The Cost of Debt Rises for Nonprofits

Schools, hospitals, and other nonprofits that financed projects with cheap credit are now struggling to cope with higher interest payments

Stevenson University President Kevin J. Manning recently got bad news from the college's financial adviser at Bank of America (BAC). The suburban Maryland school, which had sold $122 million worth of bonds chiefly to pay for a second campus and new dormitories, had set aside $8.5 million to cover its interest payments. But the banker warned that if the turbulence in the credit markets continued, that tab could rise to $10.2 million—a big bite for a school with an annual budget of $85 million. "It's shocking," says Manning.

Encouraged by low interest rates in recent years, schools, hospitals, and other nonprofits aggressively tapped the debt markets to pay for buildings, equipment, and services. Many, like Stevenson, sold variable-rate demand notes, a type of bond tied to short-term interest rates. When Lehman Brothers collapsed in mid-September and panic swept the markets, the rates on those bonds quadrupled, jacking up nonprofits' monthly interest payments. Rates have eased in recent weeks, but they still remain much higher than normal. Now many institutions face the dual threats of bigger-than-expected bills on their debt and a weak financial environment that makes it hard to make up the funding gap by raising money from donors or raiding their endowments.

For some, those variable-rate demand notes were supposed to be a safe haven. Chicago's Swedish Covenant Hospital was among the many nonprofits that raised money by selling auction rate securities, bonds whose rates are set at periodic auctions. Spooked by the subprime crisis, investors failed to show up for the auctions earlier this year, and the market collapsed. As a result, Swedish Covenant's interest costs jumped from $600,000 a month to $950,000.

After that, Chief Executive Mark Newton replaced the hospital's auction rate securities with variable-rate notes. To avoid getting hit with a surprisingly large debt bill again, he also bought derivatives known as interest rate swaps, complex financial deals that protect against interest rate fluctuations. But those agreements have created another concern in the wake of Lehman's demise: the solvency of the parties on the other end of the deals. "I worry about counterparty risk," says Newton.

THE LEHMAN EFFECT

Institutions that had interest rate swaps with Lehman had to find new trading partners after the investment bank filed for bankruptcy. At least one, Simmons College in Boston, is still looking. That's a reason why credit rating agency Moody's Investor Services (MCO) is considering downgrading Simmons' debt. If Moody's does cut the rating, the college's borrowing costs would rise. (Simmons' vice-president for finance wasn't available for comment.)

Meanwhile, nonprofits face some tough decisions. Guilford College in Greensboro, N.C., saw the rate on its bonds rise to 8.05% before settling down to 2.2% in late October. It can afford to meet its current debt obligations. But the uncertainty has President Kent Chabotar wary, especially because enrollment is off. He's cutting faculty and administrative jobs to keep costs in check. "Suppose rates spike again?" says Chabotar. "We've got to have [financial] flexibility."

Stevenson's Manning worries he won't be able to cover his debt costs if there's another jump in rates. Enrollment is off, and the state government reduced funding. The massive drop in stocks has slammed the endowment, which has eroded from $53 million to $40 million since June. Says Manning: "It's a little scary right now."

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