University Bonds: Are the Ties that Bind Too Long?

One of the pieces of kindling that lit the protests against tuition hikes at the University of California was UC Santa Cruz professor Richard Meister’s contention that the University of California pledged student fees as collateral for US$1.6 billion in construction bonds issued in August 2009. The bonds-for-fees discussion isn’t an only-in-California debate. The issue of how university bonds are paid should be part of a larger discussion concerning how a university should serve both its constituency and the debt market.

Public and private universities across the country have been on a credit binge for the past twelve months.  Bonds, in the billions and billions, have been issued by illustrious and well-endowed universities such as Harvard, Princeton, Stanford, and Yale.  Whether contending bad credit default swaps bets, Bernie Madoff, or drops in state or endowment funding, formerly financially-secure institutions have been taking on huge debts despite the economic downturn.   Universities use the money from bond sales to raise or improve buildings, refinance current debt, or cover operating costs.  Forbes writers Bernard Condon and Nathan Vardi describe Harvard’s situation in early 2009 as “borrowing money, much like a homeowner who takes out a second mortgage in order to pay off credit card bills,” and Harvard’s peers seem to be following suit (see chart).

There is a silver lining for academia in all this, namely the municipal bond market.  State-funded universities, as well as private universities, which operate as non-profit educational corporations, sell their IOUs as municipal bonds which are most often rated AAA/AA1, qualifying the debt as the most secure and least risky for investors.   And the municipal bond market has hungrily absorbed the flood in bond supply unleashed by cash-strapped universities. For example, Cornell University raised US$500 million dollars in 30 minutes with its March sale.   More recently, when Yale University sold US$1 billion in five-year bonds on November 3, it was overwhelmed by US$5 billion dollars worth of orders.  Desired by institutional investors such as banks, mutual funds and insurance companies, university bonds seem a safe haven in a rocking economy. Could you ever imagine Harvard or Stanford in bankruptcy court?

While seeming a sure win for investors, higher education, given cuts in faculty and services on top of tuition increases, appears to be an increasingly risky bet for students, faculty and staff.   Bonnie J. Kavoussi and Jillian K. Kushner, reporting for the Harvard Crimson, note that Harvard usually only increases tuition to match the inflation rate. Despite 0.2% inflation y/y in February 2009, Harvard voted to step up tuition by 3.5%, and the “hike will not translate into an actual increase in the amount of spending money available for the Faculty of Arts and Sciences from tuition.”  Harvard University, in the wake of an imploded endowment, raised fees, “resized” staff, and borrowed US$2.5 billion.  In Vanity Fair, Nina Munk writes “servicing that debt alone will cost Harvard an average of US$517 million a year through 2038, according to Standard and Poor’s” (emphasis Munk).

Instead of prizing quality of education, research and access, rating agencies like Moody’s and Standard and Poor’s value universities  that have diverse revenue streams (i.e. student tuition, medical center revenue, research overhead etc), low debt, and are in demand by students.   Agencies will cite strong student demand and admission competition as a very favorable credit metric.  In “Squeeze Play 2009 - The Public’s Views on College Costs Today,” the National Center for Public Policy and Higher Education reports that “Increasing numbers say that obtaining a college degree is the only way to succeed in America, that is, a college degree is not only important, it is a necessity. The percentage of people who believe this has now reached 55 percent…the highest percentage we’ve seen in any of our previous surveys.”   Despite the problems it may have serving the campus community, a university’s historical demand, its ability to raise fees and tuition, and the government support it enjoys via student loans proves attractive to institutional bond investors.

In “The True Cause of College-Tuition Inflation?” Stephen J. Dubner posits that spiraling tuition costs may be a function of “how much money colleges have been putting into student amenities.”  Construction projects such as gyms, dormitories, medical facilities, libraries and research centers are now viewed as necessities to an institution’s financial future as selling points that please parents and prospective students.   YetDennis  Jones  and  Jane  Wellman, researchers with the Delta Project on Postsecondary Education Costs, Productivity, and Accountability,  report that  the most damaging myth in higher education financing is that “ spending  increases  in  higher  education  are  inevitable.”  To borrow funds for these developments, universities require good credit, and Moody’s has proposed a map for universities designed to keep their credit scores AAA/AA1 clean.  Moody’s recommendations highlight tuition hikes, cost cutbacks, online education delivery and direct borrowing as means for universities to survive the Great Recession with their credit ratings intact.

However, the enormity and surplus of universities’ bonds gives one pause.  If loans are taken out to cover a university’s operating expenses, how many staff and faculty cuts will be necessary to reduce its deficit?   And how will increased revenue, which will be needed to service the loan, be generated by an institution with reduced capacity?  Lab and discussion sections can be overenrolled; small seminar classes can be converted into 200+ person lectures, clearly diminishing education quality.   But capacity cuts will affect student demand. Say the administration institutes a hiring freeze and trims faculty through retirement attrition or denial of tenure. The afflicted departments’ talent pool is emptied.  With the variety and quality of courses thinned, departments across the institution will be less able to generate student interest and demand for its classes.

Finally, how long will it take to pay back the billions of dollars borrowed plus the interest owed, and who will be writing these checks to the financial institutions to which the loans are owed?  Although administrators will in good faith attempt to repay the bonds without using tuition funds, the universities’ debt burden is bound to be distributed among current and future students whether through decreased services and increased dormitory and board fees, medical payments, campus access fees, parking tickets, transcript fees etc.  While the University of Washington excludes student tuition and ancillary fees as collateral in its bond statement, the University of California proffered student fees to help secure its bond issuance.

Already, the class of 2009 has the most heavily-indebted graduates in history.  A student at a private university who borrowed to attain his degree will likely graduate with a loan that tops US$25,000. Student loans defaults are on the rise, and Marty Nemko, in the Chronicle of Higher Education, cautions that “employers are accelerating their offshoring, part-timing, and temping of as many white-collar jobs as possible. That results in ever more unemployed and underemployed B.A.'s.”  Universities that have taken out these bonds for capital expansion and development may be indenturing a generation of vulnerable young people to satisfy bondholders or to fund projects of which they may never reap the benefit.