The Consumer Financial Protection Bureau is clamping down on student loan lenders and servicers that automatically default on loans when a co-signer declared bankruptcy or dies.
The agency said this week in its latest supervision report that such defaults are an unfair practice. The majority of private student lenders have contracts that include so-called auto-default clauses, whereby a lender or servicer accelerates a default if a co-signer declares bankruptcy or dies, even if the primary borrower continues to make on-time payments.
The agency said it ordered at least one unnamed servicer to cease the practice. Others have voluntarily done so since the CFPB first highlighted auto default clauses as a problem in early 2014.
"It is deeply concerning that our examiners found private student loan borrowers being hit with automatic defaults when their co-borrower goes bankrupt," CFPB Director Richard Cordray said in a press release. "The problems plaguing the student loan market can have a domino effect on borrowers' financial futures. The CFPB has made it a priority to police this market so that borrowers are not treated unfairly or illegally dead-ended into default."
The CFPB has broad authority under the Dodd-Frank Act to regulate "unfair, deceptive and abusive practices," commonly known as UDAAP.
The CFPB said auto-defaults were unfair because "a reasonable consumer" would be unlikely to interpret that a clause in their student loan contract would put them in automatic default if a co-borrower declared bankruptcy. Perhaps worse, one or more servicers failed to notify the student that their loan was in default, the bureau said.
Richard Hunt, president and CEO of the Consumer Bankers Association, said many student loan lenders and servicers have been "actively working" to remove clauses that would permit automatic defaults.
"It is not the practice of our member banks to accelerate loans in the event the co-borrower dies or goes through bankruptcy," Hunt said.
Because private student loans are often sold and securitized, some companies' promises to eliminate auto defaults are not being upheld, said Seth Frotman, the CFPB's acting student loan ombudsman.
"Simply extending promises to the public that auto-default provisions will not be exercised is hollow and incomplete, because future loan holders may decide to enforce these clauses," Frotman said Tuesday at an industry conference.
Over the past 18 months, the CFPB has continued to hear from borrowers with loans that have been sold or securitized and the borrowers ended up in default, Frotman said.
"In these cases, the new loan holder believes it can auto-default a borrower's loan based on these auto-default clauses," he said. "Bureau examiners will continue to review this issue at other student loan servicers to determine whether they are enforcing similarly ambiguous contract clauses."
CFPB examiners also found that student loan debt collectors have used false, deceptive or misleading representations when collecting on defaulted federal student loans for the Department of Education.
Though federal student loans are now held with the Education Department, the CFPB has oversight of the private servicers that still service those loans as well as the lenders that originated them.
The CFPB's annual report to Congress found that more than 5 million, or 30%, of borrowers with the old FFELP loans are behind on payments or in default. Those loans still make up a third of all the student loan borrowers to date, totaling more than $370 billion in debt outstanding, the agency said.
More than 43 million Americans owe roughly $1.3 trillion in student loan debt, the second-largest class of consumer debt behind mortgages, Frotman said.