Monday, May 14, 2007

Dumping Defaulted Loans

A reader sent me this excellent story of yet another nefarious lender practice, discovered by the Cleveland Plain Dealer. It works like this: once a student loan goes into default, lenders get up to 98% of their money back from the federal government (the guarantee in guaranteed loans). But instead lenders offload or "dump" the defaulted loan into the Direct Loan program by initiating Direct Loan Consolidation, pressuring the borrower to go along with it.

"the borrowers' bad debt, often multiplied because of earlier delinquencies and refinancing, gets turned into a new loan - with interest, late charges and an 18.5 percent handling fee for the industry. But this new, expensive loan is no longer the industry's liability; rather, industry employees convert it into a new government loan, issued under the federal Direct Loan program."

Let's see. So if you fall behind on your $40K loan, if lenders played by the rules they'd declare default after 9 months and collect, let's say, $38K plus interest--$45K?
Instead, they let it balloon to $100K with penalties and fees. Then they "dump" it into direct loan consolidation and take home $118K of taxpayer money.

This practice is costing taxpayers $400 million a year in fees and expenses for collection, which is often futile because the loan is already in default. It accounted for 46% of the industry's so called default "recoveries" last year.
These are the wonderful boons of competition between the direct and FFEL programs.


Anonymous said...

I'm sure there are some unscrupulous lenders out there but I have been in the industry for 1 1/2 years and haven't heard of this before, and I don't even see how it would work because even Direct won't consolidate a loan in default - it has to be repaired with the holding lender first. They will help you with the repair, but they won't consolidate it. Even if they would do it there are limits placed on the amounts of fees lenders are able to apply. I would like to see some sources on this.

Anya said...

To clarify, these loans are not defaulted when they're dumped into Direct Lending. They're bad loans that have already multiplied with fees and interest, with a high risk of defaulting.

I'm not aware of any practical limits on the fees lenders can apply, especially when it comes to capitalized interest on the debt. Stories of $30,000 going to $120,000 are all too common. Please enlighten.

Anonymous said...

The loans the Cleveland article is referring to are defaulted loans. In other words, a FFELP Stafford, SLS, PLUS, or Consolidation loan defaults. The guaranty agency pays the lender's default insurance claim, and DoEd pays the guaranty agency's reinsurance claim. The guaranty agency is holding the loan. The lender is out of the picture.

The first post refers to the very rare situation where the defaulted borrower makes three reasonable payments and then consolidates. The benefit of this for the borrower is the ability to choose any repayment plan. However, the usual situation for the defaulted borrower is a consolidation into Direct Loan without making the three reasonable payments. These borrowers are required to go on the income-contingent repayment plan. They would have to prove their payment record for a year before having an option to select a different repayment plan. In either type of default consolidation, a 18.5% fee would be added, although the recent deficit reduction act reduced the net fee to 10% to act as some type of financial incentive for guaranty agencies to reduce the churning.

Another possibility of what the first post is referring to is loan rehabilitation. In this situation, no consolidation occurs. The borrower makes 12 reasonable payments and then the same loan is transferred back to the lender, with a 18.5% fee added. In any case, collection agencies, loan servicers and others do not work for free. It seems unrealistic to hope for legislation which would 'wipe out' fees. Someone has to pay all of those companies and their staff.

A consolidation loan is a new loan, a new promissory note, so the second post is technically correct that the new loan is in good standing when originated by direct loan consolidation. The defaulted loans are gone, paid off through the consolidation process, although the default is noted on the borrower's credit record for up to seven years. Loan rehabilitation is the only way to clean the credit record.