In a report published today, DBRS analysts said that this renewed interest in reforming the bankruptcy law to make writing off student loan debt a possibility will not necessarily create the "moral hazard" some lenders fear.

Under the current bankruptcy law, private student loans are non-dischargeable. However, both a recent paper released by the Consumer Financial Protection Bureau (CFPB) on private student lending released this summer and a renewed effort by Senator Richard Durbin (D-Illinois) of the U.S. Senate Subcommittee on Financial Services and General Government have brought more traction to the issue.

The U.S. Department of Education is also still pushing to allow this debt to be dischargeable in bankruptcy.

While reforms of the bankruptcy law will initially lead to higher defaults, controls already in place under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), would mitigate the moral hazard inherent in allowing private student loans to be dischargeable, the DBRS report said.

The bankruptcy law for instance has a chapter 7 "means test." Under the existing law, the borrower’s income is subject to this test that limits a borrower’s ability to file for Chapter 7 if his or her income is above the state’s median income and if he or she can afford to pay 25% of his or her unsecured debt.

Under a Chapter 13 bankruptcy, the borrower must complete a repayment plan of up to five years and commit to use all of his or her income net of certain IRS standardized expenses, to make the plan payments before the debt is discharged.

DBRS also believes that the cost of  filing for bankruptcy might discourage borrowers from seeking a “fresh start” through this option. "Those who file under the new law pay much higher fees to bankruptcy attorneys due to the increased liability the new law imposes on attorneys, who must verify that the debtors’ claims are true and valid," analysts said.

Sallie Mae has supported reforms to the current legislation and backs proposals that allows the discharging of private student loans only if borrowers have made an attempt to pay back their debt over a certain number of years. Likewise, the CFPB report recommended that Congress permit the discharge of private loans after a period of time in repayment.

The CFPB report also stated that Congress can allow a bankruptcy filing after less than five years, but require the use of Chapter 13 proceedings for up to five years.  

Another mitigating factor is the growing presence of co-signors for student loans. According to DBRS, in 2011 over 90% of private student loans had co-signers.  

"By requiring co-signers, lenders have created a great disincentive for strategic bankruptcy filings and address the moral hazard inherent in allowing private student loans to be dischargeable," analysts explained. "If a student seeks to borrow money and discharge it in bankruptcy, the co-signer (usually a parent) will remain liable unless he or she is willing to declare bankruptcy as well."


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