL. BD. ADVOCACY & POLICY CTR., available at http://trends.collegeboard.org/sites/default/files/student-aid-2012-full-report-130201.pdf. 22 TRENDS IN STUDENT AID 2012, supra note 21, at 10 tbl.1, 17 fig.6. 23 Id.


dollars distributed.24 Otherwise, the share of non-federal loans in most years has hovered around ten percent of the student debt market.25

1. Obtaining Federal Student Loans

The federal government sets a very low bar for students to obtain access to its loans.26 In order to receive a federal loan, a borrower must: (1) be enrolled in an institution of higher learning;27 (2) maintain satisfactory progress in the course of his studies;28 (3) not be in default of any loans;29 (4) file a statement that the loan money will be used solely for educational expenses;30 (5) be a citizen or permanent resident of the United States;31 and (6) have made restitution if he has been convicted of defrauding the student loans program in the past.32 In addition, a student may become ineligible if he is convicted of a drug offense.33 Otherwise, borrowers, by their very status as students, are eligible for federal student loans, subject to conditions on the type and amounts for which borrowers qualify. However, the federal government does not set these requirements based on market-based considerations but rather on other factors such as the student’s financial need, grade level, and dependency status.34

The federal government offers three types of student loans: (1) “Stafford loans,” (2) “Perkins loans,” and (3) “PLUS loans.”35 Of these, Stafford loans are the most important in terms of amount distributed. Stafford loans made up seventy-six percent of the $113.4 billion in student loan dollars for the 2011–12 academic year, which is consistent with the historical trend.36 Since the 1991–92 academic year, Stafford loans have composed seventy to eighty percent of all student loan dollars distributed.37 In contrast, Perkins loans represent the smallest of the federal student loans programs, composing only about one percent of the student loans money distributed in the 2011–12 academic year, although

24 Id. The deviation found in the 2005–06 to 2007–08 academic years was likely a result of the easy lending environment, which at the time was backed by the federal government’s full guarantee of non-federal student loans under the then-effective Federal Family Education Loan Program. See infra note 62. 25TRENDS IN STUDENT AID 2012, supra note 21, at 10 tbl.1, 17 fig.6. 26 See 20 U.S.C. § 1091 (2012). 27 Id. § 1091(a)(1). 28 Id. § 1091(a)(2). 29 Id. § 1091(a)(3). 30 Id. § 1091(a)(4)(A). 31 20 U.S.C. § 1091(a)(5) (2012). 32 Id. § 1091(a)(6). 33 Id. § 1091(r). 34 Edmiston et al., supra note 21, at 6–7. 35 Id. at 6. 36 TRENDS IN STUDENT AID 2012, supra note 21, at 10 tbl.1, 17 fig.6. 37 Id.


this has not always been the case.38 In the 1991–92 academic year, Perkins loans constituted twenty-two percent of student loans, but its share of the student debt market declined as other sources of student loans took on more prominent roles.39 In the middle lies the PLUS loans program, which made up sixteen percent of total dollars for the 2011–12 academic year.40 Since the 1991–92 academic year, when it composed seven percent of the all student loans, PLUS loans have grown to take on a larger share of the student loan market.41

Stafford loans are either “subsidized” or “unsubsidized.”42 As noted by Kelly Edmiston, a senior economist at the Federal Reserve Bank of Kansas City, the terms “subsidized” and “unsubsidized” have specific meanings related to the terms of the loans, “as all federal loans incur subsidy costs on the part of the federal government.”43 The “subsidized” denotation means interest charges do not accrue during certain periods, namely when borrowers are attending school, while “unsubsidized” indicates interest does accrue for those periods.44 Because both types of Stafford loans offer below-market interest rates,45 the federal government sets restrictions on eligibility and borrowing limits. In order to qualify for subsidized loans, borrowers must be undergraduate students, be enrolled at least half-time, and demonstrate financial need.46 For unsubsidized loans, both undergraduate and graduate students are eligible as long as they are enrolled at least half-time.47 Borrowers do not have to demonstrate financial need for unsubsidized loans.48 The amount that students can borrow under both types of loans is also limited. For subsidized loans, borrowing limits are based on the grade year of the student, from a $3,500 limit for first years to $5,500 for upperclassmen.49 For unsubsidized loans, borrowing limits for

38 Id. 39 Id. 40 Id. 41 Id. 42 Edmiston et al., supra note 21, at 6. 43 See id. at 6 n.4. 44 Id. at 6. 45 For the 2013–14 year, the interest rate is 3.86% for undergraduates of both programs and 5.41% for graduate students of the unsubsidized program (graduate students do not qualify for subsidized Stafford loans). See Subsidized and Unsubsidized Loans, OFF. OF FED. STUDENT AID, U.S. DEPARTMENT. OF EDUC., http://studentaid.ed.gov/types/loans/subsidized-unsubsidized (last visited Mar. 16, 2014). This is in the lower end of the spectrum of variable and fixed rates offered by for-profit institutions. See Private Student Loans, FINAID, http://www.finaid.org/loans/privatestudentloans.phtml (last visited Mar. 16, 2014). 46 See Subsidized and Unsubsidized Loans, supra note 45. 47 Id. 48 Id. 49 Id.


undergraduates are based on grade year and the dependency status of the student, with increasing grade years and independent status corresponding to higher amounts.50 In contrast, graduate students have a fixed $20,500 allotment each year.51

Loans under the Perkins program are also offered to undergraduate and graduate students demonstrating financial need.52 Like subsidized Stafford loans, the interest on Perkins loans is deferred,53 after which borrowers are charged five percent.54 Borrowing limits are based on whether the student is an undergraduate or graduate student. Undergraduates are eligible to receive $5,500 per year with a total limit of $27,500.55 Graduate students may receive up to $8,000 per year for a total of $60,000.56

The federal government also provides PLUS loans to the parents of undergraduates and to graduate students who require additional financing.57 Unlike Stafford and Perkins loans, PLUS loans incorporate some element of risk assessment. Borrowers must not have any adverse credit history in order to qualify.58 However, the extent of risk assessment stops there, as borrowers are given the same rates and terms once they cross that threshold.59 Borrowers are charged the same fixed rate of 6.41%, and they are eligible for up to the full cost of attendance that is not already covered by other loans.60

2. Obtaining Non-Federal Student Loans

As previously mentioned, the federal government is the largest source of student loans. The amount of non-federal student loans distributed in the 2011–12 academic year was $8.1 billion, or only about seven percent of all student loans for that year.61 Even so, non-federal loans still play an important role in the student debt market and have been integrally linked with the student loan policies of the federal government. Until 2010, non-federal loans were a major part of the

50 Id. 51 Id. 52 See Perkins Loans, OFF. OF FED. STUDENT AID, U.S. DEPARTMENT OF EDUC., http://studentaid.ed.gov/types/loans/perkins (last visited Mar. 16, 2014). 53 Edmiston et al., supra note 21, at 6. 54 See Perkins Loans, supra note 52. 55 Id. 56 Id. 57 Edmiston et al., supra note 21, at 6. 58 Id. 59 Id. 60 See PLUS Loans, OFF. OF FED. STUDENT AID, U.S. DEPARTMENT OF EDUC., http://studentaid.ed.gov/types/loans/plus (last visited Mar. 16, 2014). 61 TRENDS IN STUDENT AID 2012, supra note 21, at 10 tbl.1, 17 fig.6.


federal student loans program. Under the now defunct Federal Family Education Loan Program (“FFELP”),62 non-federal loans used to carry the full guarantee of the federal government63 but lost it after FFELP was terminated in 2010.64

Among the sources of non-federal student loans, the private sector is the biggest player. For-profit institutions provide the vast majority of non-federal student loans: of the $8.1 billion in non-federal student loans for the 2011–12 academic year, $6.4 billion were from the private sector while the other $1.7 billion came from states and nonprofit institutions.65 And historically, for-profit institutions have constituted the vast majority of non-federal student loans.66

The terms of obtaining private sector loans differ in several ways from those of federal loans. First, risk assessment is part of the qualification process for private sector loans. Many require from borrowers evidence regarding their creditworthiness, such as current employment, a minimum credit score, and a certain debt-to-income ratio.67 Another difference is the interest rates charged by for-profit institutions. While federal loans set the same fixed interest rates for all borrowers, private sector loans are generally variable-rate loans with different rates based on the riskiness of the individual borrower.68 The Consumer Financial Protection Bureau (“CFPB”) found variable rates ranged from 2.98% to 3.55% for creditworthy borrowers and 9.50% to 19.00% for borrowers of higher risk.69 For loans that do offer fixed rates, they are predictably higher than those charged by federal loans.70 The CFPB found fixed rates ranging from 3.4% to 13.99%71 although it

62 Higher Education Act of 1965, Pub. L. No. 89-329 § 421, 79 Stat. 1219, 1236 (The program was not actually given the name “Federal Family Education Loan Program” until after Higher Education Amendments of 1992, Pub. L. No. 102-325 § 411, 106 Stat. 448, 510). 63 See 20 U.S.C. §§ 1078(b)–(c) (2012). 64 See Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, §§ 2201–2202, 124 Stat. 1029, 1074 (ordering the termination of FFELP and Fed. Loan Ins. Program). 65 TRENDS IN STUDENT AID 2012, supra note 21, at 10 tbl.1, 17 fig.6. 66 Id. 67 See PRIVATE STUDENT LOANS, CONSUMER FIN. PROT. BUREAU 12 (2012), available at http://files.consumerfinance.gov/f/201207_cfpb_Reports_Private-Student-Loans.pdf. 68 Id.; see also PRIVATE STUDENT LOANS, FINAID, http://www.finaid.org/loans/ privatestudentloans.phtml (comparison chart) (last visited May 19, 2014). 69 See PRIVATE STUDENT LOANS, supra note 67, at 12. 70 Id. 71 See id.


found that the 3.4% rate was a significant deviation from the majority of interest rates offered.72

State-affiliated nonprofit lenders and schools provide the remaining balance of non-federal loans not covered by the private sector.73 Their share of non-federal loans is a fraction of what the private sector lends: since 2009, the amount of loans from the private sector has been three times the size of loans from states and schools.74 Before 2009, the disparity was even greater.75 However, non-federal loans from these sources are notable because they more resemble federal loans than private sector loans. Non-federal loans from state-affiliated institutions tend to be fixed-rate with lower interest rates than those offered by financial institutions, and they also lack the risk-assessment elements found in private sector loans.76 The rates charged by these lenders ranged from 8% to 9.5%.77 However, they were closer to 6% to 7.5% before the 2007–08 financial crisis.78 There is less data available about non-federal loans from schools, although based on public comments received by the CFPB, it seems that the terms of school-sourced loans may resemble those of federal student loans.79

B. DISCHARGING STUDENT LOANS

In contrast to the ease of obtaining federal student loans, discharging them is akin to a stay at the Hotel California—borrowers can only get out by paying in full.80 With one narrow exception, all federal and non-federal loans are excepted from discharge under 11 U.S.C. § 523. Debtors can obtain relief from student debt only by showing that nondischargeability would “impose an undue hardship.”81 Without a definition in the Bankruptcy Code, courts have devised various tests to give meaning to the term,82 but only two have been adopted at the circuit

72 See id. at 113 n.26. 73 Id. at 30. 74 See TRENDS IN STUDENT AID 2012, supra note 21, at 10 tbl.1, 17 fig.6. 75 Id. 76 See PRIVATE STUDENT LOANS, supra note 67, at 30–31. 77 Id. at 31 (noting that interest rates increased by 200 basis points after the 2007–08 financial crisis). 78 Id. 79 See id. at 33. 80 THE EAGLES, Hotel California, on HOTEL CALIFORNIA, (Asylum Records 1977) (guests of Hotel California are welcomed upon entrance but when checking out are told “you can never leave”). 81 See 11 U.S.C. § 523(a)(8) (2012). 82 Cf. B.J. Huey, Comment, Undue Hardship or Undue Burden: Has the Time Finally Arrived for Congress to Discharge Section 523(a)(8) of the Bankruptcy Code?, 34 TEX. TECH L. REV. 89, 101–07 (2002) (discussing the many tests that courts have developed to interpret the meaning of undue hardship).


level: the Totality of the Circumstances test, which has been adopted by the Eighth Circuit only,83 and the Brunner test, employed by the majority of circuits.84 These two tests, particularly the Brunner test, impose a meaningful challenge for debtors attempting to obtain relief. 85

83 See Andresen v. Neb. Student Loan Program, Inc. (In re Andresen), 232 B.R. 127, 139 (B.A.P. 8th Cir. 1999), abrogated on other grounds by Long v. Educ. Credit Mgmt. Corp. (In re Long), 322 F.3d 549 (8th Cir. 2003). 84 See Brunner v. N.Y. State Higher Educ. Servs. Corp., 831 F.2d 395, 396 (2d Cir. 1987) (applying the standard devised by the district court in Brunner v. N.Y. State Higher Educ. Servs. Corp. (In re Brunner), 46 B.R. 752, 753–56 (Bankr. S.D.N.Y. 1985)); Nash v. Conn. Student Loan Found. (In re Nash), 446 F.3d 188, 190 (1st Cir. 2006) (“We see no need in this case to pronounce our views of a preferred method of identifying a case of ‘undue hardship’”) (The First Circuit is the only circuit which has declined to adopt any test); Educ. Credit Mgmt. Corp. v. Frushour (In re Frushour), 433 F.3d 393, 400 (4th Cir. 2005) (ruling it will adopt the Brunner test for Chapter 7 as well as Chapter 13 cases); Oyler v. Educ. Credit Mgmt. Corp. (In re Oyler), 397 F.3d 382, 385 (6th Cir. 2005) (“we opt to join other circuits in adopting the simpler rubric of the Brunner test”); Educ. Credit Mgmt. Corp. v. Polleys, 356 F.3d 1302, 1309 (10th Cir. 2004) (“we therefore join the majority of the other circuits in adopting the Brunner framework”); Dep’t of Educ. v. Gerhardt (In re Gerhardt), 348 F.3d 89, 91 (5th Cir. 2003) (“this court expressly adopts the Brunner test for purposes of evaluating a Section 523(a)(8) decision”); Hemar Ins. Corp. of Am. v. Cox (In re Cox), 338 F.3d 1238, 1240 (11th Cir. 2003) (“For the reasons stated herein, we adopt the standard set forth by the Court of Appeals for the Second Circuit in Brunner”); United Student Aid Funds, Inc. v. Pena (In re Pena), 155 F.3d 1108, 1112 (9th Cir. 1998) (“we join the Second, Third and Seventh Circuits and adopt the Brunner test to determine whether, pursuant to 11 U.S.C. § 523(a)(8)(B), a debtor in bankruptcy may discharge a student loan”); Pa. Higher Educ. Assistance Agency v. Faish (In re Faish), 72 F.3d 298, 300 (3d Cir. 1995) (“we adopt the standard for ‘undue hardship’ set forth by the Court of Appeals for the Second Circuit in Brunner”); In re Roberson, 999 F.2d 1132, 1135 (7th Cir. 1993) (“we…for the reasons discussed below, adopt the undue hardship test set forth by the Second Circuit in Brunner”). 85 But see Jason Iuliano, An Empirical Assessment of Student Loan Discharges and the Undue Hardship Standard, 86 AM. BANKR. L.J. 495, 512 (2012) (finding that 39% of the 207 bankruptcies seeking discharge of student debt in 2007 were granted at least partially); Rafael Pardo & Michelle Lacey, The Real Student-Loan Scandal: Undue Hardship Discharge Litigation, 83 AM. BANKR. L.J. 179, 184 (2009) [hereinafter Pardo & Lacey, Real Student-Loan Scandal] (noting that around 57% of the bankruptcy proceedings from the Western District of Washington had at least some part of their loans discharged); Rafael Pardo & Michelle Lacey, Undue Hardship in the Bankruptcy Courts: An Empirical Assessment of the Discharge of Educational Debt, 74 U. CIN. L. REV. 405, 479 (2005) [hereinafter Pardo & Lacey, Empirical Assessment] (finding that 45% of petitions were determined to satisfy the undue hardship requirement). It is unclear, however, whether these numbers indicate that the severity of the undue hardship standard truly is exaggerated or represents the select few petitions that could reasonably qualify under a standard as strict as


1. The Brunner Test

The Southern District of New York set forth the Brunner test.86 In devising the test, it intended the carrying of the undue hardship requirement to be an uphill challenge with little room for relief outside the cases of rare and unique circumstances.87 The Second Circuit later adopted the test,88 and it has since become the majority rule as eight other circuits have also embraced it.89 Under the Brunner test, the debtor demonstrates undue hardship through a three-part inquiry:

(1) that the debtor cannot maintain, based on current income and expenses, a ‘minimal’ standard of living for herself and her dependents if forced to repay the loans; (2) that additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period of the student loans; and (3) that the debtor has made good faith efforts to repay the loans.90

The first point of inquiry involves determining whether the debtor’s living standards were actually minimal and whether she attempted to maintain them by maximizing her income.91 Courts have generally refused to delineate the parameters of a minimal standard of living since “each case is necessarily fact specific.”92 However, we know that this minimal standard hovers somewhere between “abject poverty”93 and merely having “tight finances.”94 On the issue of maximizing income, the debtor must show that she “is making a strenuous effort to maximize her personal income within the practical limitations of her vocational

the Brunner test. But based on a gauge of “measures most predictive of receiving a discharge,” at least some debtors not seeking to discharge their student loans “were worse off than the median discharge seeker,” suggesting the reality is not wholly the latter category. Iuliano at 524. 86 In re Brunner, 46 B.R. at 756. 87 Id. at 755 (“this test has been formulated as the necessity of showing of ‘unique’ or ‘exceptional’ circumstances”). 88 Brunner, 831 F.2d at 396. 89 See supra note 84. 90 Brunner, 831 F.2d at 396. 91 See, e.g., Educ. Credit Mgmt. Corp. v. DeGroot, 339 B.R. 201, 207 (D. Ore. 2006); Healey v. Mass. Higher Educ. (In re Healey), 161 B.R. 389, 394 (E.D. Mich. 1993); Nixon v. Key Educ. Res. (In re Nixon), 453 B.R. 311, 327–28 (Bankr. S.D. Ohio 2011); Ivory v. U.S. Dep’t of Educ. (In re Ivory), 269 B.R. 890, 910 (Bankr. N.D. Ala. 2001). 92 Lowe v. ECMC (In re Lowe), 321 B.R. 852, 857 (Bankr. N.D. Ohio 2004). 93 Id. at 858 (citing Mitcham v. U.S. Dep’t of Educ. (In re Mitcham), 293 B.R. 138, 144–45 (Bankr. N.D. Ohio 2003)). 94 Rifino v. United States (In re Rifino), 245 F.3d 1083, 1088 (9th Cir. 2001).


profile.”95 Courts, though, have been permissive in marking where these “practical limitations” end. They have found that a debtor failing to work outside her field or to take a second job in order to supplement current income has not reasonably attempted to maximize her income.96

Only after satisfying the first prong of the analysis is the second prong considered. The debtor is then required to demonstrate not only a current inability to pay but also additional circumstances that strongly suggest that the current inability to pay “will extend for a significant portion of the loan repayment period.”97 Because this sort of analysis is inherently challenging due to the difficulty of pointing to present circumstances as indicative of future conditions, debtors having met the first requirement of Brunner often fail at this stage. Consequently, debtors who have successfully satisfied the second prong have been limited to those whose circumstances involve an “illness, a lack of usable job skills, [or] the existence of a large number of dependents.”98

Finally, the third prong of Brunner requires a demonstration of good faith in attempting to repay the loans. Courts have considered “the number of payments [the d]ebtor made, attempt to negotiate with the lender, proportion of loans to total debt, and possible abuse of the bankruptcy system” as important factors in making the determination of good faith.99 While this last requirement seems the least meaningful of the three Brunner prongs, this has not always been true. Courts have determined that the good faith standard had not been met when debtors satisfied one of the other requirements in Brunner.100

2. The Totality of the Circumstances Test

95 In re Healey, 161 B.R. at 394. 96 See id. at 394–95; Pa. Higher Educ. Assistance Agency v. Birrane (In re Birrane), 287 B.R. 490, 499 (B.A.P. 9th Cir. 2002). 97 Brunner v. N.Y. State Higher Educ. Servs. Corp., 831 F.2d 395, 396 (2d Cir. 1987). 98 Brunner v. N.Y. State Higher Educ. Servs. Corp. (In re Brunner), 46 B.R. 752, 755 (S.D.N.Y. 1985). 99 U.S. Dep’t of Educ. v. Wallace (In re Wallace), 259 B.R. 170, 185 (Bankr. C.D. Cal 2000) (quoting Windland v. U.S. Dep’t of Educ. (In re Windland), 201 B.R. 178, 183–84 (Bankr. N.D. Ohio 1996)). 100 See Kidd v. Student Loan Xpress (In re Kidd), 472 B.R. 857 (Bankr. N.D. Ga. 2012) (granting summary judgment to the creditor because of plaintiff’s inability to demonstrate any factual dispute about her lack of good faith); In re L.K., 351 B.R. 45, 53 (Bankr. E.D.N.Y. 2006) (holding that the debtor satisfied the first prong in Brunner but not the good faith requirement).


The Eighth Circuit alone examines undue hardship through the lens of the totality of the circumstances.101 The totality of the circumstances test is more flexible than its majority-adopted counterpart because it allows a court to rely on its expertise and understanding of the facts to reach an equitable ruling. Under this test, courts consider: “(1) the debtor's past, present, and reasonably reliable future financial resources; (2) a calculation of the debtor's and her dependent's reasonable necessary living expenses; and (3) any other relevant facts and circumstances surrounding each particular bankruptcy case.”102 Thus, unlike Brunner, which only allows petitioners with truly rare and unique circumstances to pass through its narrow gates, the totality of the circumstances test provides the “honest but unfortunate debtor” a realistic chance of obtaining relief.103

Petitioners whose cases would not have passed muster under Brunner analysis have been able to have their student loans discharged in the Eighth Circuit. For instance, the debtor in In re Shaffer was able to obtain relief despite some imprudent spending in the past and failure to seek an alternative repayment plan.104 The court viewed those facts in the context of her total circumstances, including her living expenses, employment history and prospects, and mental health issues, and determined that her condition satisfied the undue hardship standard for discharge.105 In another decision, the Bankruptcy Appellate Panel of the Eighth Circuit reversed a decision by the bankruptcy court and held that the debtor satisfied the undue hardship standard necessary for discharge.106 Although the panel did not disagree about the debtor’s youth and ability being indicative of a lifetime of positive earnings, it objected to the bankruptcy court’s finding that her future finances were secure enough to continue paying her student loans.107 It pointed to the fact that her loans had been in default despite her best efforts and had grown from $70,000 to over $118,000, and it concluded that her financial condition was insufficient to meet her student loan obligations.108

101 Andresen v. Neb. Student Loan Program, Inc. (In re Andresen), 232 B.R. 127, 139 (B.A.P. 8th Cir. 1999), abrogated on other grounds by Long v. Educ. Credit Mgmt. Corp. (In re Long), 322 F.3d 549 (8th Cir. 2003). 102 In re Long, 322 F.3d at 554. 103 Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934). 104Shaffer v. U.S. Dep’t of Educ. (In re Shaffer), 66 Collier Bankr. Cas. 2d (MB) 1370 (Bankr. S.D. Iowa 2011), aff’d, 481 B.R. 15 (B.A.P. 8th Cir. 2012)). 105 See id. 106 Conway v. Nat’l Collegiate Trust (In re Conway), 495 B.R. 416 (B.A.P. 8th Cir. 2013). 107 Id. at 421. 108 Id. at 422–24.


Thus, while the totality of the circumstances test is noticeably less harsh than Brunner, debtors must still demonstrate substantial hardship before they can obtain relief. Petitioners showing difficult circumstances have been denied discharge of their student loans by courts applying the totality of the circumstances test.109 Debtors under either test have a heightened requirement of demonstrating hardship before obtaining relief. The consequence is that a large number of debtors who are unable to pay their loans in full either seek and fail or do not even attempt to obtain relief at all.

C. THE FAILURE OF THE CURRENT STUDENT DEBT FRAMEWORK

The inconsistency of the student loans system hurts lenders and borrowers alike. Aside from for-profit institutions, lenders have adopted a social policy-based mindset when loans are distributed, but a business-based one when they are collected. This results in borrowers amassing large amounts of student debt without consideration of the likelihood of repayment. These borrowers subsequently are unable to pay back their student loans but cannot discharge them because they cannot demonstrate undue hardship. The current student loans policy, which provides essentially unlimited but nondischargeable financing, only works when borrowers are likely to be earning salaries high enough to pay off their student loans. But when employment prospects become less sanguine, the result is a growing class of individuals hamstrung by their student loans. This, in turn, leads to lower levels of spending and borrowing, as these individuals either are unable to find financing or become overly averse to incurring new debt.

Levels of student loan indebtedness and delinquency are at an all-time high. In the last decade, the number of borrowers of student debt as well as the average balance of student loans has increased considerably. In 2004, twenty-five percent of twenty-five-year-olds held student loans; by 2012, that number rose to forty percent of twenty-five-year-olds.110 Likewise, in 2004 the average balance per borrower was slightly over $15,000, but by 2012 the average balance was nearly $25,000.111

109 See Berscheid v. Educ. Credit Mgmt. Corp. (In re Berscheid), 309 B.R. 5 (D. Minn. 2002) (refusing relief to debtor maintaining minimal living expenses and having little disposable income); Wilson v. Educ. Credit Mgmt. Corp. (In re Wilson), 270 B.R. 290 (Bankr. N.D. Iowa 2001) (denying relief to debtor earning $11 per hour based on her health, age, education, and employability in other fields); Perry v. Student Loan Guarantee Found. of Ark. (In re Perry), 239 B.R. 801 (Bankr. W.D. Ark. 1999) (finding debtor’s financial difficulty caused by her decision to work with indigent clients and to support her college-aged daughter did not meet the undue hardship standard). 110 Vermilyea, supra note 15, at 1. 111 Id. at 2.


Moreover, the level of new seriously delinquent112 student loan balances has increased significantly.113 In 2004, 6.4% of student loans were seriously delinquent. In contrast, 11.7% of student loan balances were considered seriously delinquent in 2012.114

We also see signs of how unpaid student loans are undercutting the ability of borrowers to take on further debt. A study conducted by the Federal Reserve Bank of New York found that although student borrowers held more total debt than nonstudent borrowers, nonstudent borrowers were more likely to hold auto debt and mortgages than student borrowers.115 Likewise, from 2008 to 2012, the per capita debt not related to student loans decreased two times more for student borrowers than for nonstudent borrowers.116 The study also found, however, that the credit scores of young people with student debt and those without began to diverge during that same time period.117 By 2012, the difference in credit scores was fifteen points among twenty-five-year-olds and twenty-four points among those in the thirty-year-old group.118

The growing number of people impeded by their student loans may produce negative economic and social effects. The Federal Open Market Committee raised the student debt problem as one of the “risks to aggregate household spending.”119 In addition, excessive student debt may be contributing to negative societal trends. For instance, fewer student borrowers are becoming homeowners,120 and many are holding

112 Defined as 90 or more days of being past due. See FED. RESERVE BANK OF N.Y., supra note 14, at 1. 113 See id. at 10–11. 114 Vermilyea, supra note 15, at 3. 115 See Meta Brown & Sydnee Caldwell, Young Student Loan Borrowers Retreat from Housing and Auto Markets, LIBERTY STREET ECON. (April 17, 2013, 7:00 AM), http://libertystreeteconomics.newyorkfed.org/2013/04/young-student-loan-borrowers-retreat-from-housing-and-auto-markets.html. 116 Id. 117 See id. 118 Id. 119 Minutes of the Federal Open Market Committee, (Mar. 19–20, 2013) at 6, available at http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20130320.pdf. 120 STUDENT LOAN AFFORDABILITY: ANALYSIS OF PUBLIC INPUT ON IMPACT AND SOLUTIONS, CONSUMER FIN. PROT. BUREAU, 7–8 (2013), available at http://files.consumerfinance.gov/f/201305_cfpb_rfi-report_student-loans.pdf (reporting that higher levels of student debt are preventing borrowers interested in becoming homeowners from qualifying for mortgages); Annie Lowrey, Student Debt Slows Growth as Young Spend Less, N.Y. TIMES, May 10, 2013, http://www.nytimes.com/2013/05/11/business/economy/student-loan-debt-weighing-down-younger-us-workers.html; Josh Mitchell & Ruth Simon, Student Borrowers Retreat From Home Buying, Report Says, WALL ST. J., Apr.


off on household formation due to financial concerns.121 And for those already married, prolonged economic stress could contribute to increased marital strife and higher divorce rates.122

II. INCOME-RELATED REPAYMENT PLANS

An alternative to the current student loans policy is adopting a repayment system that covers the costs of a student’s education and is repaid through that student’s future earnings. Income-related repayment plans can be viewed as taking equity interests in the human capital of their participants. The federal government offers four income-related plans: Income-Contingent Repayment, Income-Based Repayment, Pay as You Earn, and Income-Sensitive Repayment plans. Additionally, several states have begun the process for their own “Pay It Forward” plans through the introduction of legislation and pilot programs.

A. FEDERAL INCOME-RELATED REPAYMENT PLANS

Income-Contingent Repayment Plan (“ICR”) was the first of the federal government’s income-related plans as an alternative to the standard ten-year, fixed-rate repayment plan offered to borrowers.123 A participant can elect to repay his federal loans based on his income over a given period of time through ICR.124 Under ICR’s formula, the borrower pays the lesser of either the amount he would repay over a twelve-year period, subject to standard amortization and an income percentage factor corresponding to his adjusted gross income, or twenty

17, 2013, http://online.wsj.com/news/articles/SB10001424127887323809304578429270600954266. 121 See STUDENT LOAN AFFORDABILITY, supra note 120, at 7–8 (noting that 75% of the decline in household formation was attributed to the 18 to 34 age group); Press Release, American Institute of Certified Public Accountants, New AICPA Survey Reveals Effects, Regrets of Student Loan Debt (May 9, 2013), http://www.aicpa.org/press/pressreleases/2013/pages/aicpa-survey-reveals-effects-regrets-student-loan-debt.aspx (finding in a survey of 237 respondents that 41% held off on contributing to their retirement, 29% postponed buying a house, and 15% put marriage on hold). 122 See, e.g., Greer L. Fox & Dudley Chancey, Sources of Economic Distress: Individual and Family Outcomes, 19 J. FAM. ISSUES 725, 741 (1998) (“Among employed and all women, the indicator of marital or partnership trouble was negatively related to economic well-being and positively related to the partner’s job insecurity”); Angela C. Lyons & Tansel Yilmazer, Health and Financial Strain: Evidence from the Survey of Consumer Finances, 71 S. ECON. J. 873, 879–81 (2005) (finding a positive correlation between financial difficulties and being divorced in households). 123 See Omnibus Budget Reconciliation Act of 1993, Pub. L. No. 103-66, sec. 4021, § 455(d)(1)(D), 107 Stat. 312, 348 (codified as amended at 20 U.S.C. § 1087e(d)(1)(D) (2012)). 124 See 20 U.S.C. § 1087e(d)(1)(D).


percent of his discretionary income.125 The repayment period cannot exceed a period of twenty-five years, meaning either the loan will be paid in full before or any outstanding amounts will be forgiven after the twenty-five-year period.126 Despite its potential value to low-income graduates, ICR failed to gain traction127 as few borrowers wanted to commit to such a lengthy repayment period.128

Undeterred, the federal government introduced Income-Based Repayment Plan (“IBR”) in 2007.129 When electing to enroll in IBR, participants choose a repayment plan based on their annual income, albeit with more favorable terms than ICR. For instance, student loans made through Federal Family Education Loan Program (“FFELP”)130 are eligible under IBR, which is not the case for ICR.131 Secondly, IBR’s repayment plan requires smaller payments. Under IBR’s formula, the borrower pays twelve monthly payments, the sum of which equals fifteen percent of the difference between his and his spouse’s (if applicable) adjusted gross income and 150 percent of the poverty line applicable to the borrower.132 However, unlike ICR, not all borrowers are eligible to enroll in IBR. Borrowers have to demonstrate partial financial hardship,133 defined as the annual amount a borrower owes in student loans exceeding fifteen percent of the difference between his and his spouse’s adjusted gross income and 150 percent of the poverty line.134 But similar to ICR, IBR’s plan has a maximum repayment period of twenty-five years, after which any outstanding amounts are forgiven.135

In 2012, the federal government created Pay as You Earn (“PAYE”) with terms modeled after but more favorable than IBR’s.136 PAYE’s plan

125 See 34 C.F.R. § 685.209(a)(2) (2012). 126 See 20 U.S.C. § 1087e(d)(1)(D). 127 See Direct Student Loans: Analyses of Borrowers’ Use of the Income Contingent Repayment Option, U.S. GEN. ACCOUNTING OFFICE 2 (1997), available at http://www.gao.gov/assets/230/224560.pdf (reporting that about 9% of borrowers in 1997 used the program and that a large percentage of those in the 9% had been placed on the plan after a default). 128 See Philip G. Schrag, The Federal Income-Contingent Repayment Option for Law Student Loans, 29 HOFSTRA L. REV. 733, 791–93 (2001). 129 See College Cost Reduction and Access Act, Pub. L. No. 110-84, sec. 203, §493C(b), 121 Stat. 784, 792 (2007) (codified as amended at 20 U.S.C. § 1098e(b) (2012)). 130 See id. 131 See id. 132 Id. (directing that repayments for borrowers electing into IBR follow the formula outlined in subsection (a)(3)(B)). 133 Id. 134 Id. at (a)(3). 135 See 20 U.S.C. § 1098e(b)(7). 136 See Income-Contingent Repayment Plans, 77 Fed. Reg. 66136, 66136–42 (Nov. 1, 2012) (providing the revised language of 34 C.F.R. § 685.209).


calls for reductions in both the repayment amounts and the repayment periods. Under its formula, borrowers pay ten percent of the amount that the borrower and his spouse’s adjusted gross income exceeds 150 percent of the poverty line, and remaining obligations are discharged after twenty years.137 However, eligibility for PAYE is restricted. Borrowers must demonstrate partial hardship, defined as what a borrower owes under a standard ten-year plan that exceeds ten percent of the difference between the borrower and his spouse’s adjusted growth income and 150 percent of the poverty guideline.138 Additionally, the borrower cannot have an outstanding balance as of October 1, 2007 and must have received loan money after October 1, 2011.139

The federal government also created Income-Sensitive Repayment Plan (“ISR”) to run parallel with ICR.140 Because FFELP loans were excluded from ICR,141 ISR was implemented for borrowers with FFELP loans.142 ISR’s terms of repayment are based on a borrower’s earnings,143 but because the private sector was the source of loans under FFELP,144 forgiveness of the outstanding balance after a set period is unavailable. Lacking one of the most attractive features of income-related plans, the ISR, as one could predict, suffers from unpopularity. ISR is the least important of the federal income-related programs, and with the termination of FFELP, it will continue to become less significant.145

The federal repayment plans are not intended to be economically self-sustainable. They contain features that directly prevent them from resulting in anything but losses for the federal government. For instance, a participant of ICR is required to pay the lesser of either his obligation amortized by an income percentage factor or twenty percent of his

137 Id. at 66137. 138 Id. (mathematically, it would be represented as: partial hardship = obligation under 10-year plan – [.1 x ([borrower and spouse’s AGI] – [1.5 x poverty guideline])]). 139 Id. at 66136. 140 See Income-Sensitive Plan, OFF. OF FED. STUDENT AID, U.S. DEPARTMENT OF EDUC., http://studentaid.ed.gov/repay-loans/understand/plans/income-sensitive (last visited Mar. 16, 2014). 141 34 C.F.R. § 685.209(a) (2013) (calculating the repayment schedule for exclusively Direct Loans). 142 See Income-Sensitive Plan, OFF. OF FED. STUDENT AID, U.S. DEPARTMENT OF EDUC., http://studentaid.ed.gov/repay-loans/understand/plans/income-sensitive (last visited Mar. 16, 2014). 143 See 34 C.F.R. § 682.209(a)(6)(viii) (2013). 144 See Direct Loans vs. the FFEL Program, FINAID, http://www.finaid.org/loans/dl-vs-ffel.phtml (last visited May 19, 2014) (FFELP loans “come from banks and other financial institutions.”). 145 See Health Care and Reconciliation Act of 2010, Pub. L. No. 111-52, §§ 2201–2202, 124 Stat. 1029.


discretionary income.146 By calculating the formula in this way, the federal government precludes itself from taking in any potential upside of the borrower’s earnings. Likewise, with eligibility conditioned on demonstrating partial hardship, IBR and PAYE demonstrate they were designed for purposes based on social policy grounds rather than to make a profit.

B. STATE INCOME-RELATED REPAYMENT PLANS

Recently, states have begun experimenting with adopting income-related repayment plans. Oregon in 2013 proposed a pilot program called “Pay Forward, Pay Back,” in which students agree to pay a percentage of their future income in return for free tuition.147 Beyond the fact that repayment amounts will be relative to the level of income, the Oregon legislature has yet to iron out the features of its repayment plan.148 Even so, it has garnered attention from the media149 as well as from fellow state legislatures that may view income-related plans as a solution to the problems in the current student debt market. Ohio recently passed a bill to start its own pilot program with language almost identical to Oregon’s bill.150 In addition, Pennsylvania, Massachusetts, New Jersey, Maryland, Vermont, and Washington have all introduced or announced legislation to develop their own income-related repayment plans.151

Although specifics regarding the state repayment plans are not finalized, we do know that these state programs, in contrast to federal repayment plans, are intended to be self-sustaining. One of the recurring arguments made by supporters of these plans is that they will be able to pay for themselves after they reach a critical mass of participants.152

146 34 C.F.R. § 685.209(b)(1)(ii) (2013). 147 See H.R. 3472, 77th Leg. Assemb., Reg. Sess. (Or. 2013). 148 See id. (“A proposed pilot program shall . . . provide that, in lieu of paying tuition or fees, students must sign binding contracts to pay . . . a certain percentage of the student’s annual adjusted gross income upon graduation from the institution for a specified number of years.”). 149 See, e.g., Richard Perez-Pena, Oregon Looks at Ways to Attend College Now and Repay State Later, N.Y. TIMES, July 7, 2013, http://www.nytimes.com/2013/07/04/education/in-oregon-a-plan-to-eliminate-tuition-and-loans-at-state-colleges.html?_r=0; Douglas Belkin, Oregon Explores Novel Way to Fund College, WALL ST. J., July 3, 2013, http://online.wsj.com/news/articles/SB10001424127887324251504578582101593420808. 150 See H.R. 242, 130th Gen. Assemb., Reg. Sess. (Ohio 2013). 151 Press Release, Econ. Opportunity Inst., Leaders from 19 States Convene for First National Pay It Forward Conference, (Oct. 7, 2013), http://www.eoionline.org/newsroom/leaders-from-19-states-convene-for-first-national-pay-it-forward-conference/. 152 See, e.g., Belkin, supra note 149 (“The state would likely borrow for the fund's seed money, which could exceed $9 billion, but the program's designers intend it to become self-sustaining.”); THE PROBLEM OF STUDENT DEBT IN


Once a threshold number of graduates enters the repayment period, their contributions into the plans will sufficiently cover the cost of enrollment for new students.153 According to one study, participants would only have to pay three percent of their adjusted gross income in a twenty-four-year period for a repayment plan to be self-sustaining.154 Because their contributions would exceed the costs of their education, this plan would run on a surplus by its twenty-fifth year.155 Even if the repayment period is not shortened in the end,156 the program may still fail to become economically viable because of the perverse consequences that income-related plans produce. The following section discusses those weaknesses in greater depth.

C. PROBLEMS INVOLVING INCOME-RELATED REPAYMENT PLANS

1. Adverse Selection

The obvious limitation of an income-related repayment plan is its susceptibility to adverse selection.157 Assuming states make enrollment voluntary, income-related plans will disproportionately attract those pursuing low-income careers. However, those students who know they will likely have high-paying jobs will avoid the plans. This undermines a crucial element of income-related plans in which students with high

OREGON AND THE PATH FORWARD, STUDENTS FOR EDUC. DEBT REFORM 29–30 (2012), available at https://olis.leg.state.or.us/liz/2013R1/Downloads/CommitteeMeetingDocument/28091; Testimony of Jason Gettel in Support of HB 2838, Policy Analyst, Or. Ctr. for Pub. Policy (Feb. 25, 2013), available at https://olis.leg. state.or.us/liz/2013R1/Downloads/CommitteeMeetingDocument/4460; JOHN BURBANK, PAY IT FORWARD: REFINANCING HIGHER EDUCATION TO RESTORE THE AMERICAN DREAM, ECON. OPPORTUNITY INST. (2013), available at http://www.eoionline.org/wp/wp-content/uploads/higher-education/PayIt Forward-Testimony-WA-Feb-2013.pdf (“By Year 26, [Pay It Forward] would be revenue positive, and by Year 28 [Pay It Forward] would generate about $200 million, with net revenues growing each year forward.”). 153 See id. 154 See Gettel, supra note 152, at 3. 155 See id. 156 An income-related plan imposing a 24-year repayment period could fail to gain traction with students or face strong pressure for a shorter repayment period. See Schrag, supra note 128, at 791 (“Unwillingness to sign up for a twenty-five year repayment plan was, by far, the most important negative factor attributed to the income-contingent repayment plan.”). 157 See Dylan Matthews, No, Oregon is Not Abolishing Tuition, WASH. POST, http://www.washingtonpost.com/blogs/wonkblog/wp/2013/07/10/no-oregon-is-not-abolishing-tuition/?wprss=rss_ezra-klein&clsrd (last visited Mar. 16, 2014); Alex Holt, The Downsides of Oregon's 'Pay It Forward' Plan, NAT’L REVIEW ONLINE, http://www.nationalreview.com/agenda/354532/guest-post-alex-holt-downsides-oregons-pay-it-forward-plan-reihan-salam (last visited Mar. 16, 2014).


potential incomes subsidize those students with low potential earnings. States can make enrollment mandatory, but the ease with which students can circumvent this measure will substantially reduce its effectiveness. Because these repayment plans apply to in-state public universities, students for whom enrollment is not in their interests can elect to attend out-of-state or private schools.

Because the switching costs of attending schools without income-related plans are low, the success of mandatory enrollment as a measure of mitigating adverse selection will rely on other factors, namely the cost of attending out-of-state or private universities and the future earnings of students with high potential income. Within this cohort of “high-income” students, some will invariably have higher potential earnings than others. In choosing between a school which requires enrollment in a repayment plan and one that does not, these students will weigh the costs of having to enroll in the Pay It Forward program to the increased cost of attending an out-of-state or private university. For the members of the cohort whose potential incomes are on the lower end of the spectrum, they will enroll since it is still cheaper to do so than to attend a private school or go out-of-state. The other students, who would contribute the most under an income-related plan, will still elect to attend a private or out-of-state school.158

Of course, the extent to which adverse selection affects these programs will depend on the predictive ability of students. Adverse selection becomes more prevalent as students can better predict their future earnings. Strong evidence indicates that students can, in fact, accurately predict their future earnings based on various factors, such as their field of study. Certain majors, especially ones in the science, technology, engineering, and mathematical (“STEM”) subject areas, have higher employment and wage prospects than ones in the social sciences and humanities.159 Thus, assuming students will act according

158 This appears to raise human capital flight as another potentially negative effect of income-related repayment plans. There is likely to be strong correlation between the students who are the most talented and who have the highest future earnings. If these students elect to attend out-of-state schools in order to avoid enrolling in repayment plans, then states instituting income-related plans could suffer long-term consequences by driving their brightest young people out of state. 159 See, e.g., Mark Berger, Predicted Future Earnings and Choice of College Major, 41 INDUS. & LAB. REL. REV. 418, 426 (1988); Russell Rumberger & Scott Thomas, The Economic Returns to College Major, Quality and Performance: A Multilevel Analysis of Recent Graduates, 12 ECON. EDUC. REV. 1, 15 (1993); Scott Thomas, Deferred Costs and Economic Returns to College Major, Quality, and Performance, 41 RES. HIGHER EDUC. 281, 301–04 (2000). But see Eric Eide & Geetha Waehrer, The Role of Option Value of College Attendance in College Major Choice, 17 ECON. EDUC. REV. 73, 79 (1998) (noting that the option to attend graduate school increases the value of


to their self-interests, the economic basis of income-related plans in which high-earners subsidize low-earners will not be realized since those who are confident that they will have high future earnings will find ways to avoid enrolling.

2. Incentive to Waste and Disincentive to Monitor

Income-related repayment plans alter the behavior of students and universities, and lead to increased waste and lower academic quality in schools. First, these plans lead to inefficiencies since students do not internalize the full costs of their education. When traditional loans are the means of financing college, the student’s liability increases with the level of educational resources he consumes, such as taking additional semesters to graduate, majoring in multiple disciplines, and participating in exchange programs and other expensive alternatives. However, income-related plans weaken this mechanism since future obligations of repayment no longer correspond with present use of educational resources. Stated differently, if students will owe the same amount regardless of what they consume now, why wouldn’t they err on the side of over-consuming? This is not to suggest that these expenditures are wasteful—double majors and exchange programs can be valuable additions that enhance a student’s education. The problem is that students, whereas before elected these options only when the benefits justified the additional costs, can now take advantage of these resources even when they do not add substantial value to their education. Thus, by altering the financial equation, income-related plans may produce a wave of Blutos inclined to extend the best years of their lives.160

The altered behavioral dynamics produced by income-related plans may also result in more waste from universities. Schools were restrained in spending recklessly when students carried at least part of the burden for new expenses. Regardless of whether students actually monitored spending by the administration, the possibility of student complaint would have posed some check on college spending. However, universities know that students under the framework of income-related plans have little reason to object when they benefit without having to bear the costs of the increased spending.

humanities and social science degrees beyond their immediate post-graduation wages); Kimberly Goyette & Ann Mullen, Who Studies the Arts and Sciences? Social Background and the Choice and Consequences of Undergraduate Field of Study, 77 J. HIGHER EDUC. 497, 524 (2006) (finding that vocational majors are paid more immediately after graduation, but arts and science majors are more likely to enter graduate school which leads to higher earnings long-term). 160 See ANIMAL HOUSE (Universal Pictures 1978) (“Christ. Seven years of college down the drain. Might as well join the f---ing Peace Corps.”).


In fact, schools may have greater incentive to spend recklessly, especially if their budgets are tied to the number of students who are enrolled per institution. They may focus their attention on amenities non-essential to teaching, such as new residential buildings, better-performing athletic teams, and enhanced dining options, in order to attract more students.161 Schools may also increase enrollment by lowering their standards and accepting students who may not be ready for college. Additionally, other actors are unlikely to get involved, either because of a lack of incentive or capacity to make change. The state government may want to curb the level of waste, but its incentive to regulate may be offset by the associated administrative costs and its ability to pass down increased costs onto taxpayers. The groups which are advocates of the program may also want to mitigate the level of waste because they want the plan to succeed, but there seems to be little they can do.

3. Less Responsiveness to Labor Market Demands

Income-related plans can also disrupt the signaling mechanism that exists in the labor market. When students assume the cost of their education in traditional loans, what they choose to study is, at least in part, in response to the signals that come from the labor market. Students are deterred from careers for which employers have little demand because the wages of these jobs cannot pay for the cost of education they have to repay. Likewise, they are incentivized to pursue careers whose incomes exceed the cost of their education. In this way, students are channeled into careers for which there is demand in the labor market.

However, income-related plans alter the equation, as there are no longer any careers whose education costs exceed their earnings. Since the repayment obligation is a percentage of a graduate’s income, all careers become viable on a cost-benefit scale. This will result in an increase of graduates entering low-income careers for which few jobs are available in the labor market and a decrease in the number of graduates for careers where high demand exists.

III. PROPOSAL: RISK-BASED STUDENT LOANS AND BANKRUPTCY CODE REVISION

Rather than focusing on income-related repayment plans, states and the federal government should adopt policies of incorporating risk assessment in the distribution of student loans, which presently is practiced only by financial institutions. Risk-based pricing of student loans is a superior policy to reforming the student debt infrastructure because risk-based loans lead to lower default rates and a more efficient

161 See Simkovic, supra note 13, at 567–70 (discussing the perils of the “student-as-customer approach” that can develop in higher education).


distribution of student loan money. Risk-based loans also lead to other benefits that are lacking in income-related repayment plans. Risk-based loans encourage parties to practice self-discipline, incentivize borrowers to enter careers that are in demand, and in some cases pressure schools to keep from inflating the costs of education.

As a second measure, the federal govesrnment should amend the Bankruptcy Code’s section 523(a)(8), the exception to discharge provision, to its original language as it was enacted in the Bankruptcy Reform Act of 1978.162 Student loans should be dischargeable in bankruptcy except for the first five years of the repayment period, and the undue hardship inquiry should only be applied for bankruptcy proceedings occurring within that five-year period. This way, the inequity and harm resulting from applying the undue hardship requirement is largely avoided, but lenders are still protected from abuses by opportunistic borrowers.

A. BENEFITS OF A RISK-BASED LOANS POLICY

The decision for states and the federal government to adopt a risk-based student loans policy would lead to a more efficient student debt infrastructure. For one, risk assessment in student loans would increase sustainable employment since students would be channeled into those schools and academic majors with better employment prospects due to the lower interest rates that are attached to those universities and majors.163 Conversely, students would be discouraged from those schools and concentrations with lower employment prospects because of the higher financing costs attached to them, and eventually those schools and departments would have to become more cost-effective in order to continue attracting students. Thus, risk-based loans could in some cases lead to a decline in education costs as colleges and departments are pressured to cut costs when offering instruction of questionable value.

162 See Bankruptcy Reform Act of 1978, Pub. L. No. 95-598, 92 Stat. 2549. 163 There is the criticism that a risk-based loan policy may discourage students from pursuing low-paying but socially important professions, such as those in the public sector. This Note focuses on the long-term sustainability of a student loan system and thus does not address this concern. A risk-based system, however, is not inconsistent with providing carve-outs or other forms of preferential treatment for careers that lead to the public good. To a degree, such exemptions already exist through special programs, such as the Public Service Loan Forgiveness Program and the Teacher Loan Forgiveness Program, which permit the discharge of federal student loans for graduates entering into these careers. See Public Service Loan Forgiveness, OFF. OF FED. STUDENT AID, U.S. DEPARTMENT OF EDUC., http://studentaid.ed.gov/repay-loans/forgiveness-cancellation/charts/public-service (last visited Mar. 16, 2014); Teacher Loan Forgiveness, OFF. OF FED. STUDENT AID, U.S. DEPARTMENT OF EDUC., http://studentaid.ed.gov/repay-loans/forgiveness-cancellation/charts/teacher# teacher-loan-forgiveness (last visited Mar. 16, 2014).


The relevant actors are also impacted. Lenders benefit from increased repayment and reduced defaults. Because high-risk borrowers would be unable to obtain as much financing as low-risk borrowers, a greater percentage of loan money would be repaid, and fewer loans would go into default. Borrowers would also benefit from this new framework. Students with high employment prospects would see lower-priced loans as interest rates become tailored to reflect their low borrower risk. High-risk borrowers would benefit indirectly because they would be deterred from taking on excess debt.164 While policies that hamper access to capital for wealth-creating activities should generally be avoided, in this case borrowers may be better off when they are prevented from causing harm to themselves. Admittedly, there is an undercurrent of paternalism in this argument, but allowing students to borrow beyond their ability to repay, when we know the consequences, is an argument that is difficult to defend. By doing so, borrowers are committing themselves to financial hardship for very little in return, and student loan capital is trapped in unproductive ventures. Granted, other reasons for financing the costs of higher education exist,165 but these policy considerations are not sufficiently overwhelming to justify a policy that produces a class of young people hopelessly in debt. A framework that leads to an educated but bankrupt class of individuals seems like a worse alternative than one that produces a marginally less educated but financially solvent group of people. Although the tradeoff

164 But see Jonathan D. Glater, The Unsupportable Cost of Variable Pricing of Student Loans, 70 WASH. & LEE L. REV. 2137, 2142 (2013) (arguing that because students currently are unresponsive to signals made in the labor market, they will also be unresponsive to risk-based interest rates). This Note would push back on the assertion that students are unresponsive to labor market demand: trends in choice of major, professional school enrollment, and pressure faced by colleges to provide employment data are evidence that students have responded to signals from employers. See Tamar Lewin, Interest Fading In Humanities, Colleges Worry, N.Y. TIMES, Oct. 31, 2013, at A1; see also Douglas J. Besharov & Terry W. Hartle, Here Come the Mediocre Lawyers, WALL ST. J., Feb. 22, 1985, available at http://www.welfareacademy.org/pubs/legal/herecome_85.pdf (discussing that enrollment in professional schools, particularly in law schools, has fluctuated based on demand in the marketplace); Ethan Bronner, Law Schools’ Applications Fall as Costs Rise and Jobs Are Cut, N.Y. TIMES, Jan. 31, 2013, at A1; Melissa Korn, Colleges Are Tested by Push to Prove Graduates’ Career Success, WALL ST. J., Mar. 17, 2014, http://online.wsj.com/news/articles/SB10001424052702303546204579435050684294642. It is true that not all students choose majors that lead to the highest incomes, but this does not prove that they are irrational. An alternative explanation is that they value the non-economic benefits of their chosen major significantly more than their peers so that their chosen major’s non-economic benefits outweigh its economic costs. The implication, then, is that these students will consider other career choices when the price becomes high enough. 165 See Gunier, supra note 2; Glater, supra note 2.


of a risk-based loan policy is reduced access to higher education, we promote a framework that leads to improved lives for borrowers and higher efficiency in the allocation of student loan money.

B. DEVELOPING A RISK-BASED LOANS PROGRAM

1. Cohort Default Rate and Gainful Employment Rate

The federal government does not incorporate risk assessment in the distribution of student loans with one exception. It tracks each school’s Cohort Default Rate (“CDR”) and limits student loan distribution based on this data.166 CDR is the percentage of borrowers defaulting on their student loans in a given period.167 A school becomes ineligible for federal loans when its three most recent CDR measures are above twenty-five percent or when its most recent CDR surpasses forty percent.168 As the high thresholds suggest, CDR was not meant to be a precise instrument but “as a broad measure to evaluate the risk” of lending to particular schools.169 But as schools found ways to manipulate their CDR data, the usefulness of CDR declined.170 Partly to close these loopholes, the government developed the Gainful Employment Rule (“GER”), which relies on the repayment rate and debt-to-earnings ratio rather than simply the percentage of defaults to determine loan eligibility.171

The data available from the federal government’s tracking of each school’s CDR and GER can provide a starting point for how lenders price their loans, since CDR and GER data are likely correlated with borrower risk.172 However, CDR and GER data may also incorporate other factors, such as a borrower’s socioeconomic status and parental education, which, although linked to borrower risk, disadvantage poor

166 See PRIVATE STUDENT LOANS, supra note 67, at 79. 167 Id. 168 Id. 169 Id. 170 See Jean Braucher, Regulation in the Fringe Economy Symposium: Mortgaging Human Capital: Federally Funded Subprime Higher Education, 69 WASH. & LEE L. REV. 439, 464–65 (2012) (discussing how some schools have helped their graduates obtain deferment and forbearance on their student loans, which is excluded in the computation of a school’s CDR, to continue being eligible for federal student aid). 171 Id. 172 See, e.g., Thomas A. Flint, Predicting Student Loan Defaults, 68 J. HIGHER EDUC. 322, 344–45 (1997) (finding that low income leads to greater difficulty in repayment and thus a higher chance of default); Jacob Gross et al., What Matters in Student Loan Default: A Review of the Research Literature, 39 J. STUDENT FIN. AID 19, 23 (2009) (noting that the majority of defaults stem from inadequate income).


and first-generation students if relied upon too heavily.173 Of the two sets of data, CDR has a greater risk of including these factors since it simply calculates the default risk of a school’s graduates. GER, while less susceptible, may still be influenced by these factors through its data on the repayment rate. Because it is possible to accurately measure borrower risk while discounting the presence of these factors, it is worthwhile to seek other means of gauging borrower risk that do not as heavily rely on CDR and GER.

2. Employment Prospects of Borrowers

Rather than considering purely the default risk of borrowers, lenders should assess borrower risk on the employment prospects of students. This way, lenders do not systematically penalize poor and first-generation students since socioeconomic status and parental education are less likely to be linked to gainful employment rates of graduates than default rates. At the same time, lenders could still accurately determine borrower risk since employment prospects should be strongly correlated with a borrower’s likelihood of repaying.

In determining a borrower’s employment prospects, lenders should consider the borrower’s field of study, choice of institution, and academic performance since these factors have all been found to predict the future earnings of graduates.174 As discussed earlier, certain concentrations such as STEM majors have higher employment and wage prospects than other majors.175 Similarly, the quality of the borrower’s institution makes risk-based loans more accurate. By including the quality of education, the methodology does not penalize schools that focus on humanities and the social sciences but whose graduates still find gainful employment. Just as importantly, it does not unfairly benefit schools of dubious value that emphasize STEM and STEM-related majors. Finally, academic performance of students should also be imputed in loan pricing, as higher-achieving students will ordinarily have higher rates of employment.176

173 See Laura Knapp & Terry Seaks, An Analysis of the Probability of Default on Federally Guaranteed Student Loans, 74 REV. OF ECON. & STAT. 404, 408 (1992); Gross et al., supra note 172, at 23. But see Flint, supra note 172, at 345; J. Fredericks Volkwein et al., Factors Associated with Student Loan Default Among Different Racial and Ethnic Groups, 69 J. HIGHER EDUC. 206, 228 (1998). 174 See, e.g., Thomas, supra note 159, at 304; see also Berger, supra note 159, at 426; Rumberger & Thomas, supra note 159, at 15 (“The results confirmed the importance of all three qualitative factors on earnings”). 175 See Thomas, supra note 159, at 291, 300. 176 See Volkwein et al., supra note 173, at 226–27; see also Kevin Gray, Can Student Loan Default be Forecast Accurately?, 15 J. STUDENT FIN. AID 31, 36 (1985); David Stockham & Jon Hesseldenz, Predicting National Direct Student


3. Challenges to Developing a Risk-Based Loans Program

Pricing loans based on these criteria creates its own set of difficulties, however. These challenges arise in the form of tracking information to keep risk pricing accurate and in the risk of exacerbating grade inflation and grade distribution issues in universities. Regarding the problem of tracking information, students may attempt to game the system through the ease with which they can change majors. Likewise, lenders may be similarly slow in adjusting rates to changes in institutional quality and shifts in labor market demands of various majors. In addition, imputing student performance may incentivize universities to inflate grades, which along with unequal grade distribution would make the pricing of student loans less accurate.

Information on a student’s major is neither fixed nor always available. Many underclassmen have no declared majors, presenting difficulties on how to price loans for these borrowers.177 Moreover, it is common for students to change majors after they have already declared one.178 Because of the ease with which students can change their academic majors, some may behave opportunistically in order to receive lower rates on their student loans. A borrower could declare a major with lower rates when applying for loans and then switch her major a couple years later. Because the more advanced courses for majors are not taken until the junior and senior years, opportunistic students could receive rates lower than their true risk assessment for at least half of their college careers.

Similarly, lenders may have a hard time keeping track of changes to institutional quality and labor market demands. While they do not occur quickly, the information regarding these changes is less available.

Loan Defaults: The Role of Personality Data, 10 RES. IN HIGHER EDUC. 195, 201 (1979). 177 See OCCUPATIONAL AND ACADEMIC MAJORS IN POSTSECONDARY EDUCATION: 6-YEAR EDUCATION AND EMPLOYMENT OUTCOMES, 2001 AND 2009, NAT’L CTR. FOR EDUC. STATISTICS tbl.1 (2012), available at http://nces.ed.gov/pubs2012/2012256.pdf. 178 See, e.g., Cecilia Simon, Major Decisions, N.Y. TIMES, Nov. 2, 2012, http://www.nytimes.com/2012/11/04/education/edlife/choosing-one-college-major-out-of-hundreds.html?_r=0 (noting that 61% of students in the University of Florida change their majors by the end of sophomore year); see also Changing Your Major, SAMFORD UNIV. CAREER DEV. CTR., http://www.samford.edu/careerdevelopment/changing-major.aspx (last visited Mar. 16, 2014) (“Statistics indicate that approximately two thirds of all university students change their major at least once during their college career”); Choosing a Major, PURDUE UNIV. CTR. FOR CAREER OPPORTUNITIES, https://www.cco.purdue.edu/Student/major.shtml (last visited Mar. 14, 2014) (“Before graduation over 50 percent of college students change their major at least once”).


Therefore, loan prices would potentially reflect historic rather than current risk so that students would be channeled into concentrations and institutions that no longer have the best employment prospects.

Imputing academic performance into loan rates could also create problems. For one, factoring in a student’s grade point average (“GPA”) could actually make risk assessment less accurate. This is due to the unequal grade distribution common in many universities. Concentrations with high employment prospects, such as STEM majors, tend to distribute lower overall grades than majors, such as the humanities, that have lower employment prospects.179 Factoring in grades could also spur a race to the bottom among certain schools. Universities and colleges could increase their attractiveness by inflating grades in order to offer lower rates on their loans. The incentive to inflate grades would be the strongest among poor-performing and for-profit colleges, the schools whose students tend to have the worst employment prospects, because they would suffer the greatest under a risk-based infrastructure.180 Poor performing and for-profit institutions could obtain lower rates by raising their average GPA without making any real changes to the quality of their education or employment prospects of their students.

4. Possible Solutions to Challenges

While it is unlikely that these downsides related to a risk-based policy can be completely eliminated, it is possible to substantially mitigate their impact. On the issue of tracking information on majors and institutional quality, lenders could stagger their pricing based on a student’s grade level. In other words, the choice of major would be computed less heavily in the pricing of loans for underclassmen but more heavily as they become upperclassmen. This way, the fact that underclassmen have not yet declared a major would not greatly distort the pricing mechanism of student loans. This would also negate student incentive to behave opportunistically since students would have less to gain from misleading lenders. And in terms of accuracy, a staggered approach makes sense as student loans reflect borrower risk more precisely this way. Because there is no certainty that an underclassman intending to be a STEM major will graduate as one, the rates of her loans would reflect this uncertainty. But as the likelihood of her graduating as a STEM major increases, her choice of major should be imputed more heavily to reflect this greater certainty. Lastly, lenders could become

179 See, e.g., Alexandra Achen & Paul Courant, What Are Grades Made Of?, 23 J. ECON. PERSP. 77, 81–82 (2009); Richard Sabot & John Wakeman-Linn, Grade Inflation and Course Choice, 5 J. ECON. PERSP. 159, 160–64 (1991). 180 See David J. Deming et al., The For-Profit Postsecondary School Sector: Nimble Critters or Agile Predators? (Nat’l Bureau of Econ. Research, Working Paper No. 17710, 2012), available at http://www.nber.org/papers/w17710.pdf?new_window=1.


more up-to-date on changes in risk factors by incorporating their own data from various government agencies with that of private lenders. Financial institutions have made their student loans risk-based and are likely to have in place mechanisms to forecast major shifts in trends. By keeping track of changes occurring in the private sector, states and the federal government could be better aware of movements in the employment market.

Lenders can also take steps to address the problems associated with grade inflation and uneven grade distribution. They could require colleges to adopt “putting grades in context” and “grade rationing” as possible solutions.181 Additionally, an academic index proposed by Valen Johnson, who studied the problem of grade inflation while a professor at Duke University, serves as another way of mitigating grade inflation.182

The “putting grades in context” policy involves posting information, such as the mean grade and size of the course, to increase transparency and to deter grade inflation.183 Lenders may require schools to adopt “grades in context” guidelines before becoming eligible to receive loan money. Having agreed to make their actions transparent, schools may be discouraged from engaging in a race to offer the highest grades. However, this measure is unlikely to deter poorly performing and for-profit schools because the mechanisms of mitigating grade inflation through greater transparency and potential reputational cost do not apply to these types of schools. Because they already suffer in reputation but are nevertheless able to achieve their aim of lowering interest rates, forcing these schools to put their “grades in context” is likely to have little effect on their behavior.

Thus, lenders may have greater success by requiring schools to ration grades, which involves distributing grades on a curve so that high marks are not disproportionately allotted.184 Grade rationing would address the disparate grade distribution that exists between STEM departments and other concentrations with lower employment prospects. This may also make STEM majors more attractive to students since it eliminates the grade arbitrage that exists between STEM and non-STEM departments.

181 See Talia Bar et al., Putting Grades in Context, 30 J. LAB. ECON. 445, 446 (2012) (discussing mechanisms colleges have adopted to “put grades in context” and “ration grades” in order to reform their grading practices). 182 See VALEN E. JOHNSON, GRADE INFLATION: A CRISIS IN COLLEGE EDUCATION, 209–24 (2003). 183 See Bar et al., supra note 181, at 446. 184 See Bar et al., supra note 181, at 461.


Lastly, lenders could require schools to recalculate grades based on an academic index.185 An academic index attempts to provide a more accurate portrait of a student’s academic achievement by adjusting GPAs to account for such factors as a student’s relative performance compared to her peers and the quality of the peers with whom he took those classes.186 Because nominal grades are recalculated to their adjusted values, applying an academic index would effectively negate the perverse consequences produced by the grade disparity existing between high-risk and low-risk fields of study.

C. AMENDING THE EXCEPTION TO DISCHARGE IN THE BANKRUPTCY CODE

In conjunction with incorporating risk assessment into student loans, this Note proposes that the exception to discharge protection afforded to student loans be reversed. It argues such an action is consistent with the historical intent of section 523(a)(8) of the Bankruptcy Code and serves the policy objectives that Congress had intended for the provision by balancing the equitable interests of the borrower and the lender.

1. History of Section 523(a)(8) of the Bankruptcy Code

Prior to the 1970s, student loans received the same treatment in bankruptcy as other loans.187 However, reports of opportunistic borrowers seeking discharge of their student loans immediately after graduation188 prompted Congress to consider restrictions on the discharge of student loans in bankruptcy. In 1978, Congress enacted section 523(a)(8) to make federal student loans nondischargeable.189 However, Congress allowed the discharge of student loans after five years, and the undue hardship inquiry only applied to debtors filing bankruptcy within that five-year period. In 1979, Congress expanded section 523(a)(8) to include loans made by colleges.190 A few years later,

185 See Johnson, supra note 182, at 209–24. 186 See id. 187 See Pardo & Lacey, supra note 85, at 419 (citing 11 U.S.C. § 35(a), which did not list student loans as a nondischargeable debt (1976) (repealed by Bankruptcy Reform Act of 1978, Pub. L. No. 95-598, 92 Stat. 2549)). 188 See Pardo & Lacey, supra note 85, at 419–22; see also Thad Collins, Forging Middle Ground: Revision of Student Loan Debts in Bankruptcy as an Impetus to Amend 11 U.S.C. 523(a)(8), 75 IOWA L. REV. 733, 738 (1990); Janice Kosel, Running the Gauntlet of “Undue Hardship” – The Discharge of Student Loans in Bankruptcy, 11 GOLDEN GATE U. L. REV. 457, 458 (1981); Kurt Wiese, Discharging Student Loans in Bankruptcy: The Bankruptcy Court Tests of “Undue Hardship, 26 ARIZ. L. REV. 445, 446 (1984). 189 See Bankruptcy Reform Act of 1978, Pub. L. No. 95-598, § 523(a)(8), 92 Stat. 2549, 2591. 190 See Bankruptcy Reform Act of Aug. 14, 1979, Pub. L. No. 96-56, § 3(1), 93 Stat. 387, 387.


all loans by nonprofit institutions were excepted from discharge.191 In 1990, “educational benefit overpayments” were added into section 523(a)(8) to receive bankruptcy protection.192 Congress once again broadened the scope of section 523(a)(8) to include loans from for-profit institutions.193

The most important change to section 523(a)(8) did not occur until much later, when the five-year nondischargeability period was eliminated. Congress first lengthened the five-year period to seven years,194 but in 1998 it eliminated the provision altogether.195 In doing so, the undue hardship requirement, which had been intended only for borrowers filing bankruptcy during the initial five-year period, became the benchmark by which all bankruptcy petitions were evaluated.

2. Amending Section 523(a)(8) Back to Its Original Language

This Note in an earlier part discussed the harm resulting from requiring an undue hardship inquiry in every bankruptcy proceeding involving student loans. The interpretation that courts have adopted to understand the term “undue hardship” has imposed a significant burden on student borrowers. It has frustrated the policy goals of a “fresh start” in bankruptcy as borrowers who have had their other debts discharged are required to hold onto their student loans. Section 523(a)(8) fails to provide a compelling reason for its existence in its current framework. The application of the undue hardship requirement neither remedies any specific fraud or abuse committed by student borrowers, nor does elevating the requirements needed to discharge student loans accomplish any specific policy goals.

The federal government should revamp section 523(a)(8) to its 1978 language. That version of section 523(a)(8) balanced the equitable interests of borrowers with the need to prevent potential abuse. By conditioning the discharge of student loans to an undue hardship requirement for the first five years of the repayment period, opportunistic borrowers are precluded from using bankruptcy to obtain a free education. And by limiting the application of the undue hardship inquiry to only bankruptcy proceedings during the five-year period,

191 See Bankruptcy Amendments and Federal Judgeship Act of 1984, Pub. L. No. 98-353, § 454(a)(2), 98 Stat. 333, 376. 192 See Crime Control Act of 1990, Pub. L. No. 101-647, § 3621(1), 104 Stat. 4789, 4964–65. 193 See Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8, § 220, 119 Stat. 23, 59. 194 See Crime Control Act of 1990, Pub. L. No. 101-647, § 3621(2), 104 Stat. 4789, 4965. 195 See Higher Education Amendments of 1998, Pub. L. No. 105-244, § 971(a), 112 Stat. 1581, 1837.


legitimate student debtors are able to seek the shelter provided by the Bankruptcy Code.

3. Revised Section 523(a)(8)’s Regulation of Lender Behavior

Additionally, an amended section 523(a)(8) alters the incentives of lenders and in doing so, reinforces the allocative efficiency of a risk-based student loans policy. Because lenders under current bankruptcy laws do not suffer the full financial cost of failing to assess borrower risk,196 they are less compelled to consider the likelihood that a borrower can reasonably repay her obligations. However, when lenders are no longer afforded protection from discharge, they have a higher incentive to evaluate and to price loans that correspond to borrower risk. The effect then is to bolster a risk-based system and to align the incentives of lenders with the interests of borrowers. Revising section 523(a)(8) may make student loans more expensive while decreasing the availability of loans as lenders become more restrained and demand higher compensation for the increased risk. However, this drawback does not outweigh the positive effects of revising the Bankruptcy Code that reinforces the sustainable framework created by a risk-based student loans policy.

IV. CONCLUSION

The current student debt infrastructure is seriously flawed. Under the current student debt system, borrowers are permitted to take large amounts of debt with little regard to their ability to repay. When many of these borrowers later do have difficulty in paying off their loans, they are stymied from obtaining relief in bankruptcy, creating a sort of financial purgatory in which these borrowers cannot take major steps in their lives, such as purchasing a house, starting a family, and saving for retirement. It is clear that change is needed. Income-related repayment plans, though, are not the solution. Rather, they are the source for further problems. Income-related plans have inherent weaknesses and cannot be sustained long-term. By disconnecting the relationship between what borrowers consume and what they are required to pay, income-related repayment plans introduce perverse incentives that make these plans unviable without outside capital.

196 See Supplemental Materials, THE WHITE HOUSE, OFF. OF MGMT. & BUDGET, http://www.whitehouse.gov/omb/budget/Supplemental (last visited May 19, 2014) (follow “Direct Loans: Assumptions Underlying the FY 2014 Subsidy Estimates” hyperlink) (showing the recovery rate of student loans nears or exceeds 100%); see also Melissa Korn, Government Sees High Returns On Defaulted Student Loans, WALL ST. J., Jan. 4, 2011, http://online.wsj.com/news/articles/SB10001424052748704723104576061953842079760 (“the federal government expects gross recovery of between $1.10 and $1.22 for every dollar of defaulted student loans”).


The better alternative is a risk-based student loan policy in conjunction with a revision of the Bankruptcy Code. In doing so, policymakers would create a framework in which student loan distribution would be based on a borrower’s future ability to repay her loans and where legitimate student debtors are able to receive the fresh start they are entitled to in bankruptcy. These changes would lead to a more sustainable student debt landscape, which would accomplish the policy goals of financing education to improve the employment prospects of its borrowers.

Documents

REFORMING THE STUDENT DEBT MARKET: INCOME- RELATED ...vjspl.org/wp-content/uploads/2019/02/511-546.pdf · Student Loan Debt, 53 SANTA CLARA L. REV. 329 (2013) (discussing the social