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?