Nonprofits Paying Price for Gamble on Finances

September 23, 2009 : The New York Times, by Stephanie Strom

Homeowners and businesses were not alone in taking on piles of debt over the last decade. Nonprofits of all sizes did the same, and now they, too, are paying the price.

Far from being conservative stewards of their assets, many nonprofits engaged in what some experts call risky financial behavior. “They did auction-rate securities, interest-rate arbitrage, complex swaps — which backfired on them the same way it would backfire on any hedge fund or asset manager,” said Clara Miller, chief executive of the Nonprofit Finance Fund, which has experienced a huge increase in organizations turning to it for assistance with soured bonds. “Organizations got to be all fancy-pants with their financial management.”

Those struggling now include the full range of nonprofits, including museums, colleges, orchestras and small local social service providers.

For example, Brandeis University, with $208 million in tax-exempt bonds outstanding, plans to close its art museum and sell off the collection to raise money. The Orange County Performing Arts Center, with $265 million in bonds, has laid off staff members. Copia, a culinary center in Napa, Calif., went bankrupt in December with $78 million in bond-related debt that its lawyer blames for its failure.

Even Harvard, with some $2.5 billion in tax-exempt bonds at the end of fiscal 2007, and Yale, with $1.6 billion, are cutting jobs, freezing salaries and delaying dormitory and lab construction.

While debt is the not primary reason for these institutions’ woes, the need to service it eats into their dwindling financial resources, forcing near Faustian choices. “Debt is the fourth horseman of the nonprofit apocalypse,” Ms. Miller said. “Add it to the failure of governments to fulfill contracts, declining donated revenues and a surge in demand for nonprofit services, and suddenly a lot of nonprofits are faced with some very hard choices.”

Much of the nonprofits’ debt is in the form of tax-exempt bonds. The number of charities issuing such bonds more than doubled from 1993 to 2006, according to figures compiled by the Internal Revenue Service, and the amount of debt linked to those bonds rose to $311 billion from $98 billion (adjusted for inflation to 2006 dollars).

In many cases, charities used the money from bonds to buy real estate and build facilities. Prep schools added golf courses, pools and observatories. Colleges bought entire neighborhoods and put up labs and sports facilities. Museums erected new wings, and symphonies added thousands of seats to their concert halls.

These nonprofits gambled that income from donations and investments would more than cover their debt service. But the recession turned that logic inside out.

Norman I. Silber, a law professor at Hofstra University who has done extensive research on the problem, calls the rising debt of nonprofits a “calamity.”

“If my analysis is correct,” said Professor Silber, who is also a member of several nonprofit boards, “over the next several years nonprofits across the country will have to renegotiate bond covenants, reduce services, cut staff or actually default and face foreclosures, repossessions, and in some cases, even bankruptcy.”

Before 1986, only nonprofit hospitals were allowed to float tax-exempt bonds, which they used to build new facilities. Then Congress amended the tax code to allow all charities access to the credit markets, and now even the tiny Family Service of Greater Boston has tax-exempt bond liabilities.

To be sure, the assets at nonprofits grew faster than bond-related debt. In the dozen years that ended in 2006, the value of assets held by nonprofits grew to $1.37 trillion from $347 billion (adjusted for inflation to 2006 dollars), thanks to more large gifts, increased property values, rising stock prices — and the explosion of tax-exempt debt.

“I think one could make a good argument that the greatest contributor to the enormous growth in university endowments and other endowments is not some wealthy person or persons,” said Robert L. Culver, chief executive of MassDevelopment, a state agency that supports nonprofits’ floating bonds, “but the federal government making available low-cost, tax-exempt debt that allowed endowments to remain invested and earn rates in the market as high as 25 percent.”

Traditionally, projected income determined how much debt an organization could handle, but Professor Silber suspects that as assets grew, lenders began extending credit based on how much money a nonprofit had in its endowment.

“Now, those assets have dropped in value by 20, 30 percent, but the amount of debt hasn’t changed,” he said.

Consider the case of New York Law School, which floated $135 million in auction-rate securities in 2006 in a deal that won an award for the creative use of structured finance.

The school had sold its library, on prime Manhattan real estate, for $136.5 million, but instead of building a library, it added the money from the sale to its endowment and borrowed for construction. Interest on the securities was just under 4 percent, the dean, Richard A. Matasar, said, compared with the 5.5 percent the school would have paid using ordinary fixed-rate bonds.

The Tax Code bars nonprofits from taking money raised with tax-exempt bonds and investing it in higher-yielding investments, a form of arbitrage. But it does not prohibit the strategy used by New York Law School, which many tax experts regard as a major flaw in the law.

“Congress’s intent in allowing charities to use bonds is to help them achieve their missions — build a health care center or a preschool,” said Dean Zerbe, former tax counsel to the Senate Finance Committee, “not to engage in fast and loose financial games.”

Mr. Matasar said the school did not engage in arbitrage. “The fact that we were fortunate enough to be able to sell a building to raise additional funds was a separate and distinct transaction,” he said.

When the credit market began souring last year, interest rates climbed sharply, hitting 12 percent in one week as buyers failed to show up for auctions of the school's securities.

In December, New York Law School refinanced its debt, converting its securities into variable-rate notes secured by a letter of credit, Mr. Matasar said. Its endowment had fallen 20 percent to $186 million.

The Culinary Institute of America ramped up its use of tax-exempt bonds to finance construction of facilities. By the end of 2007, it had $104 million in debt, about 70 percent of which was auction-rate. Charlie O’Mara, the institute’s chief financial officer, figured it saved about $750,000 in financing costs that way. “It would have been a great strategy,” he said, “if our credit markets did not blow up.”

Like New York Law School, the institute saw its cheap financing evaporate when its bond insurer was downgraded and the auction market vanished. The institute was able to refinance its debt. But experts predict that many charities, particularly cultural organizations that are seeing declining revenues, will have a harder time.

Soliciting donors to pay off debt “would be like me going to my husband and saying, ‘Give me money because I spent too much at Saks Fifth Avenue,’ ” said Naomi Levine, a former star fund-raiser for New York University who now teaches at the university's Heyman Center for Philanthropy. “It would be very, very difficult.”