Foundations Fear Recession, Double-Dip

September 16, 2011       Mark Hrywna      

The first-ever downgrade of long-term U.S. debt threw more uncertainty into any potential economic recovery just as charitable giving was creeping back to pre-recession levels.

While the downgrade will lead to higher interest rates on borrowing it also could have a ripple effect on other ratings, putting more pressure on state budgets, and in turn more nonprofits that depend on them. And the massive sell off in the markets fueled fears of a potential double-dip recession.

Stocks plunged in the week following the downgrade. The Dow Jones Industrial Average dipped below 11,000, less than a week after it was trading above 12,000.

Standard & Poor’s, the Manhattan-based ratings agency, followed up the downgrade by downgrading agencies linked to long-term U.S. debt, such as Fannie Mae and Freddie Mac. Standard & Poor’s is one of three major credit rating agencies. The two other ratings agencies, Moody’s and Fitch, are maintaining a AAA rating for the U.S.

S&P cited “political risks and rising debt burden” as reasons for the downgrade of the nation’s long-term debt. What that means for nonprofits and foundations is unclear in the short-term, though coupled with rapid drops in the stock markets.

According to Bradford Smith, president of The Foundation Center in New York City, there are two ways the downgrade can affect nonprofits. First, it could mean raising interest rates, which would put further pressure on state budgets and their ability to raise money. With states already in a tough situation, he said it if it gets tighter, many budget cuts could come at the expense of nonprofits.

Second, the volatility turns out to be more than just a market correction, foundation endowments could get a big hit, as they did in the 2008 recession. If endowments take a big enough hit, foundation giving could fall in response, just as giving was beginning to climb back to pre-recession levels, Smith said. “But it takes a crystal ball to predict that,” he said.

From an operational standpoint, the downgrade really has no impact on endowments and foundations, or their ultimate beneficiaries, said Rick Nelson, chief investment officer at Commonfund Institute in Wilton, Conn. “It’s been a non-event from that standpoint,” he said.

Another effect of the downgrade, however, might be that other entities are unable to maintain their rating if the U.S. is rated AA+. “You’re seeing that somewhat today, some insurance companies being downgraded. It could have an effect on institutions, but really it’s on a case-by-case basis, not in lockstep,” Nelson said.

The downgrade reflects a symptom and is not a driving force itself, Nelson said. Ratings agencies tend to lag what’s going on in the market, underscoring the symptoms. On the asset side, since there’s a rally in government issues, one might see higher interest rates long-term because underscoring the fact that there’s greater risk in government, but it’s not today, he said.

There were warnings during the debt ceiling debate that ratings agencies might downgrade if a deal wasn’t made, and certainly if the U.S. defaulted. Congress and the president finally agreed to a deal, it’s just that S&P wasn’t exactly enamored by it. The $2.1 trillion in cuts agreed on by policy makers “fell short” of reforms, according to S&P.

“The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics,” according to S&P’s report.

The downgrade reflects “our view that the effectiveness, stability and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned,” according to S&P. The agency assigned a “negative outlook” to the rating in April.

S&P said it could lower the long-term rating to AA within the next two years “if we see that less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our base case.” There also was a concern that the budget won’t be properly addressed until after the 2012 presidential election.

Lisa Hall, president and CEO of the Bethesda, Md.-based Calvert Foundation, said there is a concern about the possibility of a “double-dip recession.” If it does lead to a protracted downturn, it would have an impact on nonprofits throughout the country, she said.

Hall said she has the sense that the recent stock market volatility has resulted in unrealized losses, which could affect people’s perception of their wealth, therefore how much they’re giving they’re willing to do.

The biggest challenge for nonprofits will be to make sure they maintain services that are consistent with the funding they are receiving. “It is a challenge for nonprofits because they obviously want to serve the needs in their community. To be in this for the long run, they have to make adjustments to services they provide and staffing, so they’re ready when funding comes back and grants more readily available,” she said.

“It’s quite a balancing act, but where we see nonprofits get in trouble in prior downturns is when they’ve continued to provide programs and services when they didn’t have the funding to cover their expenses.”

Despite the unprecedented developments, Hall said, “fundamentally, we have the same underlying structure and financial condition that we had before this downgrade occurred.”

John Stremsterfer, executive director at the Community Foundation for the Land of Lincoln in Springfield, Ill., likened the stock market’s volatility to the drastic declines seen in 2008. Those drastic dips could affect foundations that have diverse exposure to different assets, he said, adding that his own community foundation’s portfolio is about 50 percent in the market.

Most foundations that have endowments have perpetuity on their side to weather the storm but since their spending rates are based on their rates of return, it could be more challenging to make grants to nonprofits, he said.

“Our experience over the last three years is giving for larger gifts has slowed,” he said. As a community foundation, they deal with more than charities that have annual campaigns for their income.

With the stock market, people ultimately still give those gifts but wait longer because it’s so volatile, said Stremsterfer. “We’ve seen it [the stock markets] come up just as quickly the last three years, so if it corrects in a positive direction, especially capturing year-end gifts, you could feel a renewed sense of confidence,” he said.

Endowments have a longer time horizon and have more illiquid assets and equity risks in their portfolios, Nelson said. The indirect effect is that “greater volatility tends to create greater headwinds for foundation and endowment portfolios,” he said.

Concerns about debt and the downgrade are counterintuitive, Nelson said. Government issued debt is still a very safe asset and interest rates are abnormally low anyway and are likely to go back up in general, he added.

“With the downgrade, and a rally so far in government bonds, clearly they’re riskier until these debt issues get solved in a meaningful way,” Nelson said.

What effect the downgrade and current market volatility will have is still unclear for the time being and will take time. “With bad news from so many different directions, it’s really hard to judge it in anyway,” Stremsterfer said. “It’s scary out there.”