Guest Post: The Real Problem With Student Loans in Bankruptcy

By Rafael I. Pardo

As the national economy continues to deteriorate to levels not seen since the Great Depression, the plight of the individual debtor becomes increasingly dire. While many of us are familiar with the manner in which mortgage and credit-card debt threaten the stability of American households, we hear significantly less about financially distressed student-loan debtors even though theirs is a struggle that warrants close attention.

The confluence of increasing student-loan defaults and rising bankruptcy filings portends a perfect storm where many student-loan borrowers will likely find themselves within the bankruptcy system seeking forgiveness of their debt. Unfortunately, many of them, including some who are among the most desperate for relief, are unlikely to get "the fresh start" that the bankruptcy system promises other types of individual debtors.

The problem is not that debtors are forbidden from discharging their student loans in bankruptcy, as is commonly believed. Debtors, in fact, are eligible for bankruptcy relief from their student loans as long as they are able to establish that repayment of the loans would impose an "undue hardship." As Tulane University's Michelle Lacey and I found in an empirical study we published on this subject in 2005, the real problem is that the undue hardship standard is left undefined by the Bankruptcy Code, which ultimately leads to the differential treatment of similarly situated debtors.

This discharge of student loans in bankruptcy is also potentially problematic because the Federal Rules of Bankruptcy Procedure require borrowers to initiate an adversary proceeding against their lenders, which is essentially bankruptcy's version of a full-blown lawsuit. Because bringing such proceedings necessarily requires monetary resources, it stands to reason that debtors who find themselves in bankruptcy as a result of financial distress will face significant hurdles in obtaining relief from their student loans. Lacey and I recently conducted another empirical study to determine just how big a problem the need to litigate these cases presents to borrowers seeking relief from their student loans. We found that this requirement presents serious access-to-justice concerns for student-loan debtors.

Shedding Light on a Flawed Policy

To explore trial-level outcomes of proceedings where debtors litigated their claims for relief from their student loans, we compiled an original dataset of 115 student-loan discharge proceedings in the U.S. Bankruptcy Court for the Western District of Washington that were commenced during the five-year period spanning 2002 through 2006. Because the data are confined to the experience of litigants in a single federal judicial district during a half-decade period, we cannot say that they are representative of undue hardship discharge litigation nationally. In particular, the legal standards applicable in the Western District of Washington allow for the partial discharge of student loans, which is not the case for all districts nationwide. Nonetheless, our data can still shed light on the manner in which some student-loan borrowers within the bankruptcy system have had to cope with the undue hardship discharge provision and thus help lead to a more informed assessment of whether the law has been a success or failure.

To start, we found that the student loan debtors in our study were in terrible financial shape and in severe need of relief. The annual income generated by the average debtor's household was $21,876. (All dollar amounts from our study have been converted to 2009 dollars for this post.) Once taking into account annual household expenses, exclusive of the debtor's student loans, the annual disposable income of the average debtor household was an annual deficit of $4,751 (i.e., -$4,751). In other words, the average debtor household had no excess income to repay the debtor's student loans, which averaged $79,954. To give a better perspective of the crushing student-loan burden faced by the debtors in our study, if the debtor's household could have lived expense free and the student-loan debt did not increase by virtue of accrued interest, fees, and the like, the average debtor would have had to devote more than four-and-a-half years of household income to completely repay his or her student loans!

Given this bleak financial portrait, how did the debtors in our study fare? More than half of the proceedings resulted in some amount of debt discharged. Moreover, for those borrowers who did obtain a discharge, the average debtor succeeded in getting approximately 72% of his or her student loans discharged. Despite these results, statistical analyses revealed a disturbing picture of the manner in which litigating a claim for forgiveness of debt has encroached upon the ability of struggling student-loan borrowers to get the fresh start that bankruptcy promises.

The legal standards for determining whether borrowers are entitled to a discharge of their student loans require consideration of debtors' income and expenses, as well as their age, employment status, and health status. While we found that such considerations mattered, we discovered that legally irrelevant considerations mattered even more. In fact, the most significant factors determining whether a case was successful or not were the level of experience of the debtor's attorney and the identity of the judge assigned to his or her case. We found that the adversary proceedings assigned to two of the five judges in the district were consistently associated with a significantly lower amount of discharged student loans, and that debtors who were represented by highly experienced attorneys routinely had a higher amount of discharged student loans than those represented by less experienced ones.

Reexamining Assumptions

These finding should raise serious concerns about the impediments we have put in the way of student-loan borrowers who are desperate for relief. They should also encourage policymakers to reexamine their long-standing assumptions about the manner in which our bankruptcy system works for student-loan borrowers.

Since 1976, federal lawmakers have made it increasingly difficult for struggling borrowers to obtain relief from their student loans in bankruptcy, even as the costs of higher education have skyrocketed. While reasonable minds may differ on whether it is normatively desirable for student loans to be conditionally dischargeable in bankruptcy, it is absolutely unreasonable to allow for the disparate treatment of similarly situated debtors who seek an undue hardship discharge of their student loans. The time has come for Congress to reevaluate this flawed policy.

Rafael Pardo is an associate professor at Seattle University School of Law, which he joined in 2006 after having been an associate professor of law at Tulane University from 2003 to 2006. Professor Pardo teaches in the fields of bankruptcy, commercial law, and contracts. Much of his research explores the relationship between educational debt and financial distress, particularly within the bankruptcy system. His views are his own and do not necessarily reflect those of the New America Foundation.