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Should grads be allowed to declare bankruptcy on student loans?

posted on 2015-10-12 by Eric Schulzke

With presidential candidates like Hillary Clinton calling for an end to "the crushing burden of student debt," some higher education experts have begun to question federal policy that makes it nearly impossible to discharge student loans in bankruptcy.

Current law puts student loans in a very small class of debts that cannot be discharged, a class that includes unpaid child support and criminal fines.

Starting in 1976, Congress began clamping down on bankruptcy for federally-backed student loans as a response to a spike in student loan bankruptcy. And then in 2005, Congress extended that rule to student loans issued by private lenders.

Bankruptcy is treated differently from other debts because policy makers fear students will game the system, says Rajeev Darolia, a public policy professor at the University of Missouri.

“Legislators fear that opportunists could run up large debts they never mean to repay,” Darolia said, “and then declare bankruptcy just as they finish college, when they still have few assets but strong career prospects.” In economics, this is called “moral hazard,” which means that rules create incentives for people to abuse the system.

But after looking at bankruptcy filings before and after a 2005 change in federal law that further tightened bankruptcy law on student loans, Darolia found no evidence that students were gaming the system.

Student loans should be made dischargeable in bankruptcy, many experts are suggesting, because most students who struggle with student loans, far from gaming the system, are actually victims of a system that encourages them to acquire debt for programs they are unlikely to finish or, if they do finish, do not offer realistic career options.

Noting that formal policy changes will be hard to make, some have suggested that these debts already are dischargeable because existing hardship exceptions are more flexible than most people realize.

Among the latter group is Jason Iuliano, a doctoral candidate in political science at Princeton and a Harvard Law School graduate, whose research, published in the American Bankruptcy Law Journal in 2012 found that nearly 40 percent of those who try to discharge their student loans succeed.

"Those who succeed are worse off financially than the average filer," Iuliano said, and people who barely qualify for bankruptcy probably won't qualify for loan discharge. But the process is not all that complicated, and many succeed even without an attorney.

Finally, there are those who worry that taxpayers will be left holding the bag if the policy changes. One way around this, according to Alex J. Pollack, a fellow at the American Enterprise Institute, is to make the schools who take in the tuition checks carry a share of the risk of failure, giving them an incentive to foster better outcomes.

Hardship exceptions

The notion that student loans cannot be discharged has become so ingrained that few bankruptcy attorneys or their clients even attempt to discharge them, Iuliano said.

Iuliano disagrees with some experts in the field, he said, even those who say that student loan bankruptcy should be mainstreamed. His argument is that the existing hardship exception is broad enough to amount to a policy shift if people use it more often.

According to research coauthored by Iuliano, only 1 percent of bankruptcy filers who have student loans attempt to get them discharged. But of those who try, 25 percent obtain a complete discharge while 14 percent get a partial discharge.

To decide whether to discharge a student loan bankruptcy, Iuliano said, most courts will use the three prongs of the "Brunner Test." First, can the filer maintain a minimal level of standard of living if forced to repay the loans? Second, is that situation likely to persist? And third, has the filer made a "good faith effort" to repay?

The last point means that if a student had a good job prior to filing bankruptcy but was already in default on her student loans, they might not get their loans discharged even if they are unemployed now.

Bankruptcy filers will have to file an "adversarial" complaint, Iuliano said, but this sounds much scarier than it actually is. Many successful filers do it without the assistance of an attorney, and the courts do not expect a high degree of formality.

"We see people succeeding in court with handwritten filings with smiley faces on the margins," Iuliano said.

Skin in the game

Pollack would like to see bankruptcy for student loans fully legalized. But he would balance the resulting risks to the taxpayer by giving colleges and universities real "skin in the game."

If Pollak had his way, any time a student costs the taxpayer by failing to repay a loan, whether through actual default or by shifting to an income-based repayment program, the school would cover 20 percent of the actual taxpayer cost.

"Taxpayers would still be eating 80 percent of the loss," Pollack said, but he hopes it would create some incentive for schools to be more careful about which programs they offer which students and how they nurture those students into their careers.

That, he argues, would distribute the risk among the borrower, the taxpayer and the school more fairly, giving the school an incentive to do more to guide students into high-value programs and concern themselves with transitions into the workforce.

Pollack focuses not on defaults but on the actual costs to taxpayers, even if the student is technically not defaulting but not repaying the loan on time.

"The current trend at the Department of Education is to find all kinds of reasons why people don't have to pay, including income-based repayment," Pollack said. "If that becomes a bigger part of the student loans, the default rate could come down while costs to the taxpayer still rise."

Colleges and universities should share the risk, Pollack argues, because they are the most direct beneficiaries of loans. "They are the promoters and arrangers of the loans, and the cash goes directly to the college," Pollack said. And as things stand, he said, that's where their obligation ends.

"I hope the 20 percent risk share would cause schools to think more about who can succeed with these loans," Pollack said. "How can they guide students so they become productive, guide them toward better majors, help keep them in school so they graduate."

Possible side effects

Iuliano said he hasn't considered Pollack's proposal, and would need time to consider possible implications. But he said it struck him as potentially useful, and he agreed that the "current structure doesn't place much burden on the school itself."

Side effects also concern Rajeev Darolia at the University of Missouri. "Requiring colleges to share risk could change the attitudes of the community colleges that now have open access to shift their access based on risks of defaulting on loans," Darolia said.

Darolia argues that any policy that focuses purely on default rates and punishes school accordingly would end up picking on the schools that serve those most at risk. "Harvard doesn't have a problem with loan defaults," he noted.

But he does think that if access concerns were taken seriously, risk sharing for colleges could be paired with allowing student loan bankruptcy, as long as the incentives were structured properly.

"Maybe we would not see so much access restrictions at the entry point," he said, "but we might see more a concerted effort for student support, to make sure they choose good programs and make sure they actually graduate."




Why Banks Should Be Increasing Their Loan Loss Allowance

posted on 2015-09-28 by Chris Nichols

Our banking industry has our loan loss allowance provisioning almost exactly wrong. To quote our favorite show, Game of Thrones, winter is coming. We don’t know when the cold weather will be here, maybe the first part of October or maybe around Halloween, but we know it’s coming. Since winter is coming, the question arises - How many coats should we have for the winter? For that answer, we simply look at the data and see what the average daytime temperature over the past three months has been, and we can see it is a warm 81 degrees. Based on the data, we can then conclude that we need zero coats for the winter. We should be fine come January.

Winter Is Always Cold

Of course, any banker can see the mistakes in our coat methodology, yet that is roughly how our industry arrives at our allowance for loan and lease loss (ALLL) reserve. Many banks improve on the methodology by looking back longer and taking into account last winter, but the data still gets dampened by the good / warm times. Right now, banks are still reducing their loan loss provisions as the economy is relatively strong and loans are performing. That is a problem as risk is increasing not decreasing. In some markets, commercial and residential property prices are well above their peaks of 2006. Let’s consider markets like New York, Miami, San Francisco and Seattle. In these markets, prices can be 20% to 40% above their peaks of 2007. Can this continue? Maybe, just like we can have two more months of warm weather, but it is not likely to continue for an extended period of time. Cycles happen and when they do, banks are going to want a warmer coat.

Compounding the Problem

Part of the issue is how banks handle risk management. It is bad enough that property appraised values are at a near-record level in many markets, yet loan loss provisions are now back towards their lows, similar to how they were in 2007 before the downturn (below).

To compound the problem, as of August, loan pricing in some markets are back to their tightest spreads, comparable to 2007. Pricing of Libor + 1.50% is becoming more common. Underwriting has loosened and concentrations to commercial real estate are increasing. Commercial real estate loans are now 75% of total risk-based capital and construction lending is back to 16% of total risk capital. Finally, interest rate risk has never been greater, as banks now have the longest duration in the history of banking once you take into account index, floors, caps and prepayment penalties.  All this adds up to increasing risk at the loan level and at the balance sheet level. This is at a time when margins continue to contract and are set to further contract even if rates rise in the short and intermediate term.

Empirical Evidence

While banks are highly correlated to real estate prices, let’s just isolate commercial real estate prices for the sake of simplicity. A regression of more than 900 banks in a study by the Bank of International Settlements from 2005 looks at the impact of commercial real estate on bank performance. Their coefficients have some very practical applications for modeling. For example, as can be seen below, the correlations of commercial real estate prices have a larger impact than macro-economic factors such as GDP. For every one-standard deviation of expansion (about 10.85% growth) in real asset prices, bank lending increased 1.74%, return on assets increased 0.10%, margins were reduced by 0.10%, non-performing assets decreased by 0.22% and ALLL dropped by 0.05%. This is greater than the impact of 1 standard deviation of production movement.

The implications for banks are that in good times, banks reap positive performance, however in doing so; they also set themselves up for hard times because the opposite is true. In times of falling prices, the above correlations also hold and banks experience shrinking assets, lower earnings, more asset problems and higher ALLL. What happens if we reverse these correlations?

A Better Model

The industry adopting the new Financial Accounting Standards Board (FASB) Current Expected Credit Loss (CECL) Model is a step in the right direction since it forces banks to be more forward looking. To see if this is true, we built a rudimentary model based on the above correlations and tied ALLL to property prices (and as a result, property level net operating income). Thus, every time net operating income was expected to go up, we increased the reserve, while when net operating income was expected to drop, we decreased the reserve.

What we got was a model that back tested as follows:

As can be seen, our model not only moderates some swings caused by overestimation, but it also moves largely in reverse of how most banks handle their ALLL now. Interestingly, the model also allows us to optimize reserves and ask the question:  how much should we be reserving given our current loan mix and historic underwriting exposure? The output was that while banks reserved an average of 1.98% of their net loans, they should have reserved a lower amount to the tune of 1.69% (below). Interestingly, most of the issue came in 2009 and 2010 when banks were largely using the worst case from the downturn to fuel their model.

Does The Model Work?

As a test, we reran cash flows for the industry to see if an ALLL model largely based on the inverse of today’s methodology could reduce risk. We then compared them to actual results to produce the below graphic:

The inverse ALLL Model does serve to moderate income and reduce earnings volatility by 13% which can graphically be seen above. This is a step in the right direction and places banks in a more proactive and forward looking position. This model could be refined even further to include forecasted data that has a better fit (such as effective rents) and be expanded to include other lending lines such as residential real estate (a huge missing piece).

Conclusion

Given the empirical data, we believe banks that face major metro markets should be increasing reserves, not decreasing them. We think the past extraordinary period of low rates has inflated a real estate bubble in many areas and banks are at risk. Current loan loss reserves have been dropping and instead of a 1.38%, banks should be closer to 1.94% and rising. We all know winter is coming and while we don’t know the severity, we know it will be cold. Just like basing your wardrobe on the past will leave you out in the cold, so will having your historic data biased by some of the best credit times in banking. Incorporate more forward-looking measures in your loan loss allowance methodology and you will find that you will stay warmer during the winter months. 

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CenterState Bank is a $4B community bank in Florida experimenting their way on a journey to be a $10B top performing institution. CenterState has one of the largest correspondent bank networks in the banking industry and makes its data, policies, vendor analysis, products and thoughts available to any institution that wants to take the journey with us.




FCC Levies Record $2.96 Million Fine Against Florida Company for Autodialed Calls

posted on 2015-08-20 by By Justin Brandt, Alan D. Wingfield and Chad Fuller

 

On August 11, the Federal Communications Commission handed down a $2.96 million fine against Travel Club Marketing Inc., related entities, and owner Olen Miller (collectively “Travel Club”), the largest fine in FCC history related to autodialed calls.  The fine stems from allegations that the companies violated the Telephone Consumer Protection Act in their telemarketing efforts, including sales of vacations and timeshares.  Travel Club was accused of making at least 185 “prerecorded advertising calls” to more than 142 cellular and residential telephone numbers, many of which were listed on the National Do Not Call Registry.

The fine culminates a formal regulatory process that began on October 31, 2011, when the FCC issued a Notice of Apparent Liability (NAL) to Travel Club proposing the $2.96 million forfeiture for “willful and repeated violation” of the TCPA.  When Travel Club finally responded, the FCC noted the failure “to provide any information or make any arguments whatsoever to challenge the NAL’s findings” and that Travel Club “continued to make unlawful robocalls during the time that the NAL underlying this Forfeiture Order has been pending, the fact of which militates against a cancellation or reduction of the proposed forfeiture penalty.”

Under FCC rules applicable when the calls were made, such telemarketing calls were allowed only with “either prior express consent or an established business relationship” with call recipients, which Travel Club did not possess.  The FCC has since further tightened these restrictions, ending the “established business relationship” exemption in 2012.  The previous record fine was $2.9 million, ordered by the FCC in May 2014, in relation to autodialed calls made during the 2012 United States presidential campaign.

Although the fine represents a new high for an administrative enforcement action by the FCC, an ongoing enforcement action by the FTC and several states against Dish Network under the TCPA, the FTC’s Telemarketing Sales Rule, and parallel state laws is seeking, theoretically at least, billions of dollars in penalties arising out of allegedly illegal telemarketing calls.  Our take on the Dish Network action can be found here

Troutman Sanders LLP has unique industry-leading expertise with the TCPA, with experience gained trying TCPA cases to verdict and advising Fortune 50 companies regarding compliance strategy.  We will continue to monitor regulatory and judicial interpretation of the TCPA in order to identify and advise on potential risks.




CFPB Requesting More Information Regarding Its Debt Collection Rulemaking

posted on 2015-08-20 by By Ethan G. Ostroff, David N. Anthony and Keith J. Barnett

 

The Consumer Financial Protection Bureau sent a questionnaire with almost 60 questions to randomly selected debt collectors and service providers as part of its potential rulemaking regarding debt collection, a process that began almost two years ago.   

The CFPB received 23,000 comments in response to its Advance Notice of Proposed Rulemaking (ANPR) for debt collectors, which included 162 questions.  According to the CFPB, this new “survey is being conducted in order to build the [CFPB’s] knowledge of the operational costs of collecting debt that is in default” and the answers provided to the questions are intended to “help the CFPB better understand the burden of potential regulations affecting the debt collection industry.” 

This questionnaire was sent with a cover letter from John McNamara, the Debt Collections Program Manager in the CFPB’s Division of Research Markets & Regulations.  In it, the CFPB explains it “will be gathering information from a variety of debt collection firms, creditors, and service providers” that will “inform the Bureaus’ analysis of the benefits and costs of potential new rules relative to debt collection.”   

The questionnaire asks about basic activities and operational costs of collecting debt, including, for example, questions about vendors used for activities such as dialers or print mailings, maintaining data about consumer accounts, and furnishing information to credit bureaus.  The CFPB also stated that it plans to conduct “follow-up phone interviews” with some of the companies that respond to the survey “to help us understand their operations in more detail.”




CFPB Proposes to Postpone Effective Date of TILA-RESPA Integrated Disclosure Rule to October

posted on 2015-06-29 by Maryia Y. Jones

We previously reported on the remarks made by Consumer Financial Protection Bureau Director Richard Cordray on May 12 that the CFPB would not voluntarily change the August 1 effective date for the TILA-RESPA Integrated Disclosure Rule (TRID).  This officially changed on June 24 with the CFPB’s issuance of a proposed amendment to TRID, postponing its effective date from August 1 to October 3.

The CFPB issued the proposal to correct an administrative error.  Specifically, the CFPB recently discovered that it inadvertently had not submitted the rule report to Congress as required.  Upon discovering its error, the CFPB submitted the rule report to both Houses of Congress and the Comptroller General of the Government Accountability Office on June 16, 2015.  However, under the Congressional Review Act, the TILA-RESPA Final Rule cannot take effect until, at the earliest, August 15, 2015 – two weeks after the currently-scheduled effective date.

In light of the administrative error, as well as the extent of “unique implementation challenges for industry, requiring major operational changes” that even the CFPB recognizes, it wisely decided to propose that TRID’s effective date be delayed to October 3.  The proposal is open for public comment until July 7, and the CFPB expects to make its final decision shortly thereafter.





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