Ebook Risky College Investment under Alternative Bankruptcy Regimes for Student Loans
The rapid rise in personal bankruptcy filing rates in the last decade with a historic high of 9.15% in 2005 (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 and more recently in the housing market. 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 created by bankruptcy laws would help policy makers as they work to redesign it. This paper studies alternative bankruptcy regimes in the student loan market and their implications for repayment incentives and human capital investment across different groups of high-school graduates.
The Federal Student Loan Program (FSLP) has grown significantly in the recent years with 10 million people currently borrowing under the program. One in twenty of borrowers 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 college investment and human capital over the life-cycle?
In order to address the proposed issues, I develop a heterogeneous life-cycle economy that builds up on previous work on college enrollment, borrowing and repayment under the FSLP (see Ionescu (2009)). That paper generalizes the Ben-Porath (1967) human capital model and accounts for various repayment schemes available under the FSLP. It abstracts, however, from accounting for alternative bankruptcy arrangements, the focus of the current study. Following this previous research, central to the current model is the decision of the high-school graduate to invest in his college education and to borrow against his own future income. I allow for heterogeneity in ability, human capital stock, and asset level to study repayment incentives across different groups of students. The current study takes a further step in the analysis of default and college investment incentives created by the FSLP in several dimensions: 1) I account for the risk of dropping out from college. Given uncertainty in employment prospects after college, for some students college can turn out to be a mistake.
Given this risk to students’ future economic fortunes, banks might be reluctant to provide loans because of the absence of collateral. Furthermore, lack of risk-sharing may discourage some people from taking out a loan and going to college. 2) I allow for dischargeability on student loans and study the relationship between human capital investment, 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 bad job outcome after college, but drives up interest rates making life-cycle smoothing more difficult. 3) Thus, 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.
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, since the eligibility conditions are very different. Loans are based on financial need, not on credit ratings and are subsidized by the government. Agents are eligible to borrow up to the full college cost minus an expected family contribution. 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 rate is exactly how the default is paid for. I endogenize the bankruptcy decision, crucial to the proposed analysis. I consider penalties on defaulters similar to those implemented in the actual program, that might bear part of the default risk.
The model is consistent with college enrollment and completion behavior of high-school graduates in the U.S. Under both bankruptcy regimes, college students have higher levels of ability and human capital stocks than high-school graduates who do not enroll in college. Under reorganization, however, these differences are more sizable. Findings suggest that the ability level drives the decision to enroll in college, while the initial human capital level is crucial for completing college. The correlation between parental wealth and the ability and human capital stock of high-school graduates proves to be a key component in an environment where college education is risky. In the case where this correlation is not accounted for the model delivers counterfactual enrollment and completion behavior across income groups.
My results show that a change in the bankruptcy rule that restricts dischargeability of student loans induces a decline in college enrollment and dropout rates. Dischargeability benefits people with low assets and human capital levels; these are precisely the students for whom the risk of college investment is higher. The default rate is much higher under liquidation and college dropouts are more likely to default when dischargeability is allowed. Results suggest that under liquidation financially constrained people will choose to default, whereas under reorganization people default for other reasons rather than financial constraints. In fact, the model produces a default premium under reorganization, whereas under liquidation defaulters earn less than non-defaulters. The option to discharge one’s debt seems to be useful in mitigating the risk of dropping out and thus induces more human capital accumulation over the life-cycle. It makes college enrollment more attractive, in particular for those people who face a higher risk of not completing college.
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