Nonprofit Borrowers and the Credit Crisis
| Citado como | Vol. 50 No. 2 Pg. 0066 |
| Páginas | 0066 |
| Año de Publicación | 2009 |
2009 Fall, Pg. 66. Nonprofit Borrowers and the Credit Crisis
Volume 50, No. 2
Fall 2009
INTRODUCTION - THE AVAILABILITY OF TAX-EXEMPT FINANCING
Charitable corporations and other entities holding 501 (c) (3) status under the Internal Revenue Code of 1986, as amended ("Code") generally have had access to tax-exempt financing to pay for their capital projects.(fn 1 ) Although this access has been available in most states since the late 1960s or early 1970s, it was not until the early 1980s that large numbers of these entities (often referred to as charitable corporations) began accessing the tax-exempt bond and note market through state or local agencies empowered to issue tax-exempt debt on their behalf.
As their name suggests, tax-exempt bonds and notes do not result in taxable income to the purchasers of such debt. Consequently, the interest rates on tax-exempt debt are lower than conventional, taxable debt, with the concomitant result that the borrower's debt service obligations are decreased. The availability of tax-exempt debt reflects a legislative policy determination that entities that perform charitable functions should have certain tax advantages. While the primary advantage is tax-exempt status, requiring no payment of federal income taxes and exemptions at the state level from certain taxes, less expensive borrowing for capital projects is a significant benefit to most charitable corporations.
Before passage of the Tax Equity and Fiscal Responsibility Act of 1986 ("TEFRA"), banks and other financial institutions were the primary purchasers of tax-exempt debt issued by smaller charitable corporations; more substantial 501(c)(3) borrowers issued bonds through public offerings. Because of a general concern at the federal level about the loss of revenue due to the growth in tax-exempt debt, TEFRA included provisions to make access to tax-exempt debt more difficult.(fn 2 ) The results were mixed: although the new restrictions limited the purposes and uses of proceeds of each individual issue of tax-exempt bonds or notes, the growing popularity of such debt led to a substantial expansion of the total number of debt issues and the overall amount of tax-exempt debt.(fn 3 )
ISSUING TAX-EXEMPT DEBT IN NEW HAMPSHIRE
In New Hampshire, virtually all tax-exempt debt for 501 (c) (3) borrowers is issued through either the Business Finance Authority ("BFA") or the New Hampshire Health and Education Facilities Authority ("HEFA"). In essence, any tax-exempt borrower can issue bonds or notes through BFA or HEFA for virtually any capital purpose. Hospitals, ambulatory care facilities, retirement and nursing homes, colleges and universities, private schools, cultural institutions and social service agencies, among others, can access the tax-exempt market through BFA and HEFA to acquire land and existing buildings, to construct new or expanded facilities, to renovate existing facilities and to pay for associated furnishings and equipment as well as related soft costs such as architectural and engineering expenses and legal fees.
TAX-EXEMPT STRUCTURES:
THE GROWTH of NEW PRODUcTS
As the use of tax-exempt debt as a financing vehicle became more widespread, so did the number of ways to issue it. Investment bankers, known for their creativity in developing corporate financing structures such as leveraged buyouts and initial public offerings, realized that the expansion of tax-exempt borrowing could be further fueled by new structures as well. While tax-exempt debt issued through the late 1970s generally was based on a borrower's own creditworthiness, in the 1980s the concept of "credit enhancement" - the use of bond insurance provided by monoline bond insurers or letters of credit issued by banks - was introduced to the municipal marketplace.(fn 4 ) The use of credit enhancement was perceived to offer significant benefits for many borrowers. For less creditworthy institutions, bond insurance or a letter of credit allowed access to the public market, where interest rates were markedly lower than in the private placement marketplace; for more creditworthy borrowers, credit enhancement could lower the cost of obtaining capital.
In a credit-enhanced transaction, the ultimate risk of repayment to the bondholders shifts from the underlying borrower to the credit enhancer, which charges what it considers an appropriate upfront premium or annual fee for assuming the risk that it may not be repaid by the borrower. In addition to the creditworthiness of the entity seeking credit enhancement, bond insurers and letter of credit banks also base their fees on the cost of meeting their regulatory requirements for providing credit enhancement, such as capital set asides or reserves.
When credit enhancement was first gaining acceptance, the few bond insurers sought, and obtained, "Aaa/AAA" ratings from Moody's Investors Service ("Moody's") and Standard and Poor's Ratings Group ("SandP"). Although initially most letters of credit were issued by United States banks rated in the single or double "A" category by Moody's and SandP, Japanese and European banks soon entered the market, providing competition and often driving down the rates charged to borrowers for letters of credit-backed issuances. As a general matter, investors, particularly mutual fund investors, often prefer tax-exempt debt backed by a highly-rated credit enhancer because of the perceived security provided by such an entity despite the somewhat lower yield on the enhanced debt. The primary advantages for borrowers are the lower cost of capital and the ability to deal with any problematic issues with one institution rather than hundreds or thousands of bondholders.(fn 5 )
As the use of credit enhancement spread, more bond insurers entered the marketplace, with some having ratings in the "AA" category and at least one rated "A". The lower-rated insurers tended to take on less creditworthy borrowers for higher premiums, and required that their borrowers meet more strenuous economic and operating covenants. Although these insurers were less well-capitalized than their "AAA" rated counterparts, the obligations they supported were nevertheless rated at least "A", and the yield was higher.(fn 6 ) By the time these non-"AAA" rated insurers began enhancing transactions, the municipal market had become comfortable with letter of credit banks with "A" category ratings.
Transactions employing bond insurance as enhancement originally only used for long-term, fixed rate bond issues because bond insurance covers the bonds for the life of the issue. Because letters of credit do not cover the related debt for its life, but typically provide enhancement for between three and five years, letters of credit have tended to be used most often in variable rate bond issues where the interest rate is reset frequently. The majority of such issues have had weekly interest rate resets. while the bond-insured issues generally have had an up to 10 year "no call" period, in which the bonds cannot be prepaid by the borrower, variable rate issues allow the borrower to repay on 30 days' notice to the bondholders, who have the right to "tender" their bonds, i.e., have them repurchased, on seven days' notice, resulting in these bonds being referred to as variable rate demand obligations or "VRDOs". Because these bonds often change hands, they require a remarketing agent whose function is to find new bondholders when existing bondholders tender their bonds.(fn 7 )The remarketing agent also sets the weekly (or other variable) rate, based on its judgment as to what rate will allow the bonds to be resold at par. As might be expected, variable rate bonds generally carry considerably lower interest rates than fixed rate bonds because of the difference in the period for which the interest rate is set. Variable rate bonds by their nature also are more volatile and correlate much more closely to current, short-term market interest rates.
As variable rate bond issues became more accepted and provided lower costs of capital, and the use of bond insurance for fixed-rate transactions declined, the investment banking community created another opportunity for the use of bond insurance: auction-rate securities ("ARS"). These securities combined what was perceived to be the best feature of traditional insured fixed rate bonds - a guarantee that the bonds would be highly rated through the use of bond insurance for the life of the bond issue and thus would continue to trade until their final maturity without the risk that a letter of credit would not be renewed or could not be replaced - with the lower interest rate benefits and purchaser liquidity associated with VRDOs.
Auction-rate securities take their name from the frequent (7-, 28-or 35-day) auctions in which the interest rate is reset and the holders have an opportunity to have their bonds purchased. Buyers and sellers participate in a...
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