Carole J. Bolster

Healthcare financial leaders discuss the impact the crisis in the financial markets is having on hospitals' ability to access capital.


At a Glance

  • The crisis in the financial markets is having a major impact on hospitals' ability to access capital.
  • Providers are seeking longer-term fixed-rate debt rather than short-term debt.
  • Hospital management teams and their boards need to understand the upside and downside of variable-rate debt and interest rate derivatives.

hfm recently asked a few healthcare financial leaders what this crisis means for U.S. hospitals. Sharing their thoughts were:

  • John T. Bigalke, FHFMA, CPA, vice chairman and U.S. national industry leader, health sciences and government, Deloitte LLP, Orlando, Fla.
  • Lisa Goldstein, senior vice president/team leader, Moody's Investors Service, Public Finance Group/Health Care Team, New York, and a member of HFMA's Board of Directors
  • Claudia Gourdon, senior vice president, Healthcare Finance Group, New York
  • Catherine A. Jacobson, FHFMA, CPA, senior vice president of strategic planning and finance, CFO, and treasurer, Rush University Medical Center, Chicago, and Chairman-Elect of HFMA's Board of Directors
  • Kenneth Kaufman, managing partner, Kaufman, Hall & Associates, Skokie, Ill.
  • Ronald R. Long, FHFMA, CPA, executive vice president and CFO, Texas Health Resources, Arlington, Texas, and former Chairman of HFMA's Board of Directors.

hfm: Describe generally where you see the financial market difficulties affecting healthcare providers. Is it capital cost and availability, loss of investment return, higher cost of or inability to obtain insurance products, swings in operating cost trends from changing commodity costs, all of the above, none of the above?

John Bigalke: I start with the balance sheet approach, and I look at the asset side. The investment impact is going to be determined by the organization's risk tolerance, in both the kind of investments made and their duration. It's hard to generalize. On the investment side, everybody has taken a hit; how much of a hit will be dictated by the risk tolerance in their portfolio.

One other piece is that a lot of providers still have defined-benefit plans. The impact on the pension assets creates perhaps a reduction in the assets available, which increases the unfunded liability. Also, self-insured funds are going to have some investment portfolio impact. Actuaries will be challenged to come up with valuations and pension assumptions this year.

A third area that I'm most worried about is the impact on revenue. Rising unemployment is never a good thing for health care. It is going to create more uninsured people who are going to need care. Under economic pressure, employers will continue to modify their products to get consumers more engaged, and that may result in higher deductibles and copayments. Those copayments and deductibles are getting harder to collect. Also, states are having huge budget shortfalls. They're going to have to find some ways to cut, and I believe Medicaid is going to be part of that. And finally, we are seeing a slowdown in people's willingness to have elective procedures. Those procedures are profitable for the healthcare industry.

Claudia Gourdon: In general, the disruptions in the financial market can be characterized as a liquidity crisis and a reassessment of risk, which is translating into an increase in the cost of capital. Liquidity certainly is dried up, and the cost of the funds that are available has also gone up. In conjunction with the increase in the cost of capital, of course, is a decrease in any investment returns. And, by the way, donor contributions are declining as benefactors are also impacted by declines in the investment income. Insurance is becoming more costly, or, in some instances, unavailable, which is forcing providers to obtain funds based on their own credits rather than on any enhancements. And, certainly, there has been a huge compression in the amount of senior leverage available to borrowers. So, in summary, providers are having to deal directly with very skeptical lenders who themselves have much less flexibility and fewer funds to lend, and the cost and availability of capital is reflecting this new paradigm. There are also fewer lenders, and the concentration of funding sources is driving up the costs as well.

The changes in commodity prices will exacerbate difficulties, but the major portion of a provider's costs is really employee-related. On that front, while salaries and benefits continue upward pressure, it's actually possible that that pressure may be a little less intense right now in the short term as unemployment increases overall and providers find it easier to find staff and avoid using overtime and contract employees.

A potentially more important factor that comes to play on the cost side is the fact that patients are presenting later and sicker as they delay prevention or don't take earlier treatment. This puts pressure on the emergency departments, and that usually leads to an increase in the providers' costs.

But the larger problem for the providers' financial situation is on the revenue side. With the financial markets in turmoil, the economy in decline, and revenues at the payer level-the federal government, the state government, and the insurers-those revenues are declining. State health plans that rely on investment income are getting hurt. States face their own budget area problems and are reacting by reducing their payments to providers. They're delaying their committed Medicaid payments and their so-called charity care payments, and it's very unlikely that Medicaid payments in general are going to increase in this environment unless Congress does something special. Insurance companies are increasing their scrutiny on the claims that they receive, which also effectively delays payment. Then individuals, who are being required to make higher and higher copayments, are delaying or seeking to avoid payments altogether, because they are worried about their mortgages. So all of these delays in payments are translating into reduced revenues for the providers, and this is going to wreak havoc with their financial situations.

Catherine Jacobson: Currently, there is literally a freeze on the credit markets with no tax-exempt healthcare issues being done in more than three weeks. This is being driven by the lack of liquidity in buyers of municipal debt, most notably mutual funds and institutional buyers as they concentrate their holdings in cash and U.S. Treasuries. Once liquidity returns to the market, it is expected that buyers will return, but there has been a fear since February about the supply side. There are still a lot of building projects to finance, and some organizations are still trying to get out of their auction rate bonds. Even when the market returns (and I believe that it will), we will see higher cost due to the pent-up supply.

The times of low-cost debt and tight credit spreads are over. Health care, like much of the economy, has benefited from low-cost debt for a number of years now. Given the dynamics in the market and supply noted above, the cost is going to go up and stay up. In addition, credit spreads have widened significantly, which means that lower rated credits will be hit the hardest by this increase. Bond insurers are no longer a viable option, thus the underlying credit of the organization is how the debt will be priced. Finally, there has been a significant reduction in the means to issue lower cost variable rate debt. The bond insurers are nonexistent to provide credit enhancement, meaning that the only credit support available is through banks, and they are becoming much tighter with debt capacity. There are also fewer investment banking firms to do the remarketing. Finally, a whole market has almost evaporated with the collapse of the auction rate market. Again, like credit spreads, fewer organizations will be able to issue variable rate debt, which typically costs less over the long term. In the short term, because of the issues with auction rate bonds, bond insurers, and bank issues, variable interest rate costs have spiked very high on and off throughout 2008. I'd expect that to be reduced when the market shakes out and buyers return.

In terms of investments, hospitals and healthcare systems are required by the rating agencies and banks to keep a significant amount of cash on their balance sheets to offset their debt. Organizations then benefit by the investment returns to fund their operations and capital investment. This market has produced significant reductions in market value, and in some cases, actual investment income. The major issue will be the actual loss in cash from investment income (interest, dividends, and realized gains), as that will require organizations to reduce either expenses or capital to stay even. The market valuations don't impact cash, but they could impact debt covenant ratios (days cash on hand, debt service coverage ratios, and debt/cap ratios). Those invested more conservatively will be less affected by impact on cash, but there are significant market valuation reductions being taken even on bond funds.

A separate issue related to investments is defined-benefit pension plans. As asset returns decrease (and market valuations are included in this), organizations will be required to use more operating cash to fund their pension plans.

We've seen AIG go, and in addition to being an insurer, the firm was also a significant holder/buyer of municipal debt impacting the market dynamics noted above. Insurance companies are going to get hit hard with valuation adjustments to their investments, and like hospitals, insurance companies are required to hold large amounts of cash and investments to support their claim-paying ability. Organizations should be talking to their insurers about their financial situation. I think that this is the next shoe to fall. Even if the insurer stays in business, it will probably need to raise premiums to offset investment losses.

All of the above just compound the industry risk that we always face, especially considering that hospitals have little ability to impact reimbursement, particularly from governmental payers, who make up half of the payments to the industry. Add to that the fear of what the federal government will have to do to pay for the bailout plan, and the concern over Medicare becomes even bigger.

Ronald Long: Recent capital market events have resulted in increased difficulty for healthcare providers attempting to access the debt markets. The demise of municipal bond insurers has removed the ability of providers with A or lower ratings to access the markets at a lower cost of capital by utilizing bond insurance. Due to the recent flight to quality, these lower-rated providers may encounter difficulty selling their bonds at all, not to mention at yields that begin to approach historic averages, without bond insurance. The recent decline in bank balance sheet equity due to write-downs of mortgage securities, swaps, and increasing losses on loans has begun to limit the amount of reserves that banks are willing to commit to liquidity support for variable rate financing. Again, for lower-rated providers, access to this lower interest rate vehicle may not be available at all, and if it is, the yields on the bonds will exceed historic averages due to lack of bond insurance and higher bank liquidity fees. Finally, for those providers that historically used swaps as a way to manage interest rate risk, the required restructuring of underlying variable rate bonds, such as auction rate securities, will result in a mismatch of rates and reduce the effectiveness of the swap. This may also trigger mark to market treatment in the provider's financial statements due to this mismatch.

For those providers that maintain an exposure to equities in their investment portfolio, the recent decline in equity values may create a short-term funding issue for capital projects. This decline in investment values, together with possible restrictions of debt issuance may create an inability to pursue planned projects in the short to medium term. The decline in equity values will also create a current funding requirement and increasing liability for defined-benefit plans. This will be a repeat of the 2001-03 scenario during which providers suddenly struggled with the increased funding and expense recognition requirements of their defined-benefit plans.

Kenneth Kaufman: During the last two weeks of September and into early October, we witnessed unparalleled chaos in the world financial markets and attempts by the U.S. federal government and Congress to stabilize the situation. The news has gotten worse nearly every day. This bigger-than-ever-experienced crisis is certainly far bigger than health care. Hospitals and health systems, like all capital markets participants, have been severely affected. Beginning about mid-September, the market for tax-exempt healthcare bonds started to deteriorate rapidly. Short-term rates on variable-rate demand bonds (VRDBs)-the single remaining variable-rate vehicle available to hospitals and health systems following the demise of auction rate securities-skyrocketed to as high as 10 percent for daily resets. Many VRDBs have been tendered and have not been remarketed to new buyers, resulting in draws on bank loans for the liquidity. Rates for fixed-rate bonds have increased, and only smaller bond issues that can be sold to retail investors are "getting done."

By first days of October, 95 percent of the healthcare bond deals in the queue were "pulled" and the markets basically were not functioning for either long-term bonds or VRDBs. This results from the fact that investors, who normally purchase hospital bonds and other kinds of securities, are not at this point willing to invest their capital in these vehicles, but instead are putting their money in treasuries and cash. Safety of principal is now more important to them than yield.

Confidence in bond insurance as a form of credit enhancement is all but dead. Banks that remain in a strong position are offering lines and letters of credit, but the prices are steeper and the covenants are tougher. Some hospitals are still getting new credit; others are renewing existing credit. The situation is entirely bank-specific and hospital-specific.

hfm: On the debt side, we've seen a whole class of borrowing vehicles, the auction rate securities, disappear, but in a fairly orderly fashion. First, would you agree with that assessment? Second, what are the long-lasting impacts of this change in the provider financing market, specifically on rates and capital availability? Third, are there other borrowing options similar to auction rate securities that are at risk of disappearing?

Bigalke: Absence of this large pool of investment banks is creating a change in the dynamics of not only the auction rates, but also other short-term rollover instruments. There has to be some kind of a remarketing pool for any of these variable-rate debt instruments to continue to be marketed; otherwise, they risk being put back to the issuer. There was a short-term significant spike in the interest rates on some of these; some of them went up to 8 percent on short-term variable debt on tax-exempt hospitals. That has come back down, but it was a shock to the system. It disrupted the natural flow of some of the traditional investment mechanisms that needed to roll over where the auction rates were or where there were short-term variable issues.

As we move forward, there is still a backlog of some of the long-duration bonds that are ready to go to market. It's not so much that the credits aren't good; it's that the uncertainty is still there. Interest rates are hard to predict. There's probably some credit risk. Then add a bottleneck of liquidity, and if there is a need for any kind of a bank commitment or standby letters of credit or anything like that, it creates an environment of uncertainty so it's hard to get deals closed, or it is hard to get them closed on the terms and rates that you think make sense for the project. Right now the healthcare organizations with liquid balance sheets are going to be able to ride the market out, and they'll be able to move forward with the projects in due course. I think it will return to normal; the question is when.

Lisa Goldstein: Yes, the auction rate securities are being restructured. Is it in an orderly fashion? I think so. There was some panic early on, and hospitals are quickly but effectively navigating the choppy waters that auction rates represented back in February when they started to fail.

What we've seen is many providers that had auction rate securities quickly started talking to the commercial banks for liquidity, and many converted or refinanced their auction rates with variable rate products backed by a bank, so liquidity support for many came from a commercial bank. In our opinion, it actually has more risk than auction rate securities, because unlike auction rate securities, the variable rate debt has a tender or put risk, whereas the risk with auction rates was changes in interest rates, which we saw. Variable rate debt also has change-in-interest-rate risk, but it has put risk, too; i.e., the bonds could be put back to the bank or to the hospital for payment, whereas auction rate securities are traded among bondholders with no put risk.

So hospitals may have the benefits of a low interest cost in a better market, but we now have put risk. One structure is being replaced for another, and in a better market in both scenarios, the hospitals enjoy low-interest rates, but now we have risk associated with the commercial banks and put risk. Others are simply refinancing right into fixed rate. They're done with any type of short-term interest rate risk, and they just want to know what their interest rate is going to be for the next 30 years, say. But it seems like most are going into some type of variable rate product.

Gourdon: I'm going to take a more fundamental view. The auction rate securities and other short-term securities in general enabled providers to borrow short for long-term projects. So the yield curve for a very long time enabled providers to roll their debt at short-term rates. But "short term" was often still longer than the lenders were actually borrowing at and these imbalances are now readjusting. We saw short-term rates skyrocket on tax-exempt short-term bonds recently. Swaps are at almost 8 percent. So the short term is not going to be a place to get your funds right now if you're investing in a long-term capital project. The long-term impact is less leverage overall, certainly much less senior debt. We're seeing more subdebt available, but the rates are often so high that people are deciding to use equity. It's just not worth it to get the subdebt.

As far as other types of borrowings that are at risk, I think that very large undrawn, unsecured revolving lines of credit with extremely low nonutilization fees may be a thing of the past. Lenders need to get an adequate return. But other than that, the market is in such flux right now that it is hard to say that one type of security as opposed to another is going to disappear. The market is clearly shrinking. It is hard to say whether VRDBs will disappear. I would be surprised if this class of borrowings goes away entirely. Also, letters of credit are still a good fee-producing source of income for many lenders, so I think that they will remain, but perhaps in a somewhat different form.

Jacobson: Most of this is addressed above. The market was able to handle most of the auction rate restructuring, but there is still some out there, and the current market freeze is not helping those organizations. Even though VRDBs are getting battered right now in pricing, I do see these continuing as an option, but much more limited than in prior years. The only credit enhancement available will be a bank letter of credit or an organization's self-liquidity (available only to AA credits). Fewer organizations will be able to access variable rate debt.

Kaufman: I think we're more than halfway through the process of exiting the auction rate securities market, but the auction market turmoil paled as a problem during the last months, so I don't see any statistics on that anymore. Many hospitals and health systems experienced difficult and complex debt restructurings associated with exiting the auction rate securities market. New options were very costly for some, and it was an incredible amount of hard work on a lot of folks' parts. Capital market liquidity was available, allowing almost all the hospitals that wanted or needed to get out of auction rate securities to do so. There's still auction paper out there, but by and large, the vast majority of organizations that needed to restructure accomplished that job.

With the auction rate securities meltdown, the only variable-rate product available to hospitals and health systems is VRDBs. The tax-exempt money market funds, which usually are big buyers of VRDBs, are not participating in the VRDB market due to concern about redemptions from their holders. The impact on hospitals is this: VRDBs that are put back to the bank set at a different interest rate, which is defined by an agreement between the borrower hospital and the bank. If the bonds go unmarketed for some period of time, as defined in the specific bond documents, their amortization schedule changes, assuming typically a three- to five-year schedule. What this means is that an instrument, which formerly allowed the borrower to pay back debt over a 30-year period, may eventually require full payment within three to five years.

There are billions of healthcare VRDBs out there. We're still seeing renewals, and it's very choppy. Covenants are tougher and prices are obviously much more expensive, but for some hospitals that still need to get credit and get existing credit renewed, some of that is still happening. But you would not want to generalize about the situation. Right now, everybody's stunned about there not being a market. When the market is functioning again, a lot of people are probably going to want much more natural fixed-rate debt in their debt mix.

When debt capital can be obtained, higher costs are a likely reality. At the same time, the very significant decline in the stock market, particularly the 777-point drop on September 29, adds asset-side, balance-sheet stress to the liability-side stress already being experienced by hospitals and health systems. Depending upon individual hospital investments, income from cash, pension, and endowment portfolios is declining as the market drops. Clearly, both sides of the balance sheet are moving in the wrong direction simultaneously.

Long: I do not agree that auction rate securities have disappeared in an orderly fashion. Beginning in the Spring of 2008, investment banks that had sold billions of these securities with the unwritten promise that they would provide liquidity in the case of failed auctions suddenly, and without warning, stopped providing liquidity. Many providers were forced to react quickly to avoid paying outrageous interest costs, which in some cases exceeded 15 percent. There were no offers by the investment banks to help restructure these bonds by contributing services or helping to defray costs of new bond issuance. Instead, the explanations were based on the sudden financial difficulties of the investment banks. To be fair, not all investment banks acted this way, but it was clear that the providers were not the primary consideration.

The long-term impact of the auction rate debacle is the destruction of a multibillion-dollar market that allowed healthcare providers to access relatively inexpensive capital. Because of the current decrease in available bank liquidity support and the disappearance of bond insurers, together with the flight to quality, it is unlikely that all providers will be able to obtain replacement funding through the variable rate demand market. This will result in an overall increase in the cost of capital for the healthcare industry.

hfm: In September, Wellpoint reported a significant impact ($214 million write-down) in its investment portfolio from the write-down in value of Fannie Mae and Freddie Mac. Will others in the healthcare industry be feeling similar impacts in their investment holdings from declines in Fannie/Freddie, Bear Sterns, Lehman Brothers, AIG, and other financial market declines? What is the likely magnitude of the impact? Are there particular holdings/classes of holdings that would cause you serious concern?

Gourdon: Yes. Most providers tend to invest fairly broadly and relatively conservatively. But to the extent that Fannie and Freddie were considered conservative, they are being negatively impacted. It's also important to note that days cash is being more closely watched as a benchmark of financial strength. As providers try to increase that ratio, they're having to hold investments in instruments that essentially have almost no return or in fact no return. This is exacerbating the overall decline in investment income that the providers are seeing. Generally, I haven't seen providers invest directly in real estate, which is particularly at risk. It's hard to identify one investment that's an area of concern. And it's equally difficult to quantify the magnitude of the impact.

Jacobson: See the notes above regarding insurance companies. While it is fairly easy to find exposure to companies and asset classes in equities and in bond funds, it gets much more complex if you hold hedge funds. In addition, a "cash" fund may not actually be a "cash" fund. The most important thing to do is to go through all of your investments and find out what you really have in there and ask whether you are getting the return for the risk. I think that we will find many people moving to simpler, less complex types of investments. In addition, managers need to be looking at programs like securities lending, overnight sweep arrangements, etc. to make sure that they can get their money back after it has been lent out.

Long: In the case of Fannie Mae and Freddie Mac, we need to be clear that the exposure to write downs was for common and preferred stock. The senior debt and mortgage pass-through securities issued by these two organizations now carries the backing of the federal government, and holders of those securities actually saw an increase in market value as a result.

As for other financial holdings, both bonds and stocks, it would be prudent for providers to review the holdings of their fund managers to identify possible failing institutions. Fund managers should be questioned regarding their reasoning behind these holdings.

hfm: How are providers reacting to these changes in the financial markets? Are we seeing a move to simpler financial structures in both the borrowing and investment side? If so, is this being dictated by boards/management or by the market? Are capital projects being delayed or cancelled?

Goldstein: Capital projects are being delayed, in part because the markets are frozen and they can't issue the debt to get the money to start the projects. I haven't heard of any widespread cancellations of projects.

Gourdon: Many providers are prefunding whatever costs are coming up by drawing down on their existing line of credit. But they are also, if they can, lining up new facilities and taking down those funds, even if they don't immediately need them. The facilities that we're seeing are certainly less structured than they were before. I think that trend is being driven not only by the market, but also by the providers, who are more cautious. We're seeing quite a lot of interest in asset-backed lending, and we're seeing a lot of demand for lines of credit based on accounts receivable from a wide variety of different credit-quality providers. In other words, some of the better credit-quality providers are expressing interest in asset-based lending, which is not something that I've seen before.

As far as capital projects being delayed, I would say that if there is not a clear and present need, then the projects will be delayed. Of course, if the funds are not available, obviously that will also delay the projects. And everything is being carefully scrutinized. But things have not stopped. I'm aware of projects that are moving forward, much like a home construction project. If you had started, you might be more cautious and trade down on some of the fittings, but you're going to keep going and get it done.

Jacobson: At our own organization, we are preparing a contingency plan for capital deferral if we can't find operating cash flow sources to offset the impact that we have seen to date. In terms of debt structures, they are much more limited now, and they are simpler structures, so the market is driving people to simpler structures. In terms of investments, it is as noted in the response to the third question: Know what you have. I believe that you will have people exiting financial instruments (both debt and investments) when they assess the real risk against the returns. Depending on the organization, this is coming from both boards and management.

Long: I believe we are seeing a move to more fixed rate financing due to the difficulty involved in constructing variable rate financings. For providers who are not sophisticated or have lower ratings, this is probably appropriate. However, for those that can make variable rate issues still work, there is a significant interest cost differential, particularly if you view the bonds to be long-term issues. Boards and management teams that do not have large capital structures may view these savings as too insignificant to bother with the work it now takes to make them possible. But for those large health systems who stand to reduce their borrowing costs by millions of dollars each year, we will continue to see the use of variable rate structures, as long as banks are willing to provide liquidity support.

We will see projects being cancelled or delayed. There is no question that the combination of stock market losses and tighter bond markets will have an impact on most providers that are contemplating major projects. The exceptions may be those that had funds sequestered to build specific projects either through prior bond issuance or the set aside of liquid assets for that purpose.

hfm: We've seen a lot in the business press about the distinction between Wall Street and Main Street. Are you seeing that the non-money-center banks are also fairly conservative with their lending practices so that a hospital is able to go to its local bank and get a line of credit? Is that being affected?

Gourdon: Yes, everywhere, which is of tremendous concern. The smaller banks that have not had much of a change in their deposit base continue to be a viable and relatively less expensive source of capital for the providers, but the capital source is small in terms of the amount of money that is available. And to the extent that the local banks were investing in a variety of what have turned out to be risky instruments, they are being hurt. They are reducing the amount of leverage that they will make available, and restricting their borrowing.

Many other lenders say that they essentially shut down. They are meeting their current obligations, but they are not extending any new loans. That seems to be a fairly universal line that I'm hearing from big lenders and small lenders.

So, yes, it is hitting Main Street fairly directly, and my personal view is that it will continue. Most of these lines are for working capital. They are not going away, but they are certainly not increasing. As the providers' revenues decline, the need is increasing, so there is a squeeze. If you have the same amount of borrowing available, but you need more because you're getting less income, you have a problem. And, yes, the costs are going up everywhere.

hfm: What can providers do to insulate themselves from financial market risk?

Bigalke: On the debt side, of course, providers are trying to get a more predictable debt structure. They may be willing to pay higher rates, but they are trying to get to a point where there is a little more predictability, and that is clearly prudent at the right rates. Unless a lot of your short-term debt is being put, to the extent that you can take your time and gradually move it, that's a good thing. Providers should do cash flow forecasting-be realistic about what their cash flows are and try to come up with other sources of liquidity. They are having to be a little more creative and consider alternatives.

They should also try to get positioned with all the things that they feel they have the ability to defer, set themselves up for financing of different types so that when the bottleneck clears, they can be ready to hit the market. But in terms of trying to manage their investment risks, I would refer that to the financial managers to look at the portfolios one by one. I think it's going to become more the norm that organizations more closely align their portfolio strategy with their operational strategy. I am generally impressed with the investment management schemes of a number of systems. They are weathering this rather well compared with a lot of companies, because they have accumulated resources. Now is a good time to have a surplus. It allows providers to be stable and continue to provide the care that the communities need.

Goldstein: There are a lot of lessons learned from what's gone on in the past year. When not only the management team, but also the board, by way of the finance committees, entered into interest rate swaps with the auction rate securities or with the variable rate debt to create that synthetic hedge, there was a lot of focus on the upside about the savings, and there was probably little focus on the downside or the fine print. Certainly, nothing is guaranteed about these products. And now all the swaps are in negative value. When the auction rate structures failed and hospitals converted into variable rate structures, much of that decision was dictated by the fact that many hospitals had swaps outstanding. If they had terminated the swaps and gone to fixed rate, they would have had to pay the counterparty a lot of money.

The best thing hospital management teams and boards can do to insulate themselves from financial risk is to truly understand both the upside and the potential downside of variable rate debt and interest rate derivatives.

Same thing on the asset side. If you're going to invest in, let's say, hedge funds as an investment class, you need to understand both the upside, the return and the volatility, as well as the downside. So what's a downside? For example, many hedge funds have lockout periods. You cannot get your money when you ask for it, let's say within three or six months or perhaps a year from ask to receive. That becomes a liquidity issue. When you need the money the most, you probably won't be able to get it. Why? There'll be no liquidity in the market for the hedge fund to make a market to sell the securities to get to your money. Investors in hedge funds usually have even more money in fixed income or in equities, which are much more liquid than a hedge fund. We haven't quite seen that shoe drop to any magnitude. Some still have those kinds of investments. Many hospitals have appropriately re-examined their investment strategies and are taking the long-term approach.

Gourdon: Right now, all the providers that I'm aware of are looking to further cut their expenses, improve their operations, do whatever they can to obtain new lines, cut back on unneeded expansions, everything and anything that can be considered somewhat optional or doable. In general, they're going to need to find more secured lines of credit that they can use and realign their leverage to more conservative lines. Basically, providers have fairly high operational risk, and they need to offset that risk with a more conservative financial structure. To the extent they have gotten away from that fundamental situation, they're going to have to get back to it, and that will be painful. So we're going to go through a difficult time.

To the extent that the Emergency Economic Stabilization Act of 2008 and further government support change the philosophy and the psychology of the market, that will have a ripple effect throughout the system and will make lenders feel better, which will translate into making money a little bit more available at a little less cost. Maybe some of the interest rates will increase on some Treasury bond bills that you can invest in, so I think the act is important and will have a positive ripple effect, but I certainly don't think it is going to "fix" the situation if by fix you mean to bring us back to where we were. I think it may staunch the wound. One good thing that may happen-and this will become a big political issue-is more money will become available to the healthcare industry, in particular through Medicaid and Medicare. Supporting those programs may become an increasing political requirement, which will help providers going forward, and that would make a big difference.

Right now, we're in such a period of turmoil and change with the financial markets in complete uproar and the political situation in a period of great uncertainty that it's very hard to predict what's going to happen, and therefore very hard to know what to do to protect yourself. Those two things together-those uncertainties-are feeding on each other, making a difficult situation much worse than it would be if it was just one problem rather than both.

Jacobson: There is no way to insulate yourself completely except to not participate, and that is not an option for most hospitals that rely on debt and investments to make their organizations work. The best way to be prepared and limit the exposure is to know what you have and what the risks are and make sure that if you are taking the risks, you are being compensated for it.

Kaufman: Providers are in the same boat as all other borrowers. At this point, there's little hospitals can do to insulate themselves from the event risk playing out in the credit markets. Without a doubt, risks in the financial markets greatly exceeded most players' expectations. Will we return to markets with "normal" risk profiles, or do we permanently have much greater risk in the financial markets? When the markets start functioning again, each hospital and health system will need to make borrowing decisions based on its unique risk profile. This profile includes operating risk, interest rate risk, financing risk, project risk, event risk, and the interplay of these elements.

Long: A solid investment policy that is developed with outside expertise and takes into account the medium to long-term capital needs of the provider can go a long way to controlling short-term risk from stock market volatility. This requires a long-term approach to investing and must be balanced between long-term funds and short-term funds so that the investing time horizon is appropriate to the probable needs for the funds.

A balanced approach to variable-rate versus fixed-rate debt and the prudent use of swaps only in those situations where a match of interest rates can be accomplished can also be effective in reducing interest cost without a high risk of rate volatility or liquidity availability. However, the use of variable-rate debt should be approached cautiously by providers that fear they may not be able to maintain their ratings as they may find themselves in a situation where liquidity facilities are not available and the ability to issue replacement debt at a fixed rate is problematic due to their lower rating.


Carole J. Bolster is a senior editor in HFMA's Westchester, Ill., office.

Publication Date: Saturday, November 01, 2008

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