Conversations with Financial Experts
In mid-October 2009, NACUBO facilitated four conference calls with Research Universities Council members to provide perspective on the crisis in the financial and credit markets and invite member input and discussion. Participants in the calls included the following:
- J. Michael Gower, vice president, business affairs and chief financial officer, Yeshiva University, New York City
- Albert Horvath, vice president, finance and business, Penn State, University Park, Pennsylvania
- Deborah Moon, vice president, finance and chief financial officer, Carnegie Mellon University, Pittsburgh
- Chris Cowen, managing director, national higher education consulting practice, Prager Sealy and Company
- Linda Fan, managing director, Prager Sealy and Company
- Roger Goodman, vice president, Moody’s
- John Nelson, managing director, Health Care, Higher Education Infrastructure, Moody’s
Following is a summary of all four discussions.
MODERATOR: Recognizing that the market continues to shift, give a brief overview of what impact the last couple of weeks have had, in particular to higher education institutions.
FAN: The equity markets have been suffering this week, and the credit markets, basically since September 15, have been pretty difficult as far as the issuance of new tax-exempt long-term bond issues.
We’re finding that just over this past couple weeks, as things are starting to open up a little bit more, the market is really struggling to find new levels and rates. Long-term rates are significantly higher than they were at the end of the summer, when a double A-rated higher education institution could probably issue at around 4.75 to 5 percent. Now we’re much closer to 6 percent, with there being some real concerns about the size of an issue. If you were planning on a large transaction, it would be difficult to get that done in today’s market.
Some deals are starting to come to the market, but they’ve all been very difficult, and I think that the way that transactions are going to be priced going forward will be much similar to the way deals were made back in the ‘80s, when it took more time and there was more of a pre-marketing period.
On the short-term end, as many of you know who have variable rate demand bonds, there was a significant outflow of money market funds. That resulted in a spike in short-term, tax-exempt rates, with the SIFMA [Security Industry and Financial Marketing Association] index-the weekly tax-exempt index-reaching its all-time high of 796. Over the past two weeks, it’s come down and this week [the index] was 482. We are seeing some stabilization in terms of the variable rate demand market with weekly rates being set, some in the 3’s, some in the 4’s, depending on which days they were done. And we are seeing the commercial paper market, both tax-exempt and taxable, functioning a lot better.
About a week ago, dealers were reluctant to write paper longer than a day, and things were being rolled over on a very short-term basis, but we’ve seen a few trades for higher education institutions going as far as the next calendar year in the 2’s just today. So I think that market, on the short-term side, really has opened up a lot more.
The other important thing in terms of the higher education market is the increasing scarcity and cost of liquidity, and concerns that schools have about supporting their variable rate and commercial paper portfolio from a liquidity perspective. And certainly the issue with the Commonfund and the lack of availability from commercial banks of liquidity facilities has caused a lot of institutions to think pretty seriously, not just about new money transactions and the ability to issue additional variable rate debt, but also about their current debt portfolios.
A few schools are seriously considering restructuring some of their variable rate demand bonds to longer securities but it’s a pretty difficult market in terms of much higher current rates compared to the long period of low rates that we were enjoying prior to this month.
NELSON: The events have been unprecedented, and certainly there’s never been a time that I’m aware of, after World War II, in which the degree of credit uncertainty reached such a level that even placing fixed-rate bonds became problematic for some types of borrowers in the tax-exempt municipal market. It’s extremely surprising.
When you really focus on the sources of the problem-the shortage of bank capital, the losses on banks’ balance sheets, the questions about credit default swaps and other insurance arrangements, the downgrade of the bond insurance companies-the greatest uncertainty is in the short-term money markets. That’s because those investors-or the managers who oversee those investment funds-are supposed to maintain a stable dollar value on those net assets and their funds. People are extremely wary now that any short-term instrument that’s backed by a bank, or in any way exposed to a termination risk through a swap counter-party, somehow could have unexpected risk, and they want to avoid that. So we are in an unprecedented position in the markets today.
We’re also focusing on not only these short-term credit squeeze problems, but also on the fact that they are likely triggering or already are abetting or aiding an economic downturn of substantial proportions. On one hand you could say that the universities have generally been pretty good at withstanding and experiencing downturns in the economy and emerging out of those periods pretty well-often better than other kinds of organizations. But, the fact that this is occurring at the same time as credit market instability, the stock market’s decline, and home value deterioration does make it a new era in terms of college credit risk; and it may portend more negative results in terms of future ratings than in past recessions.
I think the good news, from higher education’s perspective, is that among the borrowers in the municipal market, the larger universities—the research universities-are generally received somewhat better than many other borrowers, including different levels of government. Hospitals, for example, can barely, if at all, sell commercial paper of any kind now, and there is no market for fixed-rate bonds for hospitals.
Universities have been able to sell fixed-rate bonds, and there is some sign in the short-term market of a very minor thawing or a better appetite for short-term paper issued by high-grade issuers, which would be the top research universities, state governments, and large cities.
[Also] there’s a particular type of borrowing structure in which universities are dominant: self-liquidity borrowing of variable rate bonds and commercial paper. And in connection with the problem at the Commonfund Short Term Fund, we have reviewed all of the universities that issue self-liquidity debt and all of the universities particularly that had some liquidity in the Commonfund Short Term Fund, and have not found a significant credit problem. All of the universities either have their own liquidity readily available from other sources under their own control, or they’re able to draw down on pre-existing lines. In a few cases, they’ve quickly arranged lines. So all of those borrowers maintain their high short-term rating, and we issued a comment about that to the market, which I think was received very well by investors, who were very concerned about that.
COWEN: I agree that people have immediate concerns about what’s happening in the short-term market, where we saw very significant rate increases, and about the difficulty in issuing fixed-rate debt.
That is leading to a change in how institutions view debt management going forward and what the broader implications are going to be. I’ll describe a couple of examples. First, we’re seeing that boards are asking questions like, "What’s our exposure in risks on variable-rate debt?" and "What other access to capital do we have if we’re not able to issue bonds?"
Because things are changing so quickly, we are seeing institutions preparing more regular updates, both to senior management and to their boards of trustees. That’s probably a theme that’s going to continue as we remain in a volatile period for some time.
While I think that the markets will come back and institutions-especially those on this call today, which are among the stronger credits-will have access to capital, the problems that this crisis has brought to light are going to be with us for a number of months and years. Figuring out how to deal with that and what it will mean in payout obviously will be a challenge.
Second, I foresee greater political pressure to refrain from raising tuition. We’re already observing a number of schools that are considering scaling back planned tuition increases for fall ‘09, in light of what are likely to be growing difficulties for families in terms of getting additional loans, suffering from the stock market’s affect on wealth, and recognizing unprecedented budget deficits. Whatever the result of November 4th, it’s likely that the inability to provide federal monies for research and to make changes to medical reimbursements are likely to put more pressures on institutions to take another look at things.
Overall, it’s going to be a period in which we’ll get out of these short-term effects, but for the longer term, institutions will really need to take a look at strategic planning and what this economic and financial situation might mean in almost a "perfect storm" of a lot of negative impacts resulting from this crisis.
Insurance and Liquidity
MODERATOR: How do you see the longer-term impact on universities, with the disappearance of the insurers? Clearly that has a relationship to the liquidity issues.
NELSON: While that does have an impact, the affect is hard to separate from the capital shortage on bank balance sheets and the cost of liquidity. The loss of some money in a Rule 2a-7 regulated money fund, which was the reserve fund, was a major liquidity event that caused people to be second-guessing even money market funds.
So the loss of the ratings and the availability of the bond insurers is a contributing element to that, but the more immediate crisis that’s causing the problem now has more to do with what’s gone on in the balance sheets of the liquidity providers and the lack of confidence in the short-term money funds.
FAN: I think that the primary impact in terms of the bond insurers-and not having the availability of viable insurers for the tax-exempt market-really would impact more of the lower rated credits, the single A and below. Double A institutions will continue to have good access to the market. It had gotten to the point where some of the lower double As might have used insurance if it was cost effective, but they didn’t really need it to access the market.
What we may see going forward with some of the single A and lower credits is that we may have to go back to the days where there were some more covenants that were involved in terms of bond issues. Since the credit analysts at the institutional investors will be looking at the underlying credits a bit more closely, they may start requiring of the A-rated institutions more security features that those institutions had gotten used to not including in their transactions.
A CALL PARTICIPANT: I’m curious about the panel’s thoughts on when the credit market does open up. What do you think the future role of bond insurance will be? All of the entities out there seem to be, if not in the mix of poor credit, on watch of some sort, and for those institutions that tend to buy to a triple A rating, where do you see that future and that part of the business?
COWEN: I think that likely in the short term there probably won’t be much of a role. We have seen Berkshire Hathaway do a couple of transactions, although if you look at the pricing and the rates received on that, I haven’t been convinced that it’s cost effective.
If there’s opportunity for municipal bond insurance in the marketplace, perhaps over time other structures will come in, requiring more dedicated insurers that don’t get into these other types of insurance vehicles that caused a lot of the problem. But I don’t anticipate that that’s going to be something that will be occurring in the very near term.
MODERATOR: Relative to what’s going on in the swap market, what does your crystal ball say regarding short- and long-term activity? Do you think that what we’re going through now may essentially wipe out people’s appetites for things like swaps, not only in the short run but for the longer term?
NELSON: My guess would be that in the longer run the answer would be no, that it wouldn’t wipe it out. We’d hope to be in a position in which universities that are entering agreements like this would have more expertise and staff on board to make their own evaluations of the risks involved.
But keep in mind that swaps are not generally the source of risk that has emerged here. While many borrowers have mark-to-market positions on their swaps that are negative, and one could certainly look in hindsight and say, "Well, maybe this wasn’t a really good thing to do because we would have been better off if we hadn’t entered the swap," typically the bigger issue for us is what it says about financial management at a university. When we ask questions about why [management] thought that this particular swap was a good agreement to enter into, it’s common for chief financial officers not to be able to answer that question and, instead, to defer to their bankers or financial advisers for the answer. To us, that is not a sign of good management. I would think that recent developments would probably discourage people from entering any future agreement that they don’t fully understand..
In the short run, it may temporarily cause people to lose their appetites for these arrangements, but the vast majority of these are not fundamentally risky. It’s a question of how you want your debt service cost to be hedged in the future compared to what you could do if you issued fixed-rate debt. It’s really more of an opportunity cost type of valuation rather than an investment in some kind of private vehicle or hedge fund, which might follow a terrible strategy that causes you to lose all of your investment.
On the asset side, these swaps are generally not the source of major credit risk. It’s more the bank agreements, the acceleration, the rating triggers. Those are much bigger risks, for the most part, in variable-rate debt than the swap itself. But the fact that financial managers and universities have indicated to us that they really don’t understand the mechanics behind the swap, and why their market-to-market positions fluctuate, and what the risks are going in-to us this illustrates that there needs to be further improvement in knowledge about these.
FAN: There was a fair amount of activity up to the beginning of this year, with higher education institutions using swaps to help manage the interest rate risk in existing portfolios as well as to hedge future issuances. Right now we wouldn’t recommend that institutions enter into swaps, even though, if you look at the 6 percent of LIBOR [London Interbank Offered Rate] swap market, the rates are actually very attractive. But there’s too much concern about counter-party risk as well as the potential need to issue underlying variable rate demand bonds to go with those structures. So, for the time being, there’s not going to be much in terms of new swaps being entered into.
At the same time, a lot of institutions are looking at their current portfolios as well as swaps that may be coming on in the future and thinking about how to manage that. The swap market relative to the bond market is at all-time spreads in terms of the swap market, with the SIFMA and LIBOR swap markets being at lower rates than bond rates. So this is probably not a very good time at all to be unwinding swaps. But there may be opportunities in the future to do so.
A number of schools are also looking at their swap portfolios with respect to Lehman exposure and figuring out what their options are in terms of whether they need to unwind those or whether they are going to just sit tight and see what happens going forward. But our clients who have Lehman swaps have told us that if they’ve been in the triple-A subsidiary, there was an automatic termination;, if they had swaps that were guaranteed by the holding company or issued by the commercial bank itself, they’re in payment default but may not necessarily be required to be terminated.
NELSON: As far as the swaps go, yes, the most immediate concern we had was the Lehman swaps. It turns out that in higher education-in our rated portfolio of 500 universities-there were no Lehman Brothers derivative product company swaps. Those are the ones that were affected by the bankruptcy and went into automatic termination. The other ones are with other Lehman Brothers subsidiaries that were derivative product companies, such as their special financing group. And none of those have terminated nor have automatic triggers for the bankruptcy, so those swaps remain in place. I don’t know what the plan is, but it certainly seems likely that a number of those would move over to Barclays. So in terms of the immediate impact of the swaps terminating on universities, it hasn't been much of an event so far.
The vast majority of swaps are now on a market-to-market basis in a negative position, but that doesn’t really have a dramatic cash impact one way or another on universities, and the majority are saying to us that they’re going to most likely hold on to their swaps and see if the market-to-market doesn’t move to a more favorable trend in the future.
MODERATOR: In a similar vein, we’ve had significant discussion internally here at the university regarding securities lending. We had been a securities lending client through our custodian, and we’ve, in the last couple of weeks, suspended our participation in that. Chris, are you getting any feedback questions, concerns being raised around the whole issue of securities lending, from schools you’re working with?
COWEN: Yes, your action of not participating in securities lending is consistent with what we’re seeing with a number of institutions that are either eliminating it or scaling back. It’s probably the right decision for the short term. It’s going to be necessary to reconsider, in light of what’s happened and what we’ve all seen, what’s the appropriate risk level, and what types of strategies are appropriate for the institution going forward. Being able to take a step back, once the immediate issues subside and things are a bit stable, will help institutions make the best long-term decision about their comfort level with securities lending or many other types of programs that do have some element of exposure.
MODERATOR: Looking at the student loan market, what you think that the current circumstances mean for current and future loans and for debt in general.
NELSON: Our main concern is with universities that may have had an appreciable share of their students who were historically dependent on the private student loan market—the non-guaranteed loans. The availability of those has clearly declined.
As far as the guaranteed market, there’s more of a sense of uncertainty [about] universities needing to learn new systems and [establish] different communication channels to direct students to different lenders. But we’re being told by the universities that we rate that the supply of capital for the guaranteed student loans is less of an issue.
Generally speaking, the research universities are going to be in a better position. It would be smaller colleges and community colleges that are feeling the most impact, because of default rates, credit quality, or just the sheer scale of the students. The number of students applying for loans is unattractive to lenders at these smaller institutions, whereas the research universities are typically highly rated, large organizations, and they are exactly the customers that the lenders are interested in.
FAN: Certainly some of the access to funds, which a number of the student loan programs had in the municipal market, has decreased dramatically with the auction rate problems that we had earlier this year. Now with rates being higher it’s going to be a difficult market. In general, [I anticipate] a decrease in the supply that’s available for student loans from bank market programs that rely on the municipal bond market.
NELSON: From a credit perspective, what we’re a little more concerned about is the impact of declining home equity on household net worth. I think that’s going to have a bigger effect on demand, especially for private higher education, than the dislocation in the student loan market.
MODERATOR: For us, a lot of the concerns around financial issues began late last winter, when all of the tightness around student loans started to emerge. And in our particular case, the state guaranteeing agency decided to get out of the student lending business, and they had a significant share of our guaranteed student loan market.
What are you seeing in terms of banks continuing to play in the student lending market? We’ve certainly seen banks step out. Do you see that as a trend that’s going to continue, or have we seen the lion’s share of a shakeout at this point?
NELSON: From our perspective, the primary impacts are on the private student lending market, the nonguaranteed part of the market. There is a shortage of capital there, and there has not been a rush into that area. Banks are extremely stingy about their capital and very concerned about conserving it, so they are not looking to expand into small niche markets that might offer some business growth opportunity to them-whereas, in more normal times, they might have.
But when it comes to the much larger part of the market, the guaranteed loan market, there are new lenders taking up the void, and the main transition effect is going to be universities switching from their communications and marketing materials, to change the names of the lenders that their students would need to contact. I don’t want to minimize that as a significant communications effort, but, by all signs, it seems that there are adequate lenders in that part of the market.
COWEN: I would agree. Certainly the issues aren’t around the guaranteed programs, but in the private markets. Depending upon how quickly things improve, we would expect to then see will others fall away and, as they conserve capital, abandon or scale back on this market.
We don’t see much in the way of new entrants into the market at this time. And I think especially for, let’s say, foreign graduate students without demonstrated credit, some institutions are saying, "Do we have to step in and pick up some of the slack for them?" or for lower credit borrowers who may have qualified for loans before but don’t now? Or even for parents who would have relied upon this and aren’t going to find, let’s say, home equity lines or other sources of borrowing available? What commitments will institution feel that they have towards helping to find alternate sources of funding?
Global Rating Scale
FAN: I saw that Moody’s put out a piece reporting that the migration to the global rating scale has been postponed. For the higher education sector, we were expecting that to happen some time in November. Obviously, I understand the reasons for this, but is this an indefinite postponement or is there a rethinking of the recalibration? What more can you tell us about Moody’s thinking with regard to this?
NELSON: It’s not a rethinking of the goal of making the ratings fully comparable to the ratings that are used on a global or so called corporate scale. We are pausing while we take stock of the unprecedented developments in the credit markets, which in some senses are even more severe than what’s currently going on in the stock market.
So we’re assessing the impact on the long-term credit ratings of these liquidity events, which are becoming very substantial for some issuers. We do fully plan to resume our global scale rating effort, but at this point there has been no definitive time period established.
Disclosure and Mitigating Risk
MODERATOR: I’m sure you and your colleagues have been extremely busy over the past several weeks. As someone on the other side of that table, what might we expect in terms of our next conversation with you? Are there any kinds of changes or emerging trends that you're seeing with regard to the kinds of information that you’re going to be asking us to provide, or in what types of form you'd be expecting to see information coming from those institutions that you rate.
NELSON: That’s a very fair question. The main thing I would say is that disclosure, especially for short-term liquidity investments that are backing up your debt-or for variable rate debt, whether it’s through self-liquidity or bank-line supported-disclosure around those topics needs to be more detailed and more available for the market. Short-term investors, who are in many ways at the epicenter of this credit crunch, are hungering for more detailed information.
For example, when Moody’s writes reports about universities that are doing short-term borrowing, if it’s a bank-supported liquidity borrowing, we have, over the last year, expanded our coverage dramatically of the legal covenants, the triggers, the automatic termination events, the optional termination events, and the term-out provisions. We are also going into much more depth on the factual attributes of the swap agreements that may be entered in association with those variable rate bonds.
And then the last leg of that would be for variable-rate borrowings that are not supported by a bank but are supported by the issuer’s own liquidity or the issuer’s own lines of credit directly with a bank. For those types of borrowings, especially, the market wants more disclosure.
We are now working with several people on our team that manages our ratings for money market funds, as well as with some universities, to revamp some of our questionnaires to make them more clear. We’ll also be disclosing more of that information to investors. I think our view is that the market really needs that information and needs it quickly.
COWEN: Because things are happening so quickly, especially for the money market funds, sometimes decisions need to be made within a week’s time or even less. So, things need to be dealt with amazingly quickly at the institutional level. Also, with there being a lot more opportunities for investment than there were in the past, we are starting to see institutions post information on their Web sites for investors. Universities are being much more proactive in investor relations, describing steps that are being taken to ensure liquidity. I foresee increased investor interest in disclosure requirements.
In addition to what the rating agencies are doing, institutions will also get information out there even more quickly to ensure that investors are comfortable with the institution's liquidity position.
MODERATOR: I think we’ve seen the beginning of a slight uptick in the number of requests we’re getting from bondholders for additional information, particularly in light of what happened with Wachovia and the Commonfund. Because some of the information about that particular event was not necessarily fully understood and obviously the impact on a variety of institutions that are part of that fund was very uneven.
COWEN: That’s exactly right. we’re seeing that the institutional investors are putting more emphasis on their own internal credit and liquidity analysis than on ratings.
It’s combined with the efforts that Moody’s and the other agencies are taking to respond to this, but going a step beyond, where the institutions are not relying solely on a third-party analysis of liquidity. Rather, they’re saying, "We need to do this." Coming up with a way of getting that information out in a thoughtful, proactive manner, instead of responding to each individual call, will be the goal.
We’ve been very fortunate in higher education institutions that the disclosure requirements have been much fewer than, say, in health care. I think we may start seeing a bit of a change in that, where providing some interim disclosure and more disclosure to investors is going to be more important. For institutions to figure out a way to do that is critical, especially as we enter an environment where we’ve seen credit spreads-or not just credit spreads for like credits, but for the cost of borrowing even for institutions with similar credits-has been varying widely over the last few weeks.
While I think that's going to start becoming more normalized, I believe that investors will continue-more so than in the past-to distinguish among borrowers, from both a credit approval as well as a pricing standpoint. For an institution, taking a more active role in being investor-friendly should be advantageous.
MODERATOR: If institutions need to go into the market in the near future-assuming that things open up-what are the kinds of new emphases that they should be considering relative to risk?
FAN: The key is flexibility with respect to timing and size and structure of the transactions. Given the sharp decrease in demand for municipal bonds, this has really become an investor-driven market and it’s important to keep that in mind and to make sure that when you’re planning your financing that you leave yourself enough time in terms of going to market.
We’re finding that instead of being able to print a preliminary official statement of a fixed rate transaction on one day and price it two days later, institutions will probably need to build more time into the financing process, to make sure that the investors have time to look at the preliminary offering documents and that the credit analysts at the different firms have time to put them on their approved list. There may be a need for more investor education and perhaps electronic investor calls.
There’s also been a demand over the past several months for increased disclosure in terms of liquidity, particularly from some of the large money market funds. And while I think in the past it wasn’t necessary to respond to those-and a lot of schools have concerns about giving materials to some investors versus others-this could be a trend toward greater disclosure, particularly with respect to liquidity. Institutions may find it necessary either to have an investor Web site or, in their annual disclosure, to have more information about their internal procedures with respect to liquidity and about some of their bank arrangements. The rating agencies have been probing deeper into that and disclosing more of the specifics of those arrangements in their credit reports. Institutions may need to increase the amount of their disclosure as well.
It’s also important to have multiple relationships with investment banking firms. As we’ve seen, things can change pretty quickly, including personnel. Having more than one remarketing agent, you can switch things over pretty quickly if something happens with one of the firms. In case you need liquidity from different sources or different types of services, you’re not tied into just one or two firms. Also, it’s probably not a bad idea, if you’re doing a fixed-rate deal, to have a co-senior manager to help back up what the senior manager may be doing. In general, think about the institution’s overall financial relationships.
NELSON: I would echo what Linda said about disclosure. It’s going to be a major issue, especially if you’re doing any kind of short-term borrowing. The amount of disclosure that’s been offered in the past has been very poor to the market and has been one of the biggest sources of frustration among investors. And while Moody’s has received all the disclosure that it needs to make the rating decision, we have not disclosed to the market all the details of the liquidity sources. It got to the point where there were short-term bonds in the market that were depending on lines of credit from banks, and the universities didn’t even want us to disclose the bank that was providing the liquidity. I think those days are over; and that’s a very good move. Because of the problems and the issues, investors are demanding more disclosure, and I think that’s a good thing.
MODERATOR: Have either of you seen or do you anticipate reactions from the state issuing agencies, such as the DASNY [Dormitory Authority of the State of New York] in New York, in terms of different requirements they might impose before issuing debt to institutions?
FAN: Historically, DASNY relied pretty heavily on institutions’ underlying ratings. If you didn’t have ratings in a certain category, they would then require insurance or other forms of credit enhancement. With the virtual disappearance of the bond insurers, they’ve had to sort of rethink that.
They’ve [established] certain covenants that they’re now requesting for uninsured transactions. I was on a call with them the other day, and they were asking about debt service reserve funds, and I certainly hope that we haven't reverted that far back in terms of the way that we used to structure bond deals. But I think that they are very concerned with coming up with different types of security structures for their issues, now that the insurance market is gone.
NELSON: I can’t say that we’ve seen significant changes along those lines, but we have seen a lot more universities [establishing] underlying ratings on their own than just six months ago. In total, there are about 50 colleges and universities that we have worked with and evaluated in the past, but their ratings were only insured ratings. Now they have published their underlying ratings. That’s been the biggest trend that we’ve seen.
Impact on Future Financing
MODERATOR: Clearly, the investment side of the balance sheet is being affected significantly by what’s going on in the financial markets. The balance sheet, the assets themselves, and the impact that those will ultimately have on the operating budgets will start to affect ratios and other elements that go into an analysis of credit worthiness. What might that do to an institution looking to finance in today’s market?
NELSON: A couple of major research universities have told us that in just the first quarter of their fiscal years their endowments, their investment pools, are down by 10 percent. That would not even include the free fall that we’ve had in the first 10 days of October. And that’s certainly going to have a significant impact.
From our perspective, we would expect the impacts to be the most dramatic, not on the research universities, but more on the schools with more modest endowments and on endowments that tend to be less diversified. If they are heavily diversified, many of the medium and smaller endowments have been kind of late to the game, so the managers that they have may not be of the quality of the managers that the larger universities typically have.
Having said that, universities have tremendous strength on their balance sheets and they do have quite a bit of capacity to absorb loss without changing their credit rating. I think during the last downturn, in 2000-02, the S&P declined 52 percent from peak to trough during that period. While most universities’ endowments back then were a little more exposed to the S&P than they are now, there nevertheless was quite a bit of diversity of asset allocation; and the larger universities generally were not downgraded during that period. Most of the downgrades were concentrated in the smaller schools.
This downturn is much more substantial because it affects not just the endowment, but because of the loss of home equity it’s going to affect the demand for higher education in a way that didn’t occur last time.
For the research universities, the pressure on the federal government budget probably means that hopes for significantly expanded NIH funding, under either a Democrat or a Republican presidential administration, are a little bit muted now. We could be facing a situation where endowments-if the markets don’t recover in this fiscal year-could be down easily 20 percent or more.
And, at the same time, student demand for the highest quality and highest priced higher education will be reduced, and the NIH budget will not be as robust as people were hoping it would become. So, it is possible that there will be downgrade of research universities, but that’s not our primary area of concern. Our primary area of concern would be the small- and medium-size private colleges.
FAN: The factors mentioned are also ones that schools, both large and small, are taking into consideration when looking at their capital building programs. In a lot of cases, it’s likely that we’ll see some of those paced more slowly and perhaps managed with components that can be postponed rather than all done at once.
Most of the schools that rely heavily on debt understand that what they’re considering is the long-term opportunity cost of capital versus the cost of debt, and that, even with higher debt costs in today’s environment, there are still benefits from financing on a tax-exempt basis. So, there will still be institutions who will use the tax-exempt market to finance their projects, but over the longer term we may see a little bit of a slowdown in terms of some of these projects and the use of debt to fund them.
A CALL PARTICIPANT: Historically, we’ve viewed endowments as long-term and we operate with strategic plans. I know it’s very early in this process, but what do you see people doing in terms of staying the course or maintaining trajectory versus people ramping down? This is a question that I know every research university is thinking about right now.
NELSON: We have a very long-term view of the universities’ debt capacity and capital program. If an institution has a multiyear capital borrowing plan and it wants to stick with it, even though the endowment may have declined by 20 percent, in most cases we would probably not take a rating action. That’s especially true if the student demand is holding up very well and the fundraising is not dramatically falling. We’d take a case-by-case approach, of course. But most of the universities, the research universities, are already rated double A or triple A, and they do have a lot of capacity to absorb some losses on their balance sheets and still maintain their ratings and their borrowing plans.
MODERATOR: Every institution’s endowment has been affected by the general direction of the market over the last several months. I’ve heard some stories, at least rumors, that some institutions are taking some pretty drastic steps to rethink their asset allocation or at least where they’re tactically placing their funds at this point. Any reactions to that or any overall observations that either of you can share along that front?
NELSON: I don’t know that we have a good handle on that topic just yet. We do know from some individual cases that in the first quarter alone, before this big drop in October, that some universities were reporting an estimated 10 percent decline in the endowment in the first quarter. And when you layer on to that the likely further downdraft of that order of magnitude again, it’s possible that as we’re sitting here there are plenty of endowments around the country that are down 20-30 percent. Having said that, other endowments are so well diversified that their positions are nowhere near that.
We’ve had some discussions with universities that have indicated that they might tactically realign their asset allocations, but we’ve also had probably more discussions with universities that say they are not doing that.
COWEN: We haven’t heard very much in the way of reallocation. To reallocate on emotion, in light of what’s going on now, probably isn’t the best thing to consider at this time.
What we have heard a bit more of in terms of endowments are two things:
- Institutions think that there may be opportunities for investment, especially in light of other investors who no longer are able to get the type of leverage that they’ve had in the past. So, some attractive opportunities may present themselves. Obviously, with some of the limited access to external capital, that has implications terms of the ability to fund strategic investments in the near to intermediate term.
- We’ve also been hearing some mixed thoughts on capital calls on private equity. Some institutions are having fewer calls just because of it being a slower investment market. Others are experiencing a much more significant pace of calls for capital, because they’re not self-funding any more, because of the lack of the takeout, so the institutions need to come up with cash to fund those. What’s going to be interesting is the interaction among cash management, working capital, and the endowment as it relates to the ability to be opportunistic in the next year.
MODERATOR: I think that the implication of the whole Commonfund episode is really forcing us to think hard about how we want to manage our short-term investments going forward. We’ve pretty much been on an annual debt issuance basis. In other words, we’ve laid out our capital plan for a multiple-year period and our expectation is that we’d be going out to market every 12 to, say, 15 or 18 months, depending on how our expenses flow.
I’m sure you’re talking to a number of institutions who are in that boat, or institutions that were planning to go to market relatively soon. What, generally, have you been advising clients about in terms of when you expect things to begin to at least stabilize?
COWEN: I wish I knew the answer to that. I think that we’re probably going to be in a period of longer term volatility in the markets. We’ve seen dramatic increases on a daily basis, and swings in interest rates and investor comfort in different products. What we’re advising is to be very flexible in terms of borrowing plans and to position the institution for accessing the markets as quickly as possible if the opportunity is there to issue debt. That’s because a lot of the supply and demand issues may be changing. Hedge funds and a lot of the tender option programs are no longer around, and investors need to be more flexible and more willing to listen to the market in terms of what structure might be desirable. You can’t just go with, "We need to issue this much in this structure on this date."
Institutions also need to develop a Plan B. If you can’t get funding from the capital markets, for example, do you have bank lines in place or do you have some other funding source available? If so, and there is a sustained period of inability to access the market-or the terms for access to the market are not terribly desirable-you’ll be able to continue to move forward with your financing needs.
So that’s being done, along with having a commercial paper program in place. Fortunately, that type of borrowing structure has remained relatively accessible in light of some of the challenges that have occurred recently.
We’re also advising to continue moving forward. When we had 20-plus percent returns, people didn’t go crazy increasing capital plans. Similarly, in these constrained periods, it’s important to maintain a longer term focus-which, fortunately, higher education institutions have that the for-profit corporations do not-and not take wild swings from positive to negative that we see in so many other parts of the economy.
NELSON: We’ve seen cases of universities that had money frozen in the short-term fund. What they were able to do is essentially internally swap some treasury inflation-protected securities [TIPS] or other kinds of short-term liquidity, such as capital calls or other sales of asset that had been occurring regularly, that they had parked in endowment funds. That liquidity in their endowment fund was ready to be allocated, and they decided to shift it into their operating funds and then take the pro rata units that were frozen in the short-term fund and put those in the endowment.
MODERATOR: Have any institutions you’ve been working with had to address the impact of the Commonfund action? As you look at universities now, what are your initial reactions or thoughts as you think about credit ratings and the implications that these more recent activities might pose?
FAN: We’ve had a few institutions that were caught by surprise by the announcement of the trustee, Wachovia, that they were going to be terminating the fund. Fortunately, most institutions have either operating lines or other sources of funds that they could draw on, so as far as we know, people haven’t missed payroll or had to delay making other sorts of payments.
But, it points out the need for some sort of diversification. You don't want to have operating funds in too many different accounts, but it does make sense to make sure that there are other sources of funds that you can tap into should there be a problem with accessing your primary operating cash.
NELSON: As you might expect, we are in an intensive follow-up stage with all of the 250-plus public and private universities that we rate that had money in the Short Term Fund. And I would make a couple of general points: (1) the vast majority are organizations that had sufficient access to liquidity or (2) their exposure in the Short Term Fund was not material enough to really cause a concern. So the large majority of colleges and universities are going to be what I would characterize as "financially inconvenienced" by this, rather than materially affected in the short run.
However, there are those that have to scramble a little harder. And that might be by hastily arranging a line of credit with a local bank or swapping liquid assets from the endowment fund to the operating fund and then taking the still frozen part of the Short Term Fund assets and allocating those to the endowment pool. Those are steps that we have seen colleges take already.
We don’t anticipate finding significant numbers of colleges that are really stressed by this, although it might be a very different story if the Commonfund and Wachovia had not been able to free up about 40 percent of the fund in basically a week’s time. That provided a significantly better outcome than was potentially thought to be the case when it was first announced.
Institutions that were in Commonfund or, for that matter, in other money market funds that weren’t so transparent or on which institutions hadn’t focused much on where funds were invested may be making some changes. What may be an outcome of this, especially for the larger institutions, is that they do more direct investing and take more control over treasury management and operations in house.
MODERATOR: Any final thoughts, any words of wisdom, to help us get through the next several weeks and months?
NELSON: Moody’s is looking at this from a short-term, credit crunch perspective and then from a longer-term economic-recession perspective. We are expecting that the country is already in a recession of some type, that the depth and length of that is unknowable. But we think this recession probably will have a more material impact on higher education than, certainly, the last one, which was only six, seven years ago. In that recession, home equity values did not decline, so household net worth was not materially affected during that recession-other than declines in pensions and 401(k)s and IRAs, for the most part-since the typical family does not hold a lot of wealth in stock plans other than retirement assets. So, in terms of a wealth effect on higher education, impact probably will be much more dramatic this time.
As far as the longer term economic effects, we do stress that the basic business model of higher education and the underlying demand remain very strong, and we are not expecting to see substantial downgrades of universities as they go through this environment-although there probably will be more downgrades than upgrades over this period.
It is also our observation that not all universities, including research universities, really have adequate treasury staff. I don’t think the treasury function has been developed as robustly as the investment function. Especially if there is a protracted period when there are very large advantages to having daily floating rate debt in the market or commercial paper, then you certainly will need to have robust treasury functions-and having staff redundancy is a good thing.
COWEN: In the near term, stressing the need for flexibility and diversification is critical in all areas of financial management. Looking forward, it’s important for the institutions to take a step back and see how things were weathered before and what adjustments might be desirable. Doing that in a thoughtful manner is preferable to reacting to the headlines that we’re seeing today.
MODERATOR: The big three issues that we’re focused on right now are these:
- We’re spending a lot of time looking at our capital plan, particularly in the short run, to determine whether or not we need to slow some things down or make some changes, to be certain that we’re sensitive to what’s going on around us, and to not get too far ahead of the credit markets.
- Even though we’ve been affected by the Commonfund Short Term Fund problem, we’ve been heartened that our diversification of short-term investments and our cash management are such that it’s not going to have an impact on our day-to-day operation. However, we’re taking a very, very close look at the other vehicles that we’re invested in for the short term, to be sure that we understand completely what we’re dealing with.
- Finally, as far as the longer-term implication, obviously the downturn in the economy at some point is going to impact students and their families. We’re trying to keep our eyes wide open to see what kind of implications that might hold for us going into the next academic year. Fortunately, our first report on applications for this year shows that we’re up by 5 percent, so at least out of the gate that activity seems to be progressing nicely.
FAN: I would advise not to stare too closely at minute-to-minute news on the Bloomberg screens. All of us recognize the long-term nature of the institutions that we all work with and that the long-term strategy shouldn’t really be much different than it was prior to this.
Operationally, our clients are already doing some things that we commend: making sure that they are on top of their liquidity positions, that their procedures and letters have been put into place, that they’re updated with respect to [informing and designating] the appropriate people internally. It’s important also to make sure that people are coordinating their vacation schedules and other sorts of business out of the office so that people are in place to handle things that might arise. We’ve had some schools put together disaster scenarios so that they know exactly what they would do, for example, if there’s some bonds that are put that can’t be remarketed.
Over the long term, as you’re looking at your planning and capital projects, make sure that the assumptions that you’re using are consistent with the events of the past few weeks. We’ve had more institutions looking a bit more closely at their investment assumptions and some of the other things that will drive their capital planning to make sure that they’re more comfortable with their planning processes.
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