What Hospital Systems Can Do to Ride Out the Financial Market Turbulence
It seemed like a reasonable strategy at the time--getting the lowest possible interest rates on debt issuance by using auction-rate financing and by obtaining insurance backing to reassure investors. In fact, since 1984, when auction rate debt first emerged in tax-exempt hospital financings, the strategy has worked well. At auction, investors stepped up to purchase the insured debt in virtually every case. (In the course of two decades, only 13 auctions failed to place the debt offering). Hospitals benefited from lower rates, and investors felt relatively secure in their hospital bond holdings.
Along came the subprime mortgage frenzy, and hospital capital markets have been drawn directly into the eye of the storm. The connection between subprime mortgage lending and hospital tax-exempt bonds is not an intuitively obvious one. The connecting links include bond insurance companies such as FGIC and MBIA that also guaranteed mortgage-related securities and investors who fear that these insurers may not be able to cover the pending mortgage losses. The credit downgrades of FGIC (Financial Guaranty Insurance), XL Capital Assurance, and ACA Financial Guaranty (three of the handful of insurance providers for bond financings), along with the potential downgrade of MBIA and other insurers, leaves investors wondering what security these insurers really bring to tax-exempt bonds.
Perceiving higher risk, investors insist on higher returns, driving tax-exempt rates skyward or, in the extreme, resulting in no interested buyers at any reasonable interest rate. In the second half of 2007, for example, there were 31 failed auctions for auction-rate debt, according to Moody's. In mid-February 2008, the situation deteriorated with many more failed auctions and soaring rates. After a failed auction, the Port Authority of New York and New Jersey is now paying 20 percent on its auction-rate bonds where it used to pay 4 percent. The capital crunch facing the nation's banks as they struggle to cover mortgage write-downs also means that they are not an available resource to help stabilize the bond auction market.
Short term impact
As a result of the turbulent market, some hospital systems have seen the interest rates on their auction-rate debt soar from 2 percent to 3 percent to more than 10 percent in some auctions. This swing in rates has nothing to do with the underlying creditworthiness of the borrower, but rather with the state of the bond market. While the bond market may stabilize somewhat over coming months, the long-term high demand for capital in the hospital industry and the continuing liquidity pressure on financial institutions means that capital will be tight and tax-exempt interest rates are likely to be considerably higher than they were in the past few years.
What can hospitals do?
For hospitals and systems with insured auction-rate debt, there are several strategies to consider:
- For strong credits, it may make sense to refund the issue with fixed-rate bonds and ride on the creditworthiness of the borrowing organization going forward, foregoing the cost of insurance. Hospital leaders and boards may be reluctant to make this move, because of the costs already incurred for insurance and for swap provisions in the original issue (that are likely under water) that would have to be written down.
- In many cases, it makes sense to convert to variable-rate demand obligations, keeping the insurance and the swap provision component of the debt. Of course, this option lessens but does not eliminate the risk associated with interest volatility in the variable rate market.
- Some health systems may be strong enough to consider buying back their own debt in the short term and refinancing down the road when conditions are favorable. St. Louis-based BJC Health System, for example, recently announced plans to bid on its own auction-rated bonds and refinance the debt later. There are numerous tax questions associated with this approach, but for issuers with ample liquidity this is an alternative to consider.
In addition to the financing strategies above, hospitals and hospital systems should consider the following lessons learned from this volatile marketplace:
- Hospitals should be planning how they can absorb the greater-than-anticipated cost of financing. Incorporating assumptions about tighter debt markets and volatile interest rates will be a critical part of financial and capital planning. Financial projections that were done to support borrowing for major projects in recent years should be updated as part of the assessment for refinancing or converting debt. Already, both Standard & Poor's and Moody's are using much more stringent assumptions regarding variable rates in their analyses of the risk profiles of their credits.
- Due to skepticism about the value of insurance, the market is likely to be more focused on the underlying credit of the borrower. Thus it is in the interest of every borrower to look closely at its current and projected financial performance and to strengthen the financial fundamentals of the organization to the extent possible. Purchasing insurance is not a tactic that will make up for mediocre performance any longer.
- Recent experience points to the value of diversifying financing sources. Putting too much of the organization's financial capability in a single financing vehicle can unduly increase risk in today's market. Just as asset allocation makes sense for personal portfolio management, each organization should carefully assess its potential sources of debt funding and, in concert with its financial and investment backing advisors, select a mix of sources (fixed, variable, long- and short-term) that minimize cost at an acceptable level of risk.
Deborah S. Kolb, PhD, and Scott B. Clay are senior principals at the Noblis Center for Health Innovation and may be reached at email@example.com and firstname.lastname@example.org, respectively. Peter W. Bruton is managing director at RBC Capital Markets, and may be reached at email@example.com.
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