March 20, 2008 | Read Time: 4 minutes
The mounting turmoil in the nation’s financial markets, traceable to the problematic “subprime” loans given to less-creditworthy homebuyers amid the housing boom, has claimed new victims: hospitals, colleges, and large nonprofit cultural institutions that are now collectively paying millions of additional dollars in interest-rate charges on their long-term debts.
The credit disruptions are costing organizations such as the Los Angeles County Museum of Art and Georgetown University, in Washington, thousands of dollars a week as interest rates have risen sharply — over 60 percent on average, according to the Bloomberg News Service — on bonds issued to help pay for expansions and new programs.
Reducing Costs
At issue are the “auction-rate bonds” these groups used to borrow money. Unlike more traditional “fixed rate” bonds, for which the interest rate is set for the 20- or 30-year life of the bond, the interest charges on auction-rate bonds are reset periodically, usually weekly or monthly, at auctions where investors set the rate through a bidding process.
This type of bond, developed in the 1980s, is designed to reduce financing costs by allowing long-term borrowing to take advantage of lower, short-term interest rates established through the periodic auctions.
More than $300-billion has been borrowed using auction-rate bonds, with private colleges alone accounting for some $7-billion of that total.
Beginning last month, many of the periodic bond auctions failed to draw bidders, as investors have become skittish in the volatile financial climate.
Many of the nation’s largest banks, frequent bidders at the auctions, are reeling from the billions they’ve lost in the mortgage-foreclosure crisis.
When such auctions “fail,” the interest rate for the bond resets to a pre-established default rate, which in some instances can be as high as 12 or 15 percent. And auctions don’t have to fail to send bond interest rates higher, since those that attract only a limited number of bidders tend to result in higher rates.
“The auction-rate crisis resulted from pressures to control financing costs,” says Dwight Denison, associate professor of public and nonprofit finance at the University of Kentucky, in Lexington. “The issuers were able to reduce interest costs as long as market demand for their bonds remained strong. Given the current market concerns regarding subprime mortgages, nonprofit organizations that issued auction-rate securities are potentially left without demand for their securities, forcing interest rates on the securities to increase up to 200 percent.”
The Los Angeles County Museum of Art issued more than $315-million in auction-rate bonds over the last four years to help finance major building renovations.
“Our interest rates have gone up quite a bit,” says Ann Rowland, the museum’s chief financial officer. “It’s a little bit irrational, but investors have fled this market and therefore the rates have increased.” Ms. Rowland says the museum is now paying 7 to 8 percent in interest, up from below 4 percent in January.
The increase has cost the museum nearly $1-million in additional financing costs, and the institution is now exploring ways to refinance the now-volatile auction-rate bonds into a more traditional bond form.
“We are remaining calm and just trying to figure the best way out of this,” Ms. Rowland says.
Less severely affected is Carnegie Hall, in New York, which issued $41.6-million in auction-rate bonds six years ago.
The organization’s interest rates, which are reset at weekly auctions, increased from 3.4 percent to just over 4 percent.
“At this stage, there are currently no plans to refinance the bonds, since the increase in our interest rate has been modest and, so far, manageable,” aCarnegie Hall spokeswoman wrote in an e-mail response to questions. “As the bond market is unsettled at this time, we are watching to see what alternatives develop.”
Reluctant to Comment
Many charities employing auction-rate bonds are reluctant to discuss their recent performance.
The Bloomberg service reported last month that the Museum of Modern Art, in New York, was paying over $14,000 more a week in interest charges on its auction-rate debt.
Margaret Doyle, a museum spokeswoman, confirmed in an e-mail message that the institution’s interest rates had increased, but said that her organization had “decided not to do interviews on this subject.”
Other institutions that have been reported to use such bonds also declined to talk to The Chronicle, including the California Academy of Sciences, in San Francisco, and the Metropolitan Museum of Art, in New York.
W. Bartley Hildreth, professor of public finance at Wichita State University, says there is no need for institutions employing these bonds to panic, although he is unsure how long the current disruptions might last.
“Auction-rate securities are not bad instruments, and this episode does not show that they are flawed,” Mr. Hildreth says. “Many of these groups saved money over several years with these bonds, when their borrowing costs were much cheaper. It’s just that people didn’t always look at the potential downside when they got into them. It was a calculated decision.”
