In this period of "unprecedented" financial stress for colleges, Moody's Investors Service outlines in a report to be issued today six factors that it will consider in determining whether it downgrades the credit ratings of hundreds of colleges whose $150-billion in debt it rates.
It also lays out 13 situations it considers "analytical red flags" that could trigger a rating review.
In the "special comment" report, the agency says that if a college violates a bond covenant—which many are likely to do this year because the value of their assets has fallen relative to their debt load—that would not in itself prompt a ratings review. But it might if it coincided with one or more of the red flags.
In outlining the criteria, the ratings agency also takes some institutions to task for the poor governance that has brought their creditworthiness to a less stable state. Indeed, one of the 13 red flags is having "unresponsive and stagnant management teams and boards."
Of the six broad factors to be considered in downgrades, four are elements that undermine colleges' financial health, such as declining student demand, investment losses and weakened financial standing, and liquidity problems.
The other two are mitigating factors.
Colleges that do a better job of disclosing financial information, and those where leaders take effective action to manage their problems, may avoid downgrades. "A lagging and indecisive management response will be a significant negative factor in rating issuers in this sector," Moody's says in the report.
The second factor that could help a college is the degree to which it is able to take advantage of federal stimulus money.
Questionable Oversight
Moody's, whose ratings cover institutions that enroll about 80 percent of all college students, says some colleges are now suffering from liquidity problems because of poor governance. Among those, it says, are institutions that invested their endowments in private equity and other alternative investments and now, because the funds are committed, do not have the ability to draw on those assets if they need them.
"For many debt issuers in this sector, following the investment practices of the largest endowments has been risky and reflective of questionable governance oversight, as most institutions lack adequate staff and risk-monitoring resources necessary for overseeing private investment managers," the ratings agency writes. It also notes that most colleges that issue debt are not dependent on their endowment for operating revenue.
The red flags include: a decline in enrollment; a decline in total operating revenue; rising operating deficits; failure to produce an audit within six months of the end of the fiscal year or an audit that raises concerns; more than 70 percent of debt at variable rates; and an unexpected increase in debt (20 percent or more).
Another deals directly with how colleges invest their endowments: An investment allocation with more than 10 percent in one investment fund would be a red flag, the report says.
John C. Nelson, managing director for the group within Moody's that rates colleges, said the agency considered big allocations to a single investment manager a risk. With a cap on the amount going to a single fund, he says, "even if you gave it all to Madoff," the maximum you would lose is limited.
