The rapid rise in personal bankruptcy filing rates in the last decade with a historic high of 7% in 1997 (of U.S. adult population) centered attention on the nation’s bankruptcy rule. The literature is voluminous with the main focus on studying incentives created by various bankruptcy laws on filing behavior within unsecured credit. In the same period, default rates for student loans averaged 12% with the highest rate of 22.4% in 1990 (a 2-year basis cohort default rate). The total amount of outstanding debt reached $25 billion in 2001. Little attention, however, has been given to analyzing bankruptcy rules under the student loan market. But evidence about how much borrowers and lenders respond to the incentives in bankruptcy laws would help policy makers as they work to redesign it. This paper studies repayment incentives in an environment that mimics the student loan market characteristics and considers effects of changes in the bankruptcy rule across different groups of college graduates.
The Federal Student Loan Program (FSLP) has grown significantly in the recent years with 7 million people currently borrowing under the program. One in twenty of them defaults on his loan payments. High default rates in the late 1980s have led legislators to introduce a series of policy reforms that gradually made student loans nondischargeable under Chapter 13 in the Bankruptcy Code. Rather than a disposal of the assets through liquidation sale under Chapter 7, the reorganization chapter gives the debtor the opportunity to restructure his assets and liabilities. He needs to reorganize and start repaying his loans. Dischargeability was initially restricted in 1990 to a 7-year first payment basis or undue hardship basis, the former feature being eliminated by Higher Education Amendments to the Bankruptcy Code in 1998. A couple of questions arise immediately: How are the repayment incentives affected by the change in the bankruptcy rule? What are the implications for welfare and default rates? I am concerned in particular with redistributional effects. Finally, what are the consequences for the decision to invest in college?.
In order to address the proposed issues, I develop a heterogeneous life-cycle economy that builds up on my previous work on college enrollment, borrowing and repayment under the existing FSLP. My previous research focuses on college enrollment, borrowing and repayment in an environment that accounts for various repayment schemes available under the FSLP, but abstracts from accounting for different bankruptcy arrangements, the focus of the current study. In the current paper, I allow for dischargeability on student loans and study the relationship between debt, earnings and repayment incentives under both liquidation and reorganization rules. The option to discharge one’s debt provides partial insurance against bad luck such as job loss, but drives up interest rates making life-cycle smoothing more difficult. I introduce two sources of uncertainty in this economy: earnings and interest rate on loans (under the program the interest rate is based on the 91 day Treasury Bill rate and it fluctuates with the market). The agent can self-insure against these shocks by accumulating assets. I allow for heterogeneity in earnings, asset level post-college and debt agents encountered in college to study repayment incentives across different groups of college graduates.
The novelty of this work is that it simulates bankruptcy characteristics of the student loan market, which are very different than those of the standard credit markets. Student loans are not secured by any tangible asset, so there might be some similarities with the unsecured debt market, but unlike those types of loans (credit cards), guaranteed student loans are uniquely risky eligibility conditions being very different. Loans are financial need based, not credit ratings based and are subsidized by the government. Agents are eligible to borrow up to the full college cost minus the expected family contribution. When repaying college loans, borrowers face a menu of repayment schedules. More importantly, the interest rate does not reflect the risk that some borrowers might exercise the option to default as in the standard credit market, hence the difficulty in my treatment of capturing that particular risk. The feedback of any bankruptcy law into the interest rates is exactly how the default is paid for. I endogenize the bankruptcy decision, crucial to the proposed welfare analysis. I consider penalties on defaulters similar to those implemented in the actual program, that might bear part of the default risk. To conduct the proposed policy experiments, I first calibrate the model to match key properties of distributions for college debt, assets and life-cycle earnings for college graduates.
The model explains quantitatively and qualitatively characteristics of defaulters for the reorganization period, as delivered by Baccalaureate and Beyond (B&B 93/97) data set for college graduates in 1992/1993: borrowers with lower earning levels and higher debt levels are more likely to choose default over repayment. I use the model to run a counter-factual experiment that allows for the possibility to discharge one’s debt. My results suggests that the change in the bankruptcy rule from liquidation to reorganization induced a decline in default rates by 11.66%. In the case of liquidation financially constrained people will choose to default, whereas under reorganization people default for strategic reasons rather than financial constraints. The model implies a welfare improvement under liquidation relative to the case reorganization and repayment is required with substantial welfare gains for bottom earnings quartile relative to the higher earnings quartiles. Current work extends this set-up by endogenizing college investment and human capital accumulation and studies the effects of the change in the bankruptcy rule on college enrollment and human capital investment.
This paper complements two directions of study in the literature: bankruptcy and higher education policies. The first line of research has focused on personal bankruptcy laws and their implications for filing rates with significant contributions by Athreya, and Chattergee, Corbae, Nagajim, and Rios-Rull. These studies innovate by explicitly modeling a menu of credit levels and interest rates offered by credit suppliers with the focus on default under Chapter 7 within the unsecured credit market.2 A recent paper by Livshits, MacGee, and Tertilt incorporates both bankruptcy regimes, contrasting liquidation within U.S. to reorganization in Germany in a life-cycle model with incomplete markets calibrated to the two economies. The literature has mostly abstracted from studying bankruptcy under both regimes within U.S. Higher education government policies and their effects have been extensively studied as well with most of the interest directed toward subsidies for financially constrained students.
The literature has generally ignored the analysis of default behavior under the student loan market. An exception is the work by Lochner and Monge who look at the interaction between borrowing constraints, default, and investment in human capital in an environment based on the U.S. Guaranteed Student Loan (GSL) program. They develop a model to explain empirical findings regarding the characteristics of defaulters. As opposed to their paper, I incorporate the analysis of incentives created by the reform that changed the bankruptcy rule and provide both a qualitative and a quantitative assessment of policy implications on repayment behavior, and default rates.
To my knowledge, this is the first paper to study the effects of both liquidation and reorganization bankruptcy regimes on default incentives for student loans and welfare. The paper is organized as follows: Section 2 provides background on the bankruptcy rules; next two sections describe the model and the calibration procedure; I present results in Section 5 and conclude in the last section.
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