Student Loans: The Home Mortgage Crisis Redux

First things first, student loans can be discharged in bankruptcy. I'm not sure where this pervasive myth started that student loans are non-dischargeable, and it appeared again recently in an article by Representative Frederica Wilson, but let's lay it to rest. Shockingly, I've heard bankruptcy practitioners also say they couldn't discharge a debtor's student loans because it wasn't allowed under the bankruptcy code. Well it is -- quite unequivocally in fact -- allowed in bankruptcy. 11 U.S.C 523(a)(8) lays it out in very clear language and also states that there must be undue hardship. The Brunner Test was the Supreme Court's attempt at defining hardship. Basically, you have to be poor, have that poorness be almost guaranteed in your future, and have made a good faith effort to repay your loans in the prior five years. And student loan companies are vicious when it comes to protecting the Brunner Test. How vicious? Sallie Mae appealed the student loan discharge of a mother of five children, two of which are autistic, and fortunately for the mother, Sallie Mae lost on appeal. But that's now the second threshold. If you're not somehow in a more dire situation than a mother of five who can't work, once you pass the Brunner test, you're probably looking at an appeal.

But say you do get past the Brunner Test and the almost certain appeal by your lender because they don't think your demonic possession really counts as an undue hardship, you will get your student loans discharged just like any other debt. And there is some evidence that the success rate is fairly high, though that could also be due to the low number seeking discharge. That's the bankruptcy court functioning properly and giving people a fresh start. However, what happens when those fresh starts start to add up and the aggregate amount of money discharge gets larger? Well we know what happens, it was called 2008 to now and the culprit was home mortgages. This isn't to say that home mortgages were a bankruptcy issue, but the default on home mortgages closely parallels the discharge of student debt in bankruptcy courts. And it looks like it may be déjà vu all over again.

Student loan debt is big. A trillion dollars big or more and the government has absolutely no idea how big it actually is and it's growing at an accelerating rate. Where it took 15 years to go from $90 billion to $1 trillion, at current rates, it will take about six years to reach $2 trillion. If this is starting to sound eerily familiar, raise your hand. At least with housing there was collateral, but student loans are completely uncollateralized which is why student loan companies fight discharge so vehemently. They know there is nothing on the other side, discharge is the end of the road for their investment. I guess they should have listened to the prophetic Milhouse Van Houten when he said investing in America's children was a big mistake.

So we have a trillion dollars in uncollateralized debt, a 13 percent unemployment for 20 to 29-year-olds (also known as the group with the most student loan debt) millions of adults living with their parents, and about half of graduates not even needing their degrees -- it can't get worse right? It can always get worse. SLABS is how it gets worse. Technically they are student loan asset backed securities, but SLABS sounds a lot more ominous. For those of you who aren't familiar with asset backed securities , here's a quick primer: ABS takes loans and packages them together to create a new asset which can be bought and sold. SLABS use student loans as their underlying asset and are bought and sold the exact same way mortgage backed securities are sold. We all remember mortgage backed securities, or as they're affectionately known as now, toxic assets that required an $800 billion government bailout.

Well now there back, in student loan form!

Investors are flocking to SLABS, creating what many are calling a bubble. But for a bubble, you need a good, universally held belief that will end up being untrue. The mortgage crisis had a doozy by saying home prices would never go down, especially since home prices had gone down in various states over the past 20 years. SLABS might have an even better one -- they can't be discharged. Implied in that is that courts will force you to pay every last penny into your student loans which would make them risk proof. As I've stated above, that's completely untrue. And given the current trends about employment and income for the newest set of borrowers, SLABS are getting riskier by the graduating class. The only difference now is that we've seen what happens when asset backed securities go sideways and unfortunately, that will just make money markets dry up even faster once the storm hits. The contagion that spread in 2008-2009 will happen again -- only this time it will be faster and no bailout will be needed because the government is the primary lender.

This has all the makings of a bubble and when it bursts, it will hobble students' ability to borrow for college. Reforms are needed, but there is very little political will and talk of bubbles never penetrates those inside the bubble. For those, I would recommend going out and enjoying a tulip that won't cost you your house.


Biggest Money Mistakes 20-Somethings Make