Colleges and universities need to have active and engaged finance committees that are able to navigate them through these turbulent fiscal times. One prime example of the risks faced by many institutions that have issued Variable Rate Demand Obligations (VRDOs) is the potential impact of the recent downgrades of credit ratings on many major banks.

Many college and universities today have tax-exempt bonds in the form of VRDOs. Finance committees that monitor the fiscal stability of these institutions need to remain actively involved in monitoring the status of these VRDOs. If bondholders redeem the bonds, schools may ultimately be called upon to pay them off early, which could have an adverse effect on the institution’s financial well being.

Since most VRDOs are backed by bank letters of credit, investors have traditionally viewed them as safe and highly liquid investments, and a substantial market has developed around VRDOs. Recently, Moody’s downgraded its ratings of several major regional banks, many with letters of credit outstanding to support VRDOs. These downgrades could lead to one of two things happening:

•The variable interest rate on the related VRDOs will be reset at a higher rate to compensate investors for the perceived increase in risk associated with the letter of credit bank; and/or,

•The remarketing agent may be unable to remarket the related VRDOs even at the maximum rate set in the bond documents (possibly 12 percent to 15 percent). This is referred to as a “failed remarketing.”

If the second scenario is to occur, these recent bank rating downgrades will affect specific VRDOs backed by the downgraded banks rather than the entire market. Affected colleges and universities will need to work toward a solution of a failed remarketing of their VRDOs if this is to happen.

If the remarketing agents for the VRDOs in question are unable to find purchasers for the VRDOs which have been tendered for purchase, the bond trustee will draw on the letter of credit for the purchase price, and the investor will be paid in full with proceeds of the letter of credit. The draw on the letter of credit may then be converted to a term note with a much faster repayment schedule from the original bonds.

No Alarm Bells

There are a number of potential short- and long-term responses to the risks associated with VRDOs issued by colleges and universities. In the short term, an institution can ensure that the bank that issued the letter of credit structures appropriate rates and terms if they were not originally included in the Reimbursement or Credit Agreement. The institution may also want to ensure that the remarketing agent to one who is well-positioned to remarket the VRDOs. Thinking more long term, the institution can consider a substitute letter of credit from a different bank, they could restructure the VRDOs to bank-held bonds or they could choose refinance entirely.

None of this means that alarm bells should automatically be sounded by any college or university that currently holds VRDOs. Rather, it means that these learning institutions need to have a steady and reliable hand guiding their financial ships, one that is aware of the challenges that VRDOs create and knows how to navigate through those challenges if and when the time comes. Although to date it appears that the recent bank downgrades have resulted in some instances of very modest increases in interest rates rather than more widespread disruptions in the VRDO markets, the situation warrants continued monitoring in this uncertain economy.•