Surging Student-Loan Debt Is Crushing the System

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Student-loan defaults surged in the first three months of 2013, while efforts to collect bad loans are faltering, according to credit analysts and government audits. It is the latest twist in a college debt crisis that is hanging over recent graduates and dragging on the broader economy.

Credit-rating firm Equifax said $3.5 billion in government and private student loans went bad in the first three months of 2013, the most since the company began keeping track. The U.S. Department of Education said 6.8 million federal student loan borrowers are now in default, representing $85 billion in debt. And the department's systems for collecting the bad loans are struggling to keep up.

The Department's Office of Inspector General found in December that more than $1.1 billion in defaulted student loans were stuck in a sort of computer limbo.

(Read More: Study: Student Loan Balances Are Up, and So Are Delinquencies)

"The Department is not pursuing collection remedies and borrowers are unable to take steps to remove their loans from default status," wrote Assistant Inspector General for Audit Patrick Howard in the December 13 report, which blames a system installed in 2011 by Xerox that is supposed to transfer defaulted loan accounts from servicing companies to private collection agencies. Those collection firms have considerable power, including the ability to garnish up to 15 percent of a borrower's wages. But none of that can happen until the accounts are transferred.

A Xerox spokesman declined to comment, referring inquiries to the Department of Education.

"While we regret this delay, we are taking active steps to work with the vendor to resolve the problem," Department of Education spokesman Chris Greene said in an e-mail. He denied that borrowers who have cleared up their defaults are not being removed from defaulted status, but acknowledged "a small percentage" of bad loans have been caught up in the problem.

He said some $600 million of the affected loans will be transferred "in the coming weeks."

(Read More: How the Student Loan Crisis Drags Down Home Prices)

But government auditors say some damage is already done. The Inspector General's office says the collection problem led to a "material weakness" in the department's financial controls last fiscal year—an issue Education Secretary Arne Duncan has vowed to address. Nonetheless, spokesman Chris Greene says the numbers came out right in the end.

"Taxpayers and borrowers can rely on the integrity and accuracy of our financial reporting," Greene said.

Critics say the collection issues are a sign of a much larger problem.

"I take personal responsibility for the situation beginning, but personal responsibility does not mean you spend the rest of your life financially compromised," said Jason Paskowitz, a financial analyst from Tenafly, NJ.

(Read More: Student-Loan Delinquencies Now Surpass Credit Cards)

Paskowitz is 46 years old, but still owes more than $39,000 on loans he took out to finance his college education at Binghamton University in New York in the 1980s.

He borrowed only about $20,000. But after Paskowitz fell ill during his first year of law school in 1989 and dropped out, his loans went into default. Interest and fees began piling up, so even though records show he has paid roughly $26,000, he still owes nearly twice his original principal—25 years after graduation.

He says he was hounded for years by collection agents—"they called me every name in the book"—and in 2008 was hit with an "administrative garnishment" seizing nine percent of his debt. He says the collection agencies did not give him the full range of options available to him under the law.

"Their primary motivation is just to get as much as they can as quickly as they can," he said.

Persis Yu, an attorney with the National Consumer Law Center in Boston says keeping borrowers on the hook or not providing them with information can be in the collection firms' best interests.

"Their incentives aren't necessarily aligned with protecting borrowers' interests," she said.

(Read More: Lenders Mobilize to Help College Kids Manage Student Loans)

The Department recently attempted to address those concerns by lowering some of the commissions it pays the collection firms. Converting a defaulted loan to a "rehabilitation loan"—which rolls outstanding loan balances and fees into a new loan that removes the borrower from default—now pays the collection firm as little as eleven percent of the outstanding loan balance, compared to as much as 15 percent previously. But the option is still far more lucrative than a disability discharge, which wipes out the loan entirely and pays the collection firm a few hundred dollars in administrative fees.

"The Higher Education Act is a very complicated statute," Yu said, "and debt collectors aren't necessarily in the best position to explain options to borrowers."

But spokesman Chris Greene says the Department of Education is keeping tabs on the collection firms and looking out for borrowers' interests—including a new "one-stop" portal for complaints about the firms at

"Our entire approach to default collections is structured to encourage full repayment while ensuring borrowers understand both the consequences of their failure to repay and the options available to help them get out of default."