The Great Deleveraging or Back to Basics?

I concur with most of what Finance Editor Philip Betbeze highlighted in his recent column, Healthcare, Meet The Great Deleveraging, but I believe the recent problems highlight a more important aspect of hospital finance. The real culprit is too much financial complexity. Too many healthcare executives took on very complex financial instruments and misunderstood all types of risk inherent in these complex financial products.

For the past 10 years, many not-for-profit hospitals and health systems were told everything should be done on a corporate model. Very complex debt structures with all of the bells and whistles became very common. Even small critical access hospitals were being told to use variable rate debt backed by a bank letter of credit and hedged with swaps.

Back in 1998 the Allegheny Health, Education and Research Foundation (AHERF) bond default was triggered by a weak debt security structure based on the corporate model and MBIA even insured it. The AHERF default temporarily raised a red flag that hospital executives and their finance officers should pay more attention to what they were buying. However, since that time, numerous products to tweak a few more basis points out of the market became the norm, even though conventional fixed rate financing rates were at historical lows from 2005 to 2007.

Products like auction-rate securities, a panoply of derivatives to hedge risk, and the use of third parties to guaranty creditworthiness, gave many hospital CEOs and CFOs a false sense of security that nothing "bad" could happen. Under such financially engineered products, the "real" creditworthiness of a hospital or system was hidden behind a curtain, and no one thought about the consequences. At least the majority ignored the long lists of risks detailed in the back of an appendix to the financing proposal.

Mr. Betbeze hit the nail on the head in talking about the great deleveraging, as even the big banks have had a wake-up call.

Now in order to be successful and prudent, healthcare executives must refocus on the simplicity of debt structures and the elimination of all kinds of risks from their financing. For example, they must focus on eliminating letter-of-credit renewal risk, swap termination risk, third party credit rating downgrade risk, and financial covenant risk. At the same time they must also refocus on their core operations and construct a strategy that includes quality initiatives, electronic health records, and physician integration.

"Back to basics" is an often overused phrase, but it definitely looks like that's what we're in for in the near future. That philosophy has been our basic view of good healthcare finance and our clients seem to be weathering the current storm very well.