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Fixing Debt

July 29, 2011

Colleges and universities don't like uncertainty, and right now they're facing a lot of it.

No one knows how long it will take the economy to recover to pre-recession levels. The government's sovereign credit rating, once ironclad, is under review for potential downgrade. And people aren't even sure if, in less than a week's time, the government will be able to pay its bills. Nobody knows what the national fiscal picture means for higher education.

The current drama in Washington over the debt ceiling has only exacerbated several years' worth of economic uncertainty that led colleges and universities to convert variable-rate debt -- a potentially volatile form of borrowing in which the interest rate can change weekly depending on the market -- to fixed-rate debt. They purchased the variable-rate debt in droves because of historically low interest rates; shifting to fixed-rate debt will come at a price. But doing so provides somewhat more stability, no matter what happens in Washington -- even if the worst unfolds and the government defaults, one of several factors that could send variable rates soaring.

"We're in uncharted territory," said Karen Kedem, vice president and senior analyst at Moody's Investors Service. "We're not sure how markets will react."

Variable-Rate Debt

Even before the talks about the debt ceiling began, colleges and universities had been struggling to deal with variable-rate debt. The other end of the spectrum is fixed-rate debt, which typically carries a higher interest rate -- but that rate is locked in for a much longer period of time, typically 30 years.

In 2010, about 83 percent of the debt held by colleges and universities was at a fixed rate, according to a recent survey by the National Association of College and University Business Officers. The remaining 17 percent is variable-rate debt. The total amount of variable-rate debt has decreased since 2008, according to Moody's.

While most colleges hold some variable-rate debt, some institutions hold significantly more than others. In 2008, according to Moody's, 73 percent of private colleges that the firm rated held variable-rate debt, and at 29 percent of those colleges, more than 50 percent of debt had a variable rate.

Institutions with smaller endowments tend to have a larger share of their debt with variable rates. At institutions with endowments of more than $1 billion, about 11 percent of debt had a variable rate, according to the NACUBO survey. At institutions with endowments of less than $25 million, about 22 percent of debt had a variable rate. Institutions with smaller endowments are also likely to have higher interest rates on their variable-rate debt, because these institutions tend to have lower credit ratings.

The problem with variable-rate is not that it is a bad deal. In fact, it's usually a good deal. Variable rates on average tend to be lower than fixed rates. The NACUBO survey found that the average interest rate on variable rate debt was 1.7 percent, compared to 4.3 percent for fixed-rate debt. At the moment, a strong college could get a fixed rate of about 6 or 6.5 percent. It could get a variable rate for less than a quarter of a percent. Part of the reason that variable rates are so low is that there is significant uncertainty in the market.

The problem with variable debt is that (yes) the rate varies, which creates uncertainty for colleges and universities. The most obvious fear is that the rates will shoot up from where they are now, dramatically increasing what an institution would have to pay in interest. Given the fact that rates are so low at the moment, it is almost a given that they will rise.

Even if there aren't big swings in the interest rate, the uncertainty created by variable-rate interest makes it hard to budget interest payments, requiring colleges and universities to have liquid assets or make more dramatic changes if costs are higher than anticipated. “You can’t just have fewer teachers because your debt went up; it doesn’t work that way,” said Richard Shickle, vice president for administration and finance at Shenandoah University.

Another problem is that variable rate debt tends to be re-marketed each week, which means there's a greater chance that someone won't buy the bond, and the issuer -- the college or university -- will have to pay up. This also requires significant amounts of liquidity.

Agencies began taking a closer look at variable-rate debt when determining credit ratings in the wake of the collapse of Lehman Brothers in 2008 and an increased reliance on that form of borrowing in recent years, though it has always been a factor. The agencies prefer institutions that manage variable rates well, such as those with a diversity of financial partners and liquidity in their balance sheet in case the institution has to swallow the debt.

Colleges and universities worry that shocks at the national level will drive up the interest rate on their notes or that banks won't be able to find buyers for their debt, meaning they would have to pay the full amount at once, leading to steep cuts in other areas to free up liquidity or to default.

Because of the increased focus by credit agencies and the potential problems created by variable-rate interest, colleges and universities have tried to convert their variable-rate debt to fixed-rate debt. Some arrangements allow colleges to convert but require them to pay more. The result of converting, for the moment, would be a rise in interest rates, requiring more of a university's budget.

Shenandoah is one of those institutions with more variable-rate debt than it would like. Like many other colleges, Shenandoah made its variable-rate-debt deals before the economy fell apart in 2008, and got good deals on interest rates.

Shickle would not detail how much of the university’s debt was at a variable rate, but he said that the college was looking to halve its variable-rate debt, and that if he could get variable-rate debt down to a quarter of the university's total debt he would be happy.

The University of Michigan at Ann Arbor is one institution that began to rethink its strategy on variable-rate debt when the rating agencies changed their stance. The university had a significantly higher percentage of variable-rate debt than did its peers, with about 60 percent of its debt carrying variable rates between 2006 and 2008.

Michigan was able to drop that percentage to 32 percent by December 2010, in part by issuing very little new variable-rate debt. It kept its average interest rate low by issuing federal Build America Bonds, a now-expired program that let state and local governments and agencies issue bonds at fixed, subsidized rates. So unlike other institutions that saw an increase in their overall interest rate when they converted from variable to fixed rates, Michigan's interest rate actually dropped.

But that option was never available to private colleges and is no longer available to anyone, meaning that those colleges that are converting or planning to convert will face higher interest rates. At the same time, they do get the peace of mind of knowing that the higher interest rate is going to stick, no matter what happens at the national level.

Government Downgrade

The current debates about the debt ceiling in Washington won't necessarily drive up variable interest rates immediately, but they have people on edge.

Lawmakers are hoping to reach a deal on extending the national debt ceiling, a limit imposed by Congress on the total amount of bonds the government can issue, by Tuesday, when the government is scheduled to run up against that cap, currently set at $14.294 trillion. Negotiations between the Senate, the House of Representatives, and President Obama have yet to produce a compromise.

Failure to extend the ceiling would result in the government's not having enough money to pay its bills, which range from Medicare and Social Security payments to Pell Grants and federal research funding. In that scenario, the government would have to find some way to prioritize payments.

Because of this, both Moody's and Standard & Poor's, two ratings agencies whose assessments of credit worthiness help determine interest rates, put the national government's AAA rating, the highest assessment of creditworthiness, on review for potential downgrade. A downgrade would probably result in higher interest rates, but it would also have a ripple effect for institutions with ties to the federal government.

Moody's announced Thursday that it would be reviewing a group of 177 public finance issuers currently rated AAA -- including one university, the University of Washington -- for a possible downgrade as a result of a review of the national government's rating. Washington was singled out among all colleges and universities, many of which also carry AAA ratings, because it has an "unusually large share of revenues derived from federal research grants and Medicare and Medicaid reimbursements," the agency wrote.

That announcement follows on the heels of a previous announcement from the agency that the ratings of five states -- Maryland, New Mexico, South Carolina, Tennessee and Virginia -- were also under review. Downgrades for those states would likely have an effect on the public institutions in those states.

States and institutions with lower credit ratings also face the potential for downgrade.

Because public colleges and universities, as state institutions, and private colleges and universities, as 501(c)(3) nonprofits, are able to issue tax-free debt to finance operations, the nature of the credit market is of great concern to them. Better ratings mean an institution can borrow on better terms, including lower interest rates, and free up money for other initiatives.

An article by Standard & Poor's states that a scenario in which the government does not increase the debt ceiling "would pose serious problems for higher education institutions," including downgraded ratings. Colleges and universities would need increased liquidity to cover potential defaults, created by calls on debts, leading to costs elsewhere.

The scenario that is being discussed the most in Washington involves an increase in the debt ceiling accompanied by steep reductions in government spending. The impact of these cuts on higher education would depend on how large they are and what is targeted. "A significant reduction in sponsored research and cuts in student loan programs could further strain these institutions," the Standard & Poor's article states. "Public colleges and universities which receive state operating appropriations could also be under stress if cuts to the states filter down."

The final scenario would be an increase in the debt ceiling without any accompanying cuts, a scenario that S&P says would likely still result in a downgrade of the U.S. credit rating but have less of an impact on higher education outside of general shocks to the economy created by increased interest rates for the national government.

 

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