September 18, 2008

Casino Royale

As Wall Street has been busy laying its latest eggs this week, the reaction from the arts community—at least the reported reaction—has focused on the philanthropic side: how the downturns and bankruptcies will affect corporate donations. But there's another aspect to the crisis that affects the arts, and it's more interesting in the way it spotlights an evolution in funding that doesn't get a whole lot of attention. It's the spillover effect into the bond market.

Bonds are basically private loans gone public. A municipality or organization sells bonds to investors in order to raise cash; the investors collect interest on the bonds, and can trade them like stocks, or hold on to them until they mature. The value and maturity payout of the bonds are secured against some form of collateral (usually the future revenue stream of the project in question). Arts organizations have been issuing bonds for a little while now, usually in anticipation of a major contruction project. Lincoln Center, for instance, began issuing bonds in 2006 to fund its current renovation. It's more efficient than old-fashioned fundraising because an organization isn't stuck waiting to begin construction until sufficient funds have been raised; they can pay the contractors right away, and then devote their development to raising money to pay the interest on the bonds, and eventually pay them off.

Bonds, like any other investment, are risky, and you can measure that risk by looking at the interest rate—the higher the rate, the more chance there is the market thinks that you might not be able to recover the full value of the bond. This is also why rating agencies like Standard & Poor's or Moody's exist: they rate the credit of bond-issuing organizations. The highest rating (AAA, in S&P's grading system) means that the organization can charge a lower interest rate. A lower rating (usually B or lower in S&P's system) results in "junk bonds," more a target for short-term speculation than long-term investment (since no one thinks such bonds will actually pay out at maturity, investors make money by gambling on fluctuations in trading value).

So now you know about the bond market. But here's a question: how do you rate a bond secured against the collateral of possible future philathropic donations? Tricky. Or how does one determine the credit-worthiness of bonds from an organization, like Lincoln Center, that's never issued them before? Equally tricky. Even rating bonds from cities and states is a little too much guesswork for the market, which is why, back in the 1970s, bond insurance was invented. You buy insurance from a bond insurance company (for example, Lincoln Center originally had its bonds insured by a corporation called ACA Financial Guaranty), and that company will guarantee that the bond will continue to pay its interest and will maintain its value. In rating insured bonds, the rating agencies assign the bonds the same credit grade they give the bond insurer, which is why bond insurers work very hard to maintain good credit.

Hmmm, you might be saying, would that be the same "credit" that figures in this "credit crunch" I keep hearing people on the news mention? Damn straight it is. Bond insurers, who succumbed to the usual temptations of derivatives and collateralized bond obligations, have been gasping for air for some time now. (The crisis that insurer AIG found itself in this week? Bond insurers have been in smaller but similar crisis mode for months.) If your bond insurer goes under, or restructures, or the rating agencies finally get up off the couch long enough to recognize the obvious and downgrade its credit, your cost to issue bonds—in the form of the necessary interest you'd need to offer to get investors to buy—goes up. What's worse, the interest you're already paying out can go up, too, if you've sold what are called auction-rate bonds. Auction-rate bonds, first offered in the late 1980s by Goldman Sachs, are vaguely like adjustable-rate mortgages: every few weeks, the interest rate on such a bond is determined by a dutch auction among the bondholders. In the current credit-starved market, interest rates on auction-rate bonds have been skyrocketing.

Back in March, the Los Angeles Times reported on how the mortgage crisis was impacting bond-issuing Southern California cultural institutions:
LACMA is the biggest local cultural borrower affected as it plows ahead with new construction and renovations. Its losses are approaching $2 million since Feb. 1, according to Rowland. Interest rates have averaged 8% on LACMA’s debt; it is shelling out about $2.4 million a month to pay its bondholders, double what it had expected. The Natural History Museum, which issued bonds for renovations, has sustained losses of more than $500,000, according to Vice President James Gilson.
What's an organization to do? Refinance those bonds at a loss—a loss that's only gotten more significant as the market has continues to falter. The Orange County Performing Arts Center went through similar belt-tightening over the summer, writing off $8.8 million in bond insurance after its insurer was downgraded, and paying out some $4 million more in interest than expected. They've refinanced their debt, but it leaves them out a significant chunk of money, and with a less flexible cash flow. Now organizations are getting gun-shy: Lincoln Center was scheduled to issue another $100 million in bonds this week, but like many others (including the cities of Chicago and Boston—and municipal bonds are usually the most credit-worthy), they've elected to postpone that offering rather than pay out the higher interest rates that would be needed to move the bonds in this market.

It's worth watching to see how this crisis affects the use of bonds in the arts. So far, bonds have mostly been used to fund construction, but it's not hard to imagine an orchestra, say, opting to collect the financial benefit of a major capital campaign up front by issuing bonds. (On the pop music side, the issuance of bonds secured against the rights to an artist's catalog of songs—pioneered by David Bowie—has been a mixed success.) The current recession will probably put a temporary kibosh on arts bonds, but I wouldn't be surprised if, in a decade's time, most major fundraising initiatives are accompanied by a corresponding venture into the bond market. But it puts you at the mercy of people who, fundamentally, don't really care what it is you do. Whether that's a good thing or a bad thing depends, I suppose, on how cold your blood runs.

2 comments:

rbonotto said...

"But it puts you at the mercy of people who, fundamentally, don't really care what it is you do. Whether that's a good thing or a bad thing depends, I suppose, on how cold your blood runs."

Since it's been 19 years since a professional orchestra's played my music, I guess I could say: I feel no pain, dear mother, now.

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