Debt by a Thousand Cuts

To modify a famous phrase by Warren Buffett: Only when the tide goes out do you realize who’s swimming with too much debt.

In a report released last month, Michael Le Roy, president of Calvin College since July, wrote that a task force studying the college’s finances found that the college had racked up $115 million in debt -- a number that shocked many. While the amount is high, it is not entirely out of line for a college of Calvin’s size. The college has $442 million in assets.

The problem for Calvin is twofold. First, administrators found that the institution did not build debt service -- regular payments on the debt and interest -- into the budget, the report states. “Calvin College’s debt service payments are about 6.1 percent [of the budget] now and will grow to 9.2 percent by 2017 if our revenue holds constant,” the president wrote in the report. “The problem is that we have not built more than 0.9 percent of the debt service payment into our operating budget.”

The other component of the problem is that, since 1997, the college has been financing construction projects through borrowing while investing gifts in the hope that doing so would raise revenue that could then cover the debt and interest. But, because of the recession, those investments went south and revenues never materialized. As a result, the college is facing projected deficits, which administrators said could likely lead to program closures and other cost-saving measures to make room in the budget for debt service.

Calvin’s particular blend of problems is unique, but it is the result of two strategies that are becoming increasingly problematic for higher education institutions: a decades-long increase in the use of debt to finance institutional growth, and erratic endowment returns since 2008.

As macroeconomic conditions pressure every revenue stream available to colleges and universities – decreased margins on net tuition revenue, diminished investment returns, decreased state and federal investment and weakened revenues form health care – the hundreds of billions of dollars they’ve racked up in debt in recent years becomes harder to pay back. With diminished hopes for revenue growth in the near-term, colleges are likely to see increased pressure to cut costs to cover debt-service obligations.

“President Le Roy details exactly what the financial review discovered, in short, that Calvin has been living beyond its means,” Calvin Board of Trustees Chairman Scott Spoelhof wrote in a letter to the college last month. “Currently we are making adjustments as to how the college operates, and the board is committed to investing the time and energy necessary to create mechanisms for greater due diligence, oversight and transparency in the future.”

A Common Burden

Calvin officials have been unwilling to explain fully why the college is facing its current budget problems or who is responsible. A spokesman declined to make the president or other finance administrators available for comment for this story, pointing instead to previous statements by the president.

Several financial administrators have departed in recent months, and the college is currently searching for a new chief financial officer.

Higher education finance officials said the practice of tying debt repayment to investment returns – as Calvin did – is a rare one specifically because it is risky. Many projects financed through debt are tied to particular revenue streams, such as residence hall and dining fees for the construction of such facilities, and others are tied to pledged gifts. More general debt service is often built into the budget and funded through diverse revenue streams.

“If I’m a chief financial officer, before I seek debt financing, I want to make sure that I have some of that cash on hand, whether from my own reserves or from philanthropy,” said Charlene Butterfield, a senior higher education analyst for Standard & Poor’s.

Debt as a strategy for financing capital construction on college and university campuses has been on the rise. Between 2000 and 2011, overall debt levels at the more than 500 institutions rated by Moody’s have doubled, according to an analysis the ratings agency did for The New York Times. At Syracuse University, for example, debt rose from $150 million to $400 million under Nancy Cantor’s tenure, which began in 2004.

Now many of those colleges face difficulties in paying off that debt.

When giving Centre College’s debt a negative outlook earlier this month, Moody’s flagged the college’s high debt load as an issue. The college’s debt service, as calculated by the ratings agency, was 12.4 percent of expenses, a problem exacerbated by the college’s weak endowment returns. In recent weeks, the ratings agency downgraded the University of Tulsa and Southwestern University, citing similar debt service pressures.

Ratings officials say there is no standard for what a “reasonable” amount of debt looks like for a college or university. The calculation depends on a variety of financial metrics based on projected revenues, the interest rate on the debt, liquidity, expenses and assets, among other things.

Despite the fact that several colleges face debt issues, institutions seem poised to take on even more debt over the next few years. Interest rates are at historic lows at the moment, which means colleges can borrow money cheaply.

Several major universities, including Ohio State University and the University of California System, have issued 100-year bonds at relatively low rates. Those universities, as prominent state flagship institutions, and the elite private institutions that have also embraced the model, have high student demand and consistent fund-raising success -- factors that are hard for many less-elite private colleges to emulate.

Public colleges and universities in particularly are likely to increase their use of debt to finance projects as years of deferred maintenance come due and states seem less likely to foot the bill for construction projects they once funded with taxpayer dollars.

Investment Problems

The other end of Calvin’s equation is diminished returns on investments beginning in 2008 when the market dropped, a problem numerous colleges and universities now face.

In recent weeks both Moody’s Investors Service and Standard and Poor’s Ratings Service have flagged weak investment performance as a problematic area for colleges and universities. On average, college and university endowments saw a small decline in the 2012 fiscal year, with some institutions seeing their first major declines since 2008.

Centre College, for example, saw a loss of 3.2 percent during the 2012 fiscal year, according to a survey by the National Association of College and University Business Officers and Commonfund issued in February.

“Although this decline is not nearly as sharp as losses seen in fiscal 2009, it will suppress endowment support of university budgets over the next several years, just as spend rates had been cycling off of earlier losses,” Moody’s analysts wrote in January.

The weakened returns have some endowment-dependent colleges questioning their financial models. Grinnell College, which relied on returns on its endowment to fund the majority of its budget in recent years, recently announced it was seeking to grow net tuition revenue to compensate for several years of weak and unpredictable investment returns.

In the wake of its investment loss, Calvin will also be faced with the challenge of rethinking its business model. With between 6 and 10 percent of its current operating budget going toward debt service over the next few years, Calvin's administrators are working on a place to prioritize programs and make cuts. Le Roy told local media that the college could also add high-demand programs to generate new revenues.