Be Glad You’re Not Running a Bank

You think healthcare's tough? Be glad you're not running any financial company, period.

Those guys in the $5,000 suits and $400 ties can have it. For all the challenges you face in running a hospital or physician practice, at least you're not dealing daily with the prospect that your company is insolvent, as many banks and other financial firms caught up in the credit crisis are.

They're victims of their own cleverness. By creating ever more complicated financial products like collateralized loan obligations or their close cousins, collateralized debt obligations, these financial geniuses thought they were creating products where risk was so diversified that the product would never default. What they failed to realize is that there's a trade-off involved, and a particularly nasty one at that.

Here's why: When you slice and dice loans and other debt obligations and recombine the pieces into a single unit, you do diversify the risk. One small piece failing doesn't hurt the value of the entire product very much. It was nice while it lasted. Big institutional investors stepped in to buy this trash, and didn't do much due diligence to figure out what kinds of debt actually underpinned the CLOs and CDOs. After all, the rating agencies all blessed these vehicles.

The trade-off of developing such complicated risk-sharing debt vehicles is that with so many small pieces making up the whole, the real risk is hard to sort out. As long as everyone believes the stuff backing these products is good, then it is good. When confidence starts to wane, it's a long tumble to the bottom because you can't accurately value the product that brought it all together—and you definitely can't sell it. The process snowballs as confidence wanes. I'll refrain from colorful language here, but let's just say "junk" is "junk," no matter how big a pile of it there is.

Some of your debt might have ended up in these CDO and CLO vehicles, which are the major cannonballs tied to the end of the financial daisy chain that dragged down the credit markets last summer. They're why the auction-rate debt market imploded, which, due to no fault of your own, caused your cost of debt to skyrocket from as little as 2% interest to as much as 20%, regardless of how good your credit is.

At one point, says Bob McCarrick, senior managing director of GE Healthcare Financial Services' corporate finance segment, about 70% of healthcare debt was bought by big institutional investors who didn't know really what they were buying and what the risk was to holding that debt. McCarrick preferred to stick to his knitting and offer debt to individual companies and institutions based on old-fashioned truisms like due diligence, his clients' business prospects, and their ability to pay back that debt. His business suffered in the easy credit era, but he's better off now because he actually holds that debt—he doesn't sell it off to be chopped up by a third party. Based on his experience, healthcare lending has hit a bottom, which in these times is a good thing. Institutional funds now make up only 20% of the market.

"We're in a more traditional bank and commercial finance market," he says--which is a nice way of saying that the party's over for CLOs and CDOs. Super-cheap debt for risky borrowers is gone, likely for good.

"What is the right risk premium to pay? That will correct over time," says McCarrick. "Will it come back to the levels of pre-June 2007? Probably not."

Ah, June 2007, the last of the salad days for cheap debt.

"We're more appropriately paid for the risk we're taking," McCarrick says. He's always seen some bad debt write-offs in his business, and that won't change, but he's betting his method will find more winners than losers. "Now you're seeing default rates increase, but our write-offs pale in comparison to what banks are taking. No one has been spared."

And what about you, the healthcare borrower? Well, you can still take on debt, but you're going to pay an appropriate risk premium for the privilege.

But think of the bright side. At least you're not running a financial company or bank.