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This is Gonna Cost You

Philip Betbeze, for HealthLeaders Media, March 3, 2008
Got any auction-rate securities in your hospital's debt portfolio? If you do, you're probably not getting a whole lot of sleep these days. Who thought the financial dominoes that kicked off with the subprime housing crisis would fall this far? As the credit markets have seized up one by one, many plain vanilla debtors like hospitals and municipalities whose debt ratings haven't changed and who pay their bills on time are facing huge--though hopefully temporary--unexpected increases in debt service costs through no fault of their own. Specifically, they're facing these problems because investors, investment banks and bond insurers failed to appropriately account for risk in other areas of the debt markets.

"It's a problem," says one hospital system chief financial officer I spoke to recently who has about $400 million in debt though auction rate securities backed by Financial Guaranty Insurance Company--a bond insurer whose paper no one wants to buy. "Our interest rates have skyrocketed," he says. "We're all spending a lot more in interest right now, and we're all trying to get to market as fast as possible to refinance everything."

A key characteristic of auction-rate debt instruments is that they must periodically be re-sold in a Dutch auction. When the market is working right, institutional investors bid on debt issued by cities and hospitals based on credit ratings and--sometimes--enhanced credit ratings provided by bond insurers that stand behind those debt issuers. The investor that's willing to take the lowest interest rate wins the auction. This is an active auction market. The bonds are re-bid, typically, every seven, 28 and 45 days. The problem is, no one trusts that so-called bond insurers are able to make them whole in the unlikely event of a default, therefore no one is bidding. That means the borrower has to pay the default rate that's listed in the bond contract with the investment bank, which is extremely high--in some cases, up to 17 percent. Those kinds of rates haven't been seen in more than a quarter century.

Many hospitals and municipalities used auction rate debt until very recently to diversify their debt portfolio and manage their interest rate risk--or so they thought. For the most part, hospitals and municipalities are extremely safe bets. But because they relied on rating agencies and bond insurers to guarantee repayment, they're paying the price for those entities' mistakes outside the municipal debt markets. No one believes they can actually "insure" in case of default. Truth is, because of mistakes they made with risk assessment in a totally unrelated market--home mortgages--they can't.

In some cases, hospitals that have stellar repayment histories and credit ratings are paying as much as 15 percent interest on bonds that were generating perhaps 5 percent before the credit crisis hit. No one--not the bankers, not the borrowers, not the investors--thought this risk would ever come to pass. It's a doomsday scenario, but it's one that's going to cost hospitals big-time, at least in the short term.

"I am sure it feels like hitting an iceberg," says Arlan Dohrmann, an investment banker with Stern Bros. & Co., whose firm doesn't deal in these securities. "It's a risk that was there but not totally visible."

"I'm surprised I'm not reading more about it," the CFO I interviewed says about hospital debt, "because it's taken over all the time of accountants, investment bankers and CFOs."

Give it time. Just give it time.

Editor's note: Does your hospital or health system have any auction-rate debt? If so, I'd love to hear from you about how you're navigating this storm. Please e-mail me at the address below.


Philip Betbeze is finance editor with HealthLeaders magazine. He can be reached at pbetbeze@healthleadersmedia.com.

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