Deficiency judgments

Continuing our series of e-mails on real estate workouts, many clients are concerned about potential exposure to deficiency judgments resulting from real estate foreclosures. The New York law that deals with deficiency judgments is § 1371 of the Real Property Actions & Proceedings Law. The law provides that:

1. A plaintiff in a mortgage foreclosure action may bring an action for a deficiency judgment if the defendant has been personally served in the action.

2. The action for the deficiency judgment must be made within 90 days after the foreclosure sale.

3. The law provides that the deficiency judgment shall be equal to the amount the defendant is liable to the plaintiff (as determined by the judgment), plus interest, plus the amount owing on any subordinate liens and encumbrances, including interest, costs and disbursements, including referee's fees, less the market value of the property as determined by the court at the time of the foreclosure sale. Accordingly, if the value of the property is greater than the deficiency owed, the plaintiff will not be able to obtain a deficiency judgment.

Notwithstanding the language in RPAPL § 1371, before commencing deficiency judgment actions, secured creditors (such as banks) go through a calculation. They ask themselves the following questions:

1. If we bring a deficiency action, does the defendant have assets or earnings to satisfy the judgment? For example, if the bank believes that the defendant will file Chapter 7 personal bankruptcy to protect his or her assets, or if the defendant is "judgment proof," then they will not commence the action. Some borrowers who do have the ability to pay some or all of the judgment will come forward and offer to settle before an action for deficiency is commenced.

2. Does the defendant have the potential for good future earnings (such as a medical doctor), such that if the creditor obtains the judgment (which is good for 20 years under New York State law), they will be able to collect the judgment from future earnings?

3. What is the fair market value of the property? As mentioned above, the court will determine the fair market value at the time of the foreclosure sale, which can become a battle of appraisals, so creditors must prepare to bring in expert witnesses to testify on this issue.

4. How long will it take and how much will it cost to obtain and collect the judgment?

5. Is the deficiency a result of a "strategic default"? A "strategic default" involves a borrower who has the ability to pay his or her mortgage but chooses not to. Often that decision is tied directly to the property being "underwater" (the fair market value of the property is less than the outstanding liens encumbering the property (mortgages, home equity lines of credit, etc.)). Loan originators rely heavily on their servicers (the entities that are responsible for day–to–day management of mortgage accounts) to determine if a borrower is a strategic defaulter and then makes a determination whether to seek a deficiency judgment.

Clients or colleagues having questions about deficiency judgments should not hesitate to contact Jim Shenwick.

NYT: In Prosecutors, Debt Collectors Find a Partner

By JESSICA SILVER-GREENBERG

The letters are sent by the thousands to people across the country who have written bad checks, threatening them with jail if they do not pay up.

They bear the seal and signature of the local district attorney’s office. But there is a catch: the letters are from debt-collection companies, which the prosecutors allow to use their letterhead. In return, the companies try to collect not only the unpaid check, but also high fees from debtors for a class on budgeting and financial responsibility, some of which goes back to the district attorneys’ offices.

The practice, which has spread to more than 300 district attorneys’ offices in recent years, shocked Angela Yartz when she was threatened with conviction over a $47.95 check to Walmart. A single mother in San Mateo, Calif., Ms. Yartz said she learned the check had bounced only when she opened a letter in February, signed by the Alameda County district attorney, informing her that unless she paid $280.05 — including $180 for a “financial accountability” class — she could be jailed for up to one year.

“I was so worried driving my kid to and from school that if I failed to signal, they would cart me off to jail,” Ms. Yartz said.

Debt collectors have come under fire for illegally menacing people behind on their bills with threats of jail. What makes this approach unusual is that the ultimatum comes with the imprimatur of law enforcement itself — though it is made before any prosecutor has determined a crime has been committed.

Prosecutors say that the partnerships allow them to focus on more serious crimes, and that the letters are sent only to check writers who ignore merchants’ demands for payment. The district attorneys receive a payment from the firms or a small part of the fees collected.

“The companies are returning thousands of dollars to merchants that is not coming at taxpayer expense,” said Ken Ryken, deputy district attorney with Alameda County.

Consumer lawyers have challenged the debt collectors in courts across the United States, claiming that they lack the authority to threaten prosecution or to ask for fees for classes when no district attorney has reviewed the facts of the cases. The district attorneys are essentially renting out their stationery, the lawyers say, allowing the companies to give the impression that failure to respond could lead to charges, when it rarely does.

“This is guilty until proven innocent,” said Paul Arons, a consumer lawyer in Friday Harbor, Wash., about two hours north of Seattle.

The partnerships have proliferated from Los Angeles to Baltimore to Detroit, according to the National District Attorneys Association, as the stagnant economy leaves city and state officials grappling with budget shortfalls. Lawyers for the check writers estimate that more than 1 million of them are targeted a year. The two main debt collectors — California-based CorrectiveSolutions and BounceBack of Missouri — return millions of dollars each year to retailers including Safeway, Target and Walmart.

While the number of bounced checks has fallen as more shoppers pay with credit or debit cards, Americans still write billions of dollars worth of bad checks each year. In 2009, $127 billion worth of checks were returned, according to the most recent data from the Federal Reserve. That’s down from $182 billion in 2006.

Because the cases are not fully investigated, there is no way of knowing whether the bad checks were the result of innocent mistakes or intentional fraud. The so-called bad check diversion programs start from the position that a crime has been committed.

Before the first partnerships were rolled out in the late 1980s, merchants who received a bad check typically tried to retrieve the money themselves or through a private collection company, with abysmal results. Those merchants who suspected fraud could send along the checks to their local district attorneys.

The influx of bad-check reports overwhelmed district attorneys’ offices, according to Grover C. Trask, a former district attorney in Riverside, Calif., considered the father of such programs. “It was a way to deal with a fairly serious nonviolent crime going on in the business community, but not overburden the court system or the resources of the district attorneys,” Mr. Trask said.

The programs were quickly challenged by consumer lawyers, who took aim primarily at California-based American Corrective Counseling Services. Facing a barrage of class-action lawsuits, the company reorganized through a Chapter 11 bankruptcy in 2009.

Still, its successor, CorrectiveSolutions, which says it has contracts with more than 140 prosecutors, has been dogged by similar legal challenges, including a class-action lawsuit pending in federal court in San Francisco that claims the company “has constructed an elaborate artifice” to terrify borrowers into paying. CorrectiveSolutions, which did not respond to requests for comment, has contested the claims, court filings show.

For the collection companies, the partnerships offer a distinct financial benefit: the “financial accountability” classes. Typically, a small portion of the class fees, which can exceed $150, are passed on to the district attorneys’ offices. Check writers are led to believe that unless they take the courses, they could end up in jail.

A letter signed by the Santa Clara County district attorney, for example, informed Kathy Pepper that the “bad check restitution program” would allow her to avoid “the possibility of further action against the accused by the District Attorney’s Office.”

Petrified, Ms. Pepper agreed to pay $170 for a class and another $25 to reschedule the class last year after accidentally writing a $68 check in the midst of a divorce last year that upended her finances.

What Ms. Pepper did not know was that her bad check was sent directly from the merchant to the debt-collection company, without any prosecutor determining whether she had actually committed a crime.

Under the terms of five contracts between CorrectiveSolutions and district attorneys reviewed by The New York Times, merchants refer checks directly to the company, circumventing the prosecutors’ offices. While the merchants are required, for example, to attempt to contact the check writer, they can send any bad checks to the collection companies if the shopper hasn’t responded, typically within 10 days.

“No one at the district attorney’s office reviews the cases” before the collection company sends out letters, said Priscilla Cruz, an assistant director in the Los Angeles district attorney’s office.

As of July, CorrectiveSolutions had sent out 16,955 letters on behalf of the Los Angeles district attorney, and during that time 635 people attended the program’s classes, county data show. While few people will be prosecuted for not attending the class, there is a possibility of charges, Ms. Cruz said.

While the percentage of targeted check writers taking the classes is low — 4 percent to 7 percent in recent years — the percentage of cases referred for potential prosecution is much lower, about 0.10 percent.

Few bad-check writers are prosecuted, especially for relatively small sums, lawyers say, because it is hard to prove the person meant to defraud the merchant.

Gale Krieg, a vice president at BounceBack, said he has turned down business from prosecutors who won’t agree to at least have all copies of the checks sent to their offices, where prosecutors can determine if a crime has been committed. Mr. Krieg, who said the company has contracts in 38 states, acknowledges the limitations: “Whether they exert oversight isn’t something that we can control.”

Prosecutors point out that people who write bad checks should be held accountable for paying back what they owe.

“I view it as quite a win-win,” said Baltimore County State’s Attorney Scott D. Shellenberger. “You aren’t criminalizing someone who shouldn’t have a criminal record, and you are getting the merchant his money back.” On its Web site, CorrectiveSolutions says that its classes result in low rates of recidivism.

Some officials in district attorneys’ offices have quietly raised concerns that the programs are misleading. A November 2009 county audit of Deschutes County, Ore., titled “District Attorney’s Office-Cash handling over revenues,” wondered whether elements of the program could be “disingenuous.” The prosecutor’s office, which did not return requests for comment, contracts with CorrectiveSolutions to handle its bad checks. Ms. Yartz said she accidentally wrote a check for groceries on her credit union account, rather than her bank checkbook. She had recently moved and was in the process of closing that account.

Even after Ms. Yartz paid $100.05 in February to cover the bounced check, the returned item fee and an administration fee, she got a letter signed by the Alameda district attorney informing her that her remaining balance was $180 for the class. After consulting with a lawyer, she decided to take her chances rather than pay for a class she could not afford, to avoid being punished for a crime she said she did not commit. Ms. Yartz also questioned the need for a class on budgeting and financial accountability: “If I meant to bounce this check like a criminal, why do I need a class on budgeting?” 

Copyright 2012 The New York Times Company.  All rights reserved.

NYT: Mortgages-Life After Bankruptcy

By VICKIE ELMER

EVERY month tens of thousands of people file for federal bankruptcy protection, mostly to wipe out debts and start anew.

Many of these filers mistakenly think that it will be many years before they can obtain a mortgage or refinance an existing home loan, if they ever can — perhaps because notice of a bankruptcy filing typically stays on a credit report for 7 to 10 years. In reality, they could become eligible in as little as one year, as long as they work diligently to improve their financial picture.

Mortgages guaranteed by the Federal Housing Administration are permitted one year after a consumer exits a Chapter 13 bankruptcy reorganization, which requires a repayment plan that is often a fraction of what is owed, and two years after the more common Chapter 7 liquidation, which discharges most or all debts. Conventional mortgage guidelines from Fannie Mae and Freddie Mac, meanwhile, call for a wait of two to four years.

“There’s a lot of other things that go into your ability to get approved” for a mortgage after a bankruptcy, said John Walsh, the president of Total Mortgage, a direct lender based in Milford, Conn.

The most important point, he and other industry experts say, is that consumers re-establish their credit and show that they can manage it responsibly. They can do this by paying rent and utility bills on time, or perhaps by obtaining a secured credit card, according to Mr. Walsh.

If a bankruptcy filing was the result of a one-time occurrence, like the death of a spouse, divorce or illness, the waiting period to apply for a mortgage may be reduced. Lenders will often want borrowers to write a hardship letter explaining their situation, backed by documentation like hospital bills or a court-approved divorce settlement.  If the person has paid back 85 to 95 percent of his debts during the bankruptcy process, he will need to mention that in the letter as well, said Bruce Feinstein, a bankruptcy lawyer in Richmond Hill, Queens.

But examples of shortening the waiting period through hardship letters are “few and far between, and tough to get,” Mr. Walsh said.

Mr. Feinstein says he has seen a few clients qualify for a mortgage only two years after filing for Chapter 7, though generally borrowers can obtain a loan quicker after a Chapter 13 reorganization, because of the partial repayment of debts, he said. 

As Mr. Walsh noted, “Chapter 13 is a little more responsible” way to go from the lenders’ perspective, so lender guidelines are a bit more lenient.

Almost 70 percent of personal bankruptcies are filed under Chapter 7, according to the American Bankruptcy Institute, a research organization. The institute data noted that last year there were 1.362 million personal bankruptcy filings nationwide, down from 1.53 million in 2010, and closer to the norm over the last 15 years. At the end of the first quarter of this year there were 311,975 filings, which is 5 percent less than the first quarter of 2011.

Rebuilding credit after a personal bankruptcy will take some work. Mr. Feinstein suggests that individuals maintain or take out one or two credit cards and routinely use them. “If the payment’s due on the first, make sure it’s paid by the 25th” of the previous month, he said.

A personal bankruptcy filing will have a larger impact on a credit score than any other credit issue, according to a July report by VantageScore, which provides credit scores to lenders. Filing for bankruptcy protection will reduce a credit score by 200 to 350 or more points, it said, compared with a decline of 80 to 170 points for a foreclosure. VantageScore’s scores range from 501 to 990.

For the larger rival FICO, bankruptcy could cut a credit score by 130 to 240 points. 

Copyright 2012 The New York Times Company.  All rights reserved.

Business Debt Exception to the Means Test

The means test only applies to individuals whose debts are primarily “consumer debts,” as opposed to business debts, pursuant to § 707 ofthe Bankruptcy Code.  Congress did not define the word “primarily,” but most courts have defined the word to mean more than half.  If more than 50% of the debtor’s debts are non-consumer debts or business debts, the debtor is automatically eligible to file for Chapter 7 bankruptcy without doing the means test, and the presumption of abuse does not apply,

What are consumer debts?  Section 101(8) of the Bankruptcy Code defines a consumer debt as “debt incurred by an individual primarily for a personal, family, or household purpose.”  Many bankruptcy courts have developed a “profit motive” test.  If the debt was incurred with an eye towards making a profit, then the debt should be classified as business debt.  Accordingly, a mortgage on an individual’s home would be considered consumer debt; however, if a vacation home were purchased for investment purposes and rented out, then the mortgage would qualify as business debt.  If an individual uses credit cards for consumer purchases, then those debts are consumer debts; however, if an individual used the credit card for business purposes, then in all likelihood that debt would be deemed business debt.  If an individual guaranteed a debt for a business obligation, that personal guaranty would be deemed business debt, as would the investment losses.

With respect to tax debts, a number of bankruptcy courts outside the Second Circuit have held that those debts are business debts.  See In re Brashers, 216 B.R. 59 (Bankr. N.D. Okla. 1998), which holds that the debtor’s income tax obligations do not constitute consumer debt, also see In re Westberry, 215 F.3d 589 (6^th Cir. 2000), which also holds that taxes are not consumer debt.  Taxes are not consumer debts, according to the Westberry Court for the following reasons:

I. Tax debt is incurred differently than consumer debt.  Consumer debt is incurred voluntarily and taxes are involuntary.

II. Consumer debt is incurred for personal or household purposes, while taxes are incurred for a public purpose.

III. Taxes arise from the earning of money, while consumer debts arise from consumption.

IV. Consumer debt normally involves the extension of credit from a credit card or from the seller of goods.

Notwithstanding the fact that business debt is an exception to the means test, if an individual files for Chapter 7 bankruptcy, their business debt exceeds their consumer debt and they do not have to take the means test, a creditor, the Office of the U.S. Trustee, or the Bankruptcy Trustee may move to dismiss the case if they find that the debtor was living an extravagant lifestyle (based on the details of their Schedule J expenses), and that if they reduced those expenses they could pay creditors a significant dividend via a Chapter 11 plan.  See In re Rahim and Abdulhussain, 442 B.R. 578 (Bankr. E.D. Mich. 2010).   

Notwithstanding the fact that this is a Michigan case, this author believes that this logic would also be applicable to cases in the Second Circuit and the Southern and Eastern Districts of New York.  In In re Rahim and Abdulhussain, the court held that under § 707(a) of the Bankruptcy Code, there is cause to dismiss a case for abuse of discretion, as well as under § 707(b) of the Code.  Relying on case law, the court held that Congress only intended to deny Chapter 7 relief to dishonest or non-needy debtors.  Relying on In re Krohn, the court held that among the factors to be considered is whether the debtor is needy is the debtor’s ability to repay debts out of future earnings.  The Sixth Circuit held that debtor’s continuing lavish lifestyle would support a finding of bad faith sufficient to warrant dismissal of a bankruptcy case under § 707(a), notwithstanding the fact that the individual’s debts were primarily business debts.  In In Re Rahim and Abdulhussain, the debtor’s monthly expenses exceeded $42,000, which the court described as extravagant and lavish.  The court indicated that the record indicated that the debtors had made no effort to reduce their expenses-they leased or owned expensive cars, owned property in Florida and sent their children to private schools.  Accordingly, the court dismissed the bankruptcy case.

NYT: Debt Collectors Cashing in on Student Loans

By ANDREW MARTIN

At a protest last year at New York University, students called attention to their mounting debt by wearing T-shirts with the amount they owed scribbled across the front — $90,000, $75,000, $20,000.

On the sidelines was a business consultant for the debt collection industry with a different take.

“I couldn’t believe the accumulated wealth they represent — for our industry,” the consultant, Jerry Ashton, wrote in a column for a trade publication, InsideARM.com. “It was lip-smacking.”

Though Mr. Ashton says his column was meant to be ironic, it nonetheless highlighted undeniable truths: many borrowers are struggling to pay off their student loans, and the debt collection industry is cashing in.

As the number of people taking out government-backed student loans has exploded, so has the number who have fallen at least 12 months behind in making payments — about 5.9 million people nationwide, up about a third in the last five years.

In all, nearly one in every six borrowers with a loan balance is in default. The amount of defaulted loans — $76 billion — is greater than the yearly tuition bill for all students at public two- and four-year colleges and universities, according to a survey of state education officials.

In an attempt to recover money on the defaulted loans, the Education Department paid more than $1.4 billion last fiscal year to collection agencies and other groups to hunt down defaulters.

Hiding from the government is not easy.

“I keep changing my phone number,” said Amanda Cordeiro, 29, from Clermont, Fla., who dropped out of college in 2010 and has fielded as many as seven calls a day from debt collectors trying to recover her $55,000 in overdue loans. “In a year, this is probably my fourth phone number.”

Unlike private lenders, the federal government has extraordinary tools for collection that it has extended to the collection firms. Ms. Cordeiro has already had two tax refunds seized, and other debtors have had their paychecks or Social Security payments garnisheed. Over all, the government recoups about 80 cents for every dollar that goes into default — an astounding rate, considering most lenders are lucky to recover 20 cents on the dollar on defaulted credit cards.

While the recovery rate is impressive, critics say it has left the government with little incentive to try to prevent defaults in the first place.

Though there are programs in place to help struggling borrowers, the companies hired to administer federal student loans are not paid enough for lengthy conversations to walk borrowers through the payment options, critics say. One consequence is that a government program called income-based repayment has fallen short of expectations. Under the program, borrowers pay 15 percent of their discretionary income for up to 25 years, after which the rest of their loan is forgiven. But participation has lagged because borrowers are either not aware of the program or are turned off by its complexity.

“If people were well informed, how many defaults could be averted?” asked Paul C. Combe, president of American Student Assistance, a loan guarantee agency based in Boston. “We are hurting people here.”

For borrowers, the decision to default can be disastrous, ruining their credit and increasing the amount they owe, with penalties up to 25 percent of the balance.

Ms. Cordeiro, a single mother, dropped out of Everest College, a profit-making school, 16 credits shy of a bachelor’s degree. She said she could not get any more loans to finish. “I get these letters about defaulting, and I get them and throw them in the bin,” she said.

Jake Brock, who graduated in 2008 from Keuka College, a private liberal arts school in upstate New York, defaulted in May on a federally guaranteed loan of $8,000. With penalties and accumulated interest, the loan balance is now $13,000, he said. “I just fell behind and couldn’t dig myself out,” said Mr. Brock, who is 29 and owes a total of $100,000 in student loans.

There is no statute of limitations on collecting federally guaranteed student loans, unlike credit cards and mortgages, and Congress has made it difficult for borrowers to wipe out the debt through bankruptcy. Only a small fraction of defaulters even tries.

“You are going to pay it, or you are going to die with it,” said John Ulzheimer, president of consumer education at SmartCredit.com, a credit monitoring service.

 

The New Oil Well?

Business is booming at ConServe, a debt collection agency in suburban Rochester. The company recently expanded into a neighboring building. The payroll of 420 is expected to double in three years.

“There is great opportunity,” said Mark E. Davitt, the company’s president and founder.

Where some debt collection firms have made their fortunes collecting on delinquent credit cards or hospital bills, ConServe is thriving because of overdue student loans, a large majority of its business.

With an outstanding balance of more than $1 trillion, student loans have become a silver lining for the debt collection industry at a time when its once-thriving business of credit card collection has diminished and the unemployment rate has made collection a challenge. To recoup unpaid loans, the federal government, private lenders and others have turned to collection agencies like ConServe.

Mark Russell, a mergers and acquisition specialist, writing in the same trade publication as Mr. Ashton, the consultant at the N.Y.U. protest, suggested student loans might be a “new oil well” for the accounts receivable management industry, or ARM, as the industry is known.

“While the Department of Education debt collection contract has been one of the most highly sought-after contracts within the ARM industry for years, I believe it is now THE most sought-after contract within this industry, centered within the most sought-after market — student loans,” Mr. Russell wrote last October.

In 2010, Congress revamped the student loan program so that federal loans were made directly by the government. Before that, most loans were made by private lenders and guaranteed by the government through so-called guarantee agencies.

Of the $1.4 billion paid out last year by the federal government to collect on defaulted student loans, about $355 million went to 23 private debt collectors. The remaining $1.06 billion was paid to the guarantee agencies to collect on defaulted loans made under the old loan system. That job is often outsourced to private collectors as well.

The average default amount was $17,005 in the 2011 fiscal year. Borrowers who attended profit-making colleges — about 11 percent of all students — account for nearly half of defaults, while dropouts were four times as likely as graduates to default. A loan is declared in default by the Department of Education when it is delinquent for 360 days.

Borrowers are most often declared in default when they cannot be found. That is when the collection agencies take over. While some in the industry, like Mr. Ashton, worry about public revolt over aggressive collection tactics, there is no holding back at this point.

At ConServe, in a room of cubicles with college pennants lining the walls, collectors comb through databases and public records hunting for contact information for borrowers. If ConServe reaches a borrower who refuses to cooperate, the company considers garnisheeing wages or withholding a government check, which requires approval from the Department of Education.

Dwight Vigna, director of the department’s default division, says the government does not give up easily. If a vendor like ConServe has not found a borrower in six months, the department turns the case over to another collection agency.

In fiscal 2011, the department wrote off less than 1 percent of its loan balance, for such things as death or disability of a borrower.

“We never throw anything away,” Mr. Vigna said.

 

Lying in Wait

Arthur Chaskin, a disabled carpenter, can attest to the government’s long memory.

Since he left college in the late 1970s, Mr. Chaskin has largely ignored his student loans — until June, when a federal judge ordered him to turn over $8,200.

Mr. Chaskin had borrowed $3,500 in federally guaranteed student loans to attend Northwestern Michigan College, a community college. He did not graduate. The federal government sued him in 1997, but over the next 15 years he made only five payments.

Last January, a lawyer in Michigan working on contract for the government was alerted to a credit check for Mr. Chaskin. The lawyer filed a garnishment order and discovered a brokerage account with nearly $20,000 that Mr. Chaskin said he had opened with disability checks.

By the time the government caught up with him, Mr. Chaskin owed more than $19,000 in accumulated interest and penalties, but the judge reduced the amount to $8,200 after Mr. Chaskin pleaded for a break.

“If you wait long enough, you catch people when their guard’s down,” said the lawyer, Charles J. Holzman, who was rewarded with more than 25 percent of Mr. Chaskin’s payment.

Government officials estimate they will collect 76 to 82 cents on every dollar of loans made in fiscal 2013 that end up in default. That does not include collection costs that are billed to the borrowers and paid to the collection agencies.

While the government’s estimates take into account the uncertainty of collecting money over long periods, some critics say they don’t go far enough.

A 2007 academic study, for instance, estimated that the recovery rate was closer to 50 cents on the dollar.

“The reporting standards that the government imposes on themselves are far weaker than what they require of private institutions,” said Deborah J. Lucas, a finance professor at the Massachusetts Institute of Technology and an author of the study.

Over all, collections on federally backed student loans were $12 billion in the last fiscal year, 18 percent higher than the previous year. Of that, $1.65 billion came from seizures of government checks like tax returns and $1.01 billion was collected by garnisheeing borrowers’ wages. More than $8 billion of defaulted loans, however, were consolidated or rehabilitated.

Some borrowers say they do not see a path out of default, because they are sick, unemployed or facing so much debt they cannot imagine any way to pay it off. Some have defaulted on private student loans, too.

Patrick Writer of Redding, Calif., received a certificate in computer programming in 2008 from Shasta College, a community college. But he graduated in the midst of the financial crisis and has not been able to find a job as a programmer. He defaulted on $12,000 in federally backed loans in 2009.

“If you can’t make your utilities and your rent, your student loan payments are almost goofy, inconsequential,” said Mr. Writer, who is 57.

But Mr. Writer said he had come to realize what it meant to have a student loan that was guaranteed by the federal government. “It’s the closest thing to debtor prison that there is on this earth,” he said.

 

A Bias Toward Default

Jill Shockley, 36, of Rockford, Ill., owes more than $50,000 in federally guaranteed and private student loans, some of which are in default. A nursing school dropout, she said her loan servicer, Sallie Mae, asked her to come up with $600 a month to keep three of her federal loans from going into default. But she said she did not have enough money.

“I barely clear $30,000 a year,” she said. “I have rent, a car payment, insurance. They say maybe I should borrow from relatives.”

On paper, there are few good reasons struggling borrowers should go into default, or stay there, since there are many programs to help them keep up with payments. In addition to income-based repayment, there is forbearance for temporary financial woes and different types of deferment for issues like unemployment, military service and economic hardship. But the challenge of creating the right incentives — and getting collectors and debtors to embrace them — has bedeviled Congress and the Department of Education.

Critics say the result has often been contradictory incentives that provide little help to struggling borrowers. For instance, loan servicers are paid $2.11 a month for each borrower in good standing, but only 50 cents a month for borrowers who are seriously delinquent, too little to devote much time to them.

Guarantee agencies are paid a default aversion fee, equal to 1 percent of the loan balance, if they prevent a borrower from going into default. But the same agencies get paid much higher fees for collecting or rehabilitating a defaulted loan.

And debt collectors are rewarded primarily for collecting as much as possible, not for making sure a borrower can afford the payments, critics say.

Introduced in 2009, income-based repayment was supposed to help change that by allowing borrowers with high levels of debt but modest incomes to make relatively small payments over a long term. But many borrowers were never told about the income-based option, and many others have been frustrated by the onerous requirements. So far, 1.6 million borrowers have applied for income-based repayment; 920,000 are active participants and another 412,000 applications are pending.

In a June memo, President Obama wrote that “too few borrowers are aware of the options available to them to help manage their student loan debt.”

Education officials say there are changes in the works that could help struggling borrowers and perhaps reduce the default rate, which they attribute to the sluggish economy and dismal results among profit-making colleges.

Under proposed regulations, debt collectors would be required to offer borrowers an affordable payment plan. And, the department vows to do a better job of publicizing income-based repayment, including telling borrowers about the plan before they leave college.

In addition, borrowers will be able to apply for income-based repayment online rather than going through their loan servicer. Monthly payments will be reduced to 10 percent of discretionary income, down from 15 percent.

But efforts to change the incentive structure for guarantee agencies have stalled. And the Obama administration’s efforts to impose new regulations on profit-making colleges were initially watered down and then significantly weakened by a federal court judge.

“We’re trying to balance two priorities, working with students who have fallen on hard times while trying to be good stewards of the taxpayers’ dollar,” said Justin Hamilton, a Department of Education spokesman. “We’re always going to be in a process of continuous improvement.”

Lindsay Franke, of Naugatuck, Conn., is among the borrowers taking advantage of income-based repayment. While her monthly payment is now lower, Ms. Franke, who is 28 and has a master’s degree in business administration from Albertus Magnus College, said the program had not changed a crushing reality: she still owes too much money and makes too little to pay it off. A marketing coordinator for a law firm, she filed for bankruptcy last year because she could not afford her mortgage, car payment and student loans. She lost the house, but still owes $115,000 in student loans, both private and federal. Under income-based repayment, she pays $325 a month on her federal loans; she also pays $250 a month on her private loans. 

“I will never have my head above water,” Ms. Franke said. 

Copyright 2012 The New York Times Company.  All rights reserved.

NYT: Last Plea on School Loans: Proving a Hopeless Future

By RON LIEBER

PLAIN CITY, Ohio — It isn’t easy to stand up in an open courtroom and bear witness to the abject wretchedness of your financial situation, but by the time Doug Wallace Jr. was 31 years old, he had little to lose by trying.

Diabetes had rendered him legally blind and unemployed just a few years after graduating from Eastern Kentucky University. He filed for bankruptcy protection and quickly got rid of thousands of dollars of medical and other debt.

But his $89,000 in student loans were another story. Federal bankruptcy law requires those who wish to erase that debt to prove that repaying it will cause an “undue hardship.” And one component of that test is often convincing a federal judge that there is a “certainty of hopelessness” to their financial lives for much of the repayment period.

“It’s like you’re not worth much in society,” Mr. Wallace said.

Nevertheless, Mr. Wallace made his case. And on Wednesday, nearly six years after he first filed for bankruptcy, he may finally get a signal as to whether his situation is sufficiently bleak to merit the cancellation of his loans.

The gantlet he has run so far is so forbidding that a large majority of bankrupt people do not attempt it. Yet for a small number of debtors like Mr. Wallace who persist, some academic research shows there may be a reasonable shot at shedding at least part of their debt. So they try.

Before the mid-1970s, debtors were able to get rid of student loans in bankruptcy court just as they could credit card debt or auto loans. But after scattered reports of new doctors and lawyers filing for bankruptcy and wiping away their student debt, resentful members of Congress changed the law in 1976.

In an effort to protect the taxpayer money that is on the line every time a student or parent signs for a new federal loan, Congress toughened the law again in 1990 and again in 1998. In 2005, for-profit companies that lend money to students persuaded Congress to extend the same rules to their private loans.

But with each change, lawmakers never defined what debtors had to do to prove that their financial hardship was “undue.” Instead, federal bankruptcy judges have spent years struggling to do it themselves.

Most have settled on something called the Brunner test, named after a case that laid out a three-pronged standard for judges to use when determining whether they should discharge someone’s student loan debt. It calls on judges to examine whether debtors have made a good-faith effort to repay their debt by trying to find a job, earning as much as they can and minimizing expenses. Then comes an examination of a debtor’s budget, with an allowance for a “minimal” standard of living that generally does not allow for much beyond basics like food, shelter and health insurance, and some inexpensive recreation.

The third prong, which looks at a debtor’s future prospects during the loan repayment period, has proved to be especially squirm-inducing for bankruptcy judges because it puts them in the prediction business. This has only been complicated by the fact that many federal judicial circuits have established the “certainty of hopelessness” test that Mr. Wallace must pass in Ohio.

Lawyers sometimes joke about the impossibility of getting over this high bar, even as they stand in front of judges. “What I say to the judge is that as long as we’ve got a lottery, there is no certainty of hopelessness,” said William Brewer Jr., a bankruptcy attorney in Raleigh, N.C. “They smile, and then they rule against you.”

Debtors themselves struggle with testifying in their undue hardship cases. Carol Kenner, who spent 18 years working as a federal bankruptcy judge in Massachusetts before becoming a lawyer for the National Consumer Law Center, said that one particular case stuck in her mind.

The debtor had a history of hospitalization for mental illness but testified that she did not suffer from depression at all. “She was so mortified about the desperation of her situation that she was committing perjury on the stand,” Ms. Kenner said. “It just blew me away. That’s the craziness that this system brings us to.”

Debtors also stretch the truth in other directions. In 2008, a federal bankruptcy judge in the Northern District of Georgia expressed barely disguised disgust in deciding a case involving a 32-year-old, Mercedes-driving federal public defender with degrees from Yale and Georgetown. With nearly $114,000 in total household income, the woman’s financial situation was far from hopeless, despite her $172,000 in student loan debt.

No one keeps track of how many people bring undue hardship cases each year, but it appears to be under 1,000, far less than the number of people failing to make their student loan payments. In its most recent snapshot of student loan defaults, the Department of Education reported that among the more than 3.6 million borrowers who entered repayment from Oct. 1, 2008, to Sept. 30, 2009, more than 320,000 had fallen behind in their payments by 360 days or more by the end of September 2010. About 10.3 million students and their parents borrowed money under the federal student loan program during the 2010-11 school year.

One reason so few people try to discharge their debt may be that such cases require an entirely separate legal process from the normal bankruptcy proceeding. In addition, those who may qualify generally lack the money to hire a lawyer or the pluck to file a suit without one.

Nor is the process quick, since the lender or the federal government often appeals when it loses. And even if clients can pay for legal assistance, some lawyers want nothing to do with undue hardship cases. That’s the approach Steven Stanton, a bankruptcy lawyer in Granite City, Ill., settled on after trying to help David Whitener, a visually impaired man who was receiving Social Security disability checks. The judge was not ready to declare him hopeless and gave him a two-year “window of opportunity” to recover from his financial situation, saying he believed that Mr. Whitener had the potential to obtain “meaningful” employment.

Mr. Stanton did not see it that way. “It’s the last one I’ve ever done, because I was just so horrified,” he said. “I didn’t even have the client pay me. In all of the cases in 30 years of bankruptcy work, I came away with about the worst taste in my mouth that I’ve ever had.”

Those who do go to court face the daunting task of arguing against opponents who specialize in beating back the bankrupt.

They will often square off against Educational Credit Management Corporation, a so-called guaranty agency sanctioned by the government to handle a variety of loan-related legal tasks, from certifying students who are eligible for loans to fighting them when they try to discharge the loans in bankruptcy court.

 

On its Web site, the agency paints a picture of how much of a long shot an undue hardship claim is, noting that people “rarely” succeed in discharging student loan debt.

Some academic researchers have come to a different conclusion, however. Rafael Pardo, a professor at the Emory University School of Law, and Michelle Lacey, a math professor at Tulane University, examined 115 legal filings from the western half of Washington State. They found that 57 percent of bankrupt debtors who initiated an undue hardship adversary proceeding were able to get some or all of their loans discharged.

Jason Iuliano, a Harvard Law School graduate who is now in a Ph.D. program in politics at Princeton, examined 207 proceedings that unfolded across the country. He found that 39 percent received full or partial discharges.

His assessment of E.C.M.C.’s view of the rarity of success? “I think that’s wrong,” he said. While his sample size was small and he agrees that it’s not easy to prove undue hardship and personal hopelessness, his assessment of bankruptcy data suggests that as many as 69,000 more people each year ought to try to make a case. And they don’t necessarily need to pay lawyers to argue for them, as he found no statistical difference between the outcomes of people who hired lawyers and those who represented themselves.

Dan Fisher, E.C.M.C.’s general counsel, said it had no opinion on whether more borrowers should try to make undue hardship claims. As for the “rarely” language on its Web site, he said the company stood by its assertion that it was uncommon for an undue hardship lawsuit to end in a judgment discharging the loans in its portfolio.

Sometimes, getting any judgment is a challenge, as judges may delay a decision if the case seems too close to call or there is a possibility that the facts may change reasonably soon.

Radoje Vujovic, a North Carolina consumer bankruptcy lawyer, for instance, had more than $280,000 in student loan debt and just $23,000 in annual income.

When Judge A. Thomas Small, a federal bankruptcy judge in the eastern district of North Carolina, examined the case in 2008, he decided to wait two years before rendering final judgment, given that Mr. Vujovic thought his law practice might grow. “Must the cost of hope be permanent denial of discharge of debt?” Judge Small asked in his written opinion. “The answer to that question cannot be an unequivocal ‘yes.’ Hope is not enough to end the inquiry and, ironically, permanently tip the scales against a struggling debtor.”

The Department of Education, unhappy with the two-year delay, appealed before the period was up and persuaded a higher court to overturn the ruling. “I would stand by my decision,” Judge Small, who is now retired, said in an interview. “If you’re forced to make that decision, all you have is speculation, and speculation is really not good enough to overcome the burden of proof.”

Getting judges out of the speculation business, however, would require a new law or an entirely new standard, possibly from the United States Supreme Court. Neither appears likely anytime soon.

In the meantime, Doug Wallace, the blind man in Ohio, is nearing the end of his long wait for a ruling.

In December 2010, C. Kathryn Preston, a federal bankruptcy judge in the southern district of Ohio, tried to assess Mr. Wallace’s hopelessness by pointing to expert testimony that blindness does not necessarily lead to an inability to ever work again. But she also noted that because he lived in a rural area, he faced significant transportation obstacles. So she set a new court date for Sept. 5, to give him “additional time to adjust to his situation.”

The question for Mr. Wallace then became what sort of adjustments he was supposed to make aside from a court-ordered $20 monthly loan payment. His routine has not changed much. Aside from hernia surgery a few months ago, his days consist of sitting close to the television (he can just make it out through one eye that still has a bit of vision) and regular trips to the gym with his father. His college diploma hangs on the living room wall, and at night he sleeps underneath it on the couch of the rental house he shares with his father and sister.

Mr. Wallace’s sister, a community college student, is sometimes around during the day while his father works at a Honda factory. There are few visitors. “I’ve got friends around here, I’m sure, but they’ve got lives for themselves,” he said. “So I don’t really bother them.”

The judge did not explicitly order him to move closer to a training center, and his lawyer, Matt Thompson, said that doing so would set him up for certain failure. “I don’t think there is anyplace he could go in central Ohio and live on $840 a month,” he said.

Logistics aside, Mr. Wallace said that it was hard to imagine his overall situation ever improving and wondered who would hire a blind man in this economic environment.

“Do I think I’m hopeless?” he said. “Well, yeah, I mean, by looking at it you would think I am hopeless. Like it won’t get better for me.”

Copyright 2012 The New York Times Company.  All rights reserved.