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Covenant Crisis

Philip Betbeze, for HealthLeaders Magazine, May 12, 2009
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Many hospitals are in a bad position relative to their debt covenants. Breaches could trigger potentially draconian measures by bondholders to ensure financial viability.

The financial crisis has hurt hospitals in myriad ways. But depending on how exotic their debt financing got during the easy credit years, the damage recorded so far could be only the beginning.

A recent report from Moody's Investors Service suggests that, similar in some ways to the financial institutions that received federal bailout money and are sure to need more, many hospitals and health systems that entered into complex financial engineering vehicles such as interest rate swaps now face credit risk. That means, in many cases, that such institutions aren't getting what they bargained for when they eschewed traditional fixed-rate financing structures for other forms of debt. Now, as they are forced to post collateral as business weakens, they face a vicious cycle of downgrades begetting more collateral posting requirements.

"You have some major institutions with swap portfolios that when rates go down they have huge collateral calls," says Bart Plank, a senior vice president with Cain Brothers, a New York-based investment banking and financial advisory firm that specializes in healthcare. "It's been a perfect storm of negative events."

The strongest burned
Ironically, the hospitals and health systems that created the most exotic of these debt instruments are the ones that are arguably hurting the most now that the market has soured for their debt, says Jim Cain, managing director and chief executive officer of Cain Brothers, which has helped hospitals navigate onerous debt obligations. Such hospitals and health systems are often among the best-known and the highest-rated credits.

"There was a lot of money around, and banks wanted to get it out and get it to work," he says of the market prior to 2008. "They were aggressive on price and also on covenants. That began to change when the auction market hit the skids last spring."

That external event started the ball rolling for covenant breaches that forced collateral calls that fixed-rate borrowers didn't have to worry about. In a sense, hospitals are paying for the missteps of the folks who sold them on certain debt vehicles.

These organizations still have advantages, however. Collateral calls for otherwise strong hospitals and health systems won't come close to raining a death blow to them financially. Banks still covet such hospitals' business and are more willing to work with them on forbearance and letters of credit. Smaller hospitals will have more trouble.

"Many banks still want to be in the business, but only with higher-rated credits—larger organizations, where they can get additional business." So often, letters of credit are only issued to institutions that promise to give the banks other lines of business to manage. "Whether it's custody or treasury or underwriting business, they're bundling the extension of credit with the commitment of the buyer that there will be other services purchased."

Business downturn adds to problem
Decreases in revenues, increases in costs or a combination of both may call into play these debt covenant ratios and trigger receivership or a sale. For hospitals that are unable to refinance or obtain a letter of credit, they may cut employees and money-losing services, no matter how beneficial to the community.

To be sure, many such losses that trigger covenant violations are unrealized and unrelated to the underlying strength of the business. But they reduce balance sheet strength—from 20% to 50% in some cases, making life extraordinarily difficult for chief financial officers and forcing their attention away from operations—feeding the vicious circle. "That's a problem in itself," says Jason Sussman, a partner with Kaufman, Hall & Associates Inc., in Skokie, IL. "Explaining these losses while making sure the underlying operations are moving ahead is certainly a distraction."

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