Report finds private student loans riskier before financial crisis

Thu Jul 19, 2012 8:01pm EDT

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(Reuters) - Borrowers who took out private student loans in the run-up to the financial crisis are facing higher levels of default, reflecting the risky lending practices at the time, the Obama administration said in a new report.

The Department of Education and the Consumer Financial Protection Bureau said private lenders have since cleaned up some of the worst activities, but lawmakers should still work to improve the private loan market and enhance protections for students.

"Borrowers who took out loans at the height of the boom are still suffering from those excesses," CFPB Director Richard Cordray said.

The report said students taking out private loans may not have fully understood the loans they chose and may have unnecessarily been subjected to more expensive terms.

The two agencies said they were required by the Dodd-Frank financial oversight law to study the private student loan market and determine if gaps existed in consumer protection.

Federal and private loans do not have to be repaid while the borrower is in school, and both types offer deferment for students seeking post-graduate degrees. But unlike some private loans, federal loans have fixed interest rates and offer adjustments for borrowers who struggle to make payments.

Federal loans are much more common than private loans, with $864 billion in outstanding federal student debt and about $150 billion in outstanding private student debt, the report said.

But the private student loan market grew from less than $7 billion in 2001 to more than $20 billion in 2008, before shrinking, according to the report.

The study found that investors' desire for asset-backed securities led private lenders to market loans directly to students without involving schools. That caused some students to borrow more than they needed or turn to private loans before exhausting the available federal options.

Companies also gave loans to borrowers with lower credit scores during that period, the report said.

Student loan defaults have since risen, likely due to risky lending as well as a weak labor market. There are now more than $8 billion in defaulted private loans, or 850,000 distinct loans in default.

After 2008, lenders began requiring co-signers for more loans, increased school involvement in securing private loans and tightened credit standards for loans, the report said.

Cordray and Education Secretary Arne Duncan said Congress should step in to prevent private lending from growing risky again in the future. They want lawmakers to ensure that schools are involved in the private student loan process and find ways to offer relief to struggling recipients of private loans.

Congress should take a special look at a 2005 change to bankruptcy law that makes it more difficult to get out of private student loans, Cordray said. The change has not resulted in lower prices or better access and should be revisited, he said.

Duncan said his department plans to release a financial aid "shopping sheet" that schools can provide to help students and parents understand the aid and loan packages available to them.

"What we don't want ... is for a student to feel like the first time they really understood how much debt they were in was when the first bill arrived," Duncan said.

(Reporting By Emily Stephenson)

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