By Arthur J. Rotatori and Susie Chylik, McGlinchey Stafford
Section 1070 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) required the Consumer Financial Protection Bureau (the Bureau”) to work with the Secretary of Education to produce a report (the “Report”) to Congress on private student loans (“PSLs”). Dodd-Frank §1040 required the Report to address the following areas: (1) the history and structure of the PSL market; (2) the characteristics and behavior of consumers in the PSL market; (3) consumer protections applicable to the PSL market; (4) fair lending compliance in the PSL market; and (5) recommendations for statutory changes to improve consumer protections in the PSL market. Dodd-Frank §1040 required the Report to be submitted by July 21, 2012. The Bureau met the statutory deadline by submitting the Report on July 20, 2012. Although the Report is presented as the joint work product of the Bureau and the Department of Education (“DOE”), the Report appears to be largely the Bureau's work.
PSLs are loans for post-secondary educational expenses that are not originated or tracked through the federal student loan program. These loans have been controversial due to allegations of improper dealings between schools and lenders, improper marketing techniques and various deceptive lending practices. PSLs were first separately regulated by federal law through an amendment to the Truth-in-Lending Act (“TILA”) by the Private Student Loan Transparency and Improvement Act of 2008 (commonly known as “Title X”); Dodd-Frank §1077 is the second round of federal attention for this kind of lending. The controversial history of PSLs together with the wide range of private education lenders has prompted the Bureau to remark earlier this year that the private education lending industry is one of the least understood consumer credit markets. The Report was intended to give the Bureau some understanding of the PSL market, presumably as a prelude to further regulation of that market.
This article first discusses the process used by the Bureau to produce the Report. The process consisted of publishing a Request for Information (“RFI”) and a consideration of the public comments received in response to the RFI, as well as the Bureau's own research. After reviewing the public aspects of the drafting process, this article will consider the Report itself.
Dodd-Frank §1077 directs the Bureau to consider, at a minimum, the 10 topics listed in the statute while drafting its report. Most significantly for PSL lenders, the Bureau is directed to examine the underwriting criteria used by PSL lenders and to consider whether federal regulators and the public have access to information “sufficient to provide them with assurances that private education loans are provided in accord with …fair lending laws.” The Report is also required to examine the characteristics of all PSL lenders, including institutions of higher education.
Anecdotal evidence suggests that the Bureau was privately gathering information for its report throughout 2011. On Nov. 16, 2011, however, the Bureau began publicly gathering information for the PSL report by issuing a Request for Information (“RFI”) directed to financial service providers, consumers, schools and other members or organizations in the private education loan industry. Although, as noted above, Dodd-Frank §1077 required the Report to address a wide range of topics, the RFI was more limited in scope. The RFI contained a limited number of questions that dealt with four major topics: (1) the scope and use of PSLs; (2) information and shopping for PSLs; (3) institutional loans; and (4) repayment of PSLs.
The first topic, the scope and use of PSLs, was intended to address why students and families choose PSLs and other forms of non-federal financing. The RFI sought information as to why students choose PSLs before exhausting all federal loan options and to what extent other forms of financing, such as tuition payment plans, credit cards or home equity lines of credit, are relied upon. The questions for the second topic were directed at shopping for PSLs. The RFI sought to determine how students and their families are informed about PSLs. The Bureau invited discussion of the effectiveness of disclosures provided by private education lenders in the loan documents. In addition, the second topic asked which sources students rely upon to determine an appropriate amount of indebtedness. The question sought to understand whether ability to repay is a factor students use in determining the amount of indebtedness to incur and how students determine their ability to repay.
Third, the RFI requested information specifically regarding institutional loans. The Bureau requested information on the extent to which students are offered or solicited for private loans by the institution they are attending and how these loans compare, in terms of interest rate, ease of approval underwriting criteria and repayment terms, to loans offered by private education lenders. In addition, these questions invited the commenter to address the types of schools offering loans, how the schools select eligibility for loans, such as academic merit, financial need or recruitment, and how the school loan programs are funded.
Lastly, the fourth and largest topic of the RFI was repayment. The RFI sought information regarding several different aspects of repayment. First, the questions asked how well the repayment terms are understood at the time the student takes out the loan, during school, at graduation and when repayment begins. Second, the RFI invited educational institutions to describe the financial aid offices' best practices in providing students with information about future loan payments and affording the payments. The Bureau was interested in specific programs schools voluntarily use to create student awareness of debt and repayment and the programs' effectiveness.
Next in the topic of repayment, the RFI asked how debt affects the student's field of study, career choice after graduation or decision to attend graduate school. Fourth, the RFI asked commenters to address whether students are adequately informed of their rights and to identify the resources students are offered to protect their rights. Lastly, the Bureau sought empirical evidence of techniques that have helped students avoid default. Specifically, the Bureau invited commenters to address alternative repayment plans that have proven effective in keeping students out of default, whether private lenders have adopted repayment programs to respond to the high unemployment rate among recent graduates, whether there are techniques that private lenders should use to reduce default, and whether private lenders have developed rehabilitation programs for defaulted loans.
An underlying assumption in the consumer-oriented comments is that private education loans should be modeled after federal loans, notwithstanding the fact that private education loans are a form of consumer credit rather than a government benefit.
In summary, the RFI was largely addressed to schools and student borrowers and did not directly seek information from PSL lenders about the more controversial topics to be covered in the Bureau's report.
In total, other than consumer comments, 32 comments were submitted in response to the RFI. The commenters include consumer and advocacy groups; trade associations representing capital markets and the lender industry; private education lenders; credit unions; state student assistance agencies; and schools and associations representing schools. The commenters address several major themes in student loan lending including the current PSL market and several explanations behind its decline in the past several years, the unintended consequences of Title X, the effectiveness of the current TILA disclosures, and the audience and timing of student loan disclosures. We will discuss each of these points raised by the commenters and the potential impact of the comments on the Bureau's report to Congress.
As a backdrop to understanding the current PSL market, many commenters noted the reduction in the PSL market in the last four or five years both in terms of the number of lenders and the volume of loans. The reduced number of lenders has contributed, in part, to a lack of marketing of, and a source of information for PSLs. The commenters, excluding the consumer and advocacy group commenters, consistently identified the preferred lender list regulations required by Title X as a hurdle to schools providing the widest range of information possible to students. Commenters noted that schools entering into preferred lender arrangements must complete an annual list of unaffiliated lenders, provide certain disclosures regarding available federal aid, publish a code of conduct and annually report certain information to the U.S. Department of Education. For fear of not complying with the preferred lender requirements, many schools have chosen not to participate in preferred lender arrangements, resulting in little or no information being provided to students about nonfederal financing options. According to industry and school commenters, the combination of the reduced number of lenders in the PSL market and schools' reluctance to advise students about financial options for fear of non-compliance with the preferred lender regulations has created a void of comprehensive and comparative information for the student borrower.
In response to the question of whether the current disclosures required by TILA are effective, the commenters, again excluding the consumer and advocacy group commenters, identified that the disclosures provided some benefit to borrowers but could be simplified and streamlined. The commenters provided anecdotal evidence that the self-certification statement in particular is confusing to borrowers because it is redundant, does not provide any new information, and is presented to the borrower at a time in the application process when the borrower believes the process is complete. Additionally, the commenters noted that they would be in favor of mandatory school certification of PSLs coupled with the elimination of the self-certification statement.
Commenters who were mostly from school associations and state agencies noted that the disclosures are oriented toward undergraduate students and Title IV loans, which are not available to graduate students. Currently, the disclosures encourage student borrowers to exhaust all federal loans before using other sources of financing. “Federal loans” are defined solely as Title IV loans, excluding institutional loans and Title VII and Title VIII loans, which are subsidized federal loans for students in health professions. The result is that Title VII and Title VIII loans and institutional loans are considered “private education loans” for purposes of TILA, but often have comparable or more attractive loan terms than subsidized federal loans. A number of the same commenters argued that the disclosure advising the borrower to exhaust all federal loans before using private education loans is misleading because student borrowers are discouraged from using institutional loans and Title VII and Title VIII loans, although these loans may have better terms for the student. Also, the commenters noted that graduate students are provided the same disclosures as undergraduate students although the included information describes aid that is available only to undergraduates. The commenters noted that this is an additional source of confusion for the student borrower.
Additionally, some commenters remarked that the timing of student loan disclosures is more consistent with a mortgage transaction than an education finance transaction. For example, the potential of a long delay between the loan approval and disbursement can cause students to incur late fees from school financial offices and/or delay in registering for classes. The commenters suggest that the timing of the disclosures should be based on the flow of the student loan process which follows academic terms and school billing cycles.
Overall, the comments often make comparisons between federal loans and private education loans, the tone of which varies with the intent and quality of the comments. An underlying assumption in the consumer-oriented comments is that PSLs should be modeled after federal loans, notwithstanding the fact that PSLs are a form of consumer credit rather than a government benefit. The consumer-oriented comments also ignore any applicable state law limitations on the terms and costs of PSLs.
We note, however, that the Report compares PSLs to only one type of government loan and ignores the current weak performance of government loans, both of which call the Bureau's comparison into question.
Generally speaking, the comments provided anecdotal evidence based on group's or industry's experience rather than hard data. Interestingly, the RFI did not request (and the commenters did not provide) information on the more controversial topic required to be covered in the Bureau's report, the underwriting criteria used by PSL lenders. As will be discussed below, however, the industry privately provided the Bureau with quantitative and qualitative portfolio and loan level data, including credit criteria. We also note that the Bureau received approximately 2,000 comments from consumers. Although the Bureau did not initially make the consumer comments public, the Bureau eventually did so after scrubbing personal information from the comments. Reviews of the consumer comments have noted that the comments largely dealt with borrowers' difficulty in repaying their loans, the desire for greater repayment flexibility and confusion over the terms of their loans.
The Report is 131 pages with 85 of the pages constituting the actual report and the remaining pages constituting supporting material. The supporting material includes appendices, a glossary and notes. The body of the Report is comprised of an executive summary, an introduction, five parts discussing the required topics listed above, and recommendations from the Bureau and the DOE.
The Report makes heavy use of quantitative and qualitative information provided by nine major PSL lenders regarding their loans, their loan portfolios and their credit criteria. Please note, however, that after submitting the Report, the Bureau has stated that its use of the data supplied by the nine lenders may have been flawed. The Bureau did publish clarifying analysis on Aug. 29, 2012, but did not revise any of its conclusions. In addition, five state-affiliated non-profit lenders provided loan portfolio data. The Report references other comments submitted in response to the RFI, including nearly 2,000 consumer comments. The Report also uses additional information from five other databases.
After the Executive Summary and Introduction, Part One: Lenders, Loan Markets and Products begins with a background and history of the market. To provide context for the findings of the Report, Part One first explains the expansion and contraction of the PSL market in the last decade. The Report also noted that state-affiliated programs have reported a growth of PSL origination through 2008, similar to the for-profit market, followed by a contraction in 2009 and 2010. Finally, the Report mentioned institutional lending by schools in passing, noting that institutional lending has reported an increase in lending since 2008. The Report was noticeably silent, however, regarding the more controversial aspects of institutional loans made by for-profit schools. This is somewhat surprising given the RFI's interest in institutional loans.
Part Two: Borrower Characteristics and Behaviors, generally discusses borrowers' repayment behaviors, the demographics of PSL borrowers and prevalence of PSL use. Readers interested in the demographic detail discussed by the Bureau are advised to read Part Two of the Report closely; for present purposes we note only that the data in Part Two indicates that while a majority of student loan payments are a fraction of monthly income (5%-10% of monthly income), many graduates have difficulty making these payments.
The Bureau's strong support for the disparate impact doctrine is apparently not affected by last term's attempt to have the U.S. Supreme Court reconsider the applicability of disparate impact analysis in credit transactions.
In summary, Parts One and Two set a general theme that PSLs pose some risks to borrowers but also note that PSLs can provide value to students. The Report concedes that current market conditions result in low interest rates for some PSL borrowers but suggests that interest rates will increase when market conditions change. Because of such factors as the interest rate risk associated with PSLs and the payment flexibility afforded by government loans, the Report suggests that for most borrowers PSLs compare unfavorably to government loans. We note, however, that the Report compares PSLs to only one type of government loan and ignores the current weak performance of government loans, both of which call the Bureau's comparison into question.
Part Three discusses various Consumer Protection issues including disclosures required by TILA, the financial aid process, school certification, and bankruptcy treatment of PSLs. Recent changes to TILA, both before and in Dodd-Frank, have substantially changed the consumer protection requirements applicable to PSLs since the market contraction. The Bureau notes in the Report the unique disclosures requirements applicable to PSLs (and to no other consumer installment loan product) that have been required since 2010. The new TILA disclosures have been in effect for two financial aid cycles but the Bureau notes that it will be unable to determine the effectiveness of those disclosures until 2013. The Bureau did not explain why it was necessary for PSL borrowers to have separated from school before it could determine the effectiveness of TILA disclosures related to loan origination.
Part Three also considers the gaps created by the financial aid process that are not addressed by TILA. The Bureau asserted that existing consumer protection laws apply only after the consumer begins shopping for a loan, which for a student usually happens only after being accepted to a school. Under current practices, debt decisions (how much to borrow and at what cost) come too late in the process for students to make informed decisions. The Bureau suggested that students would be better served by having access to all pertinent loan information before making an enrollment decision, but passed over the fact that in other consumer transactions, consumers bargain for price before considering financing options.
Another issue addressed in Part Three is over-borrowing. The historical data reviewed by the Bureau suggests that direct-to-consumer marketing and funding without school certification leads to over-borrowing. Currently most lenders' risk appetite is low, which causes lenders to demand school certification for almost all student loans. While the Bureau suggested that the risk appetite could change, the widespread support for school certification from multiple participants in the PSL market and the disfavor of direct-to-consumer funding, make it questionable whether lenders would really return to make PSLs without school certification.
Part Three concludes with a discussion of the bankruptcy treatment of PSLs, which currently cannot be discharged without showing undue hardship, a high standard. The Report reviews the special bankruptcy treatment of PSLs that dates back more than 20 years and that culminated in the 2005 amendments to the bankruptcy code that exclude from discharge in bankruptcy all loans made for qualified education expenses. The Report questions whether PSLs share the characteristics of other non-dischargeable obligations, which are primarily debts owed to the public, such as a federal loan, or situations where the creditor lacked discretion to enter into the debtor-creditor relationship, in the case of a victim of a crime.
Initially, the decision to make student loans virtually non-dischargeable was based in part on the perception that if student loan debt was dischargeable, it would encourage students to purchase an intellectual asset that cannot be repossessed, while reaping the benefit from the asset for the remainder of the borrower's lifetime. The Report, however, was dismissive of this moral hazard reason for not treating PSLs like other consumer loans in a bankruptcy. The Report instead noted that co-signed loans now make up more than 90 percent of newly-originated PSLs, and that cosigners, because they do not receive the education, do not have the same incentive as borrowers for attempting to discharge a PSL through bankruptcy. The Bureau also argued that current bankruptcy law (the Chapter 7 means test; the required use of Chapter 13 for many consumers) tends to alleviate if not eliminate moral hazard concerns. The Bureau concluded its consideration of PSLs and bankruptcy by suggesting changes to the bankruptcy code such as the mandatory use of Chapter 13 by PSL borrowers or the dischargeability of PSLs after 3-5 years of attempted repayment.
Part Four addresses Fair Lending issues related to PSLs, which after the possibility of changes to the bankruptcy code, are the most significant issues for PSL lenders. Part Four begins by noting the unique nature of PSLs compared to other consumer debt products: PSLs are unsecured; the lender is unable to limit or reduce the credit commitment; and borrowers often have little or no credit history and uncertain future incomes. To compensate for these factors, the Report notes that some lenders use the only published data that correlates with the likelihood that the education program prepares the student for gainful employment, the DOE's cohort default rate (the “CDR”).
For each school, the CDR is the percentage of the school's borrowers entering repayment on federal student loans during a particular period who default prior to the end of the period. The CDR is one factor the DOE uses to determine a school's eligibility for federal student loan programs. A school is ineligible for federal loan programs if the school's three most recent CDR's are above 25 percent or the most recent CDR is above 40%. The Report noted that Congress did not design or intend the CDR to be used by PSL lenders to determine school eligibility, underwriting or debt pricing, especially at lower levels of default, but did not point to anything that restricts the use of the CDR in that manner.
The use of the CDR has fair lending implications under the Equal Credit Opportunities Act (“ECOA”). ECOA prohibits discrimination on a prohibited basis, which under current law includes discrimination resulting from the disparate impact of a lending practice. A lending practice has a disparate impact when it has a disproportionately negative impact on a prohibited basis, even though the practice is neutral on its face and the creditor has no intent to discriminate, unless the practice meets a legitimate business need that cannot reasonably be achieved by means that are less disparate in their impact. The Bureau's strong support for the disparate impact doctrine is apparently not affected by last term's attempt to have the U.S. Supreme Court reconsider the applicability of disparate impact analysis in credit transactions. While that case was withdrawn by the petitioners before the Supreme Court fully considered the issue, we note that the Court may use another opportunity to review the disparate impact doctrine in the future.
Private student lenders' use of the CDR at very low default levels for underwriting purposes is a concern to the Bureau because racial and ethnic minority students are disproportionately concentrated at schools with higher CDRs. As a result, the use of the CDR to determine loan eligibility and pricing may have a disparate impact on minority students by reducing their access to credit. Most PSL lenders use the CDR to determine school eligibility cutoff, in other words whether the lender will accept applications from a particular school's students.
While the Bureau did not conclude in its Report that PSL lenders are engaged in disparate impact discrimination, it specifically stated that the use of the CDR may reduce credit access and increase prices for minority student borrowers. The Report noted that the Bureau would need access to application-level data in order to draw definitive conclusions regarding the fair lending implications of the use of the CDR.
The Report concludes by listing the recommendations of both the Bureau and the DOE to Congress regarding the needs of participants in the PSL market. The Bureau made the following recommendations: (1) Congress should require school certification of PSLs; (2) Congress should consider changing the bankruptcy treatment of PSLs; (3) Congress should revise the definition of “private education loan” in TILA to include lines of credit but exclude Department of Health and Human Services loans to students in the health profession; (4) Congress should consider establishing a borrower accessible database that would include information about federal loans and PSLs to promote better borrower understanding; and (5) Determine whether additional data is needed with respect to post-graduation outcomes to avoid the potential fair lending issues associated with CDR.
Given the attention paid to fair lending issues in the Report, PSL lenders should expect the Bureau to continue gathering information about PSLs, but with a new focus on their loan pricing and credit criteria.
The DOE made essentially the same recommendations as did the Bureau, except that it did not address fair lending issues. Except for the fair lending recommendation, both sets of recommendations require Congressional action for implementation. The recommendation to determine what additional data is needed to avoid fair lending issues with the CDR, unlike the other recommendations, is not addressed to Congress. Given the Bureau's enforcement power under the consumer protection laws, the Bureau could act on at least some aspects of this recommendation without further Congressional action.
Other than providing the recommendations, the Bureau did not expressly state what its next steps in the PSL market will be. The Bureau staff has indicated that due to its need to publish final regulations on a number of topics per the mandate of Dodd-Frank, it is unlikely that the Bureau will consider any rulemaking with respect to PSLs until sometime in 2013. Rulemaking aside, however, the Bureau can proceed with civil investigative demands and enforcement actions in the PSL industry as it has in other consumer finance industries. Given the attention paid to fair lending issues in the Report, PSL lenders should expect the Bureau to continue gathering information about PSLs, but with a new focus on their loan pricing and credit criteria.
Arthur J. Rotatori is a partner in McGlinchey Stafford's Cleveland office, where he focuses his practice on regulatory matters relating to private student loans, personal property finance, residential mortgage lending and electronic commerce. He represents lenders, servicers and marketers working in those areas. Susie Chylik is an associate in the firm's Cleveland office, where she focuses her practice on consumer finance and regulatory matters for banks, lenders and other types of financial institutions.
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