James W. Blake
Eric A. Jordahl
Andrew J. Majka

Amid today's capital markets volatility and uncertainty, healthcare borrowers need to pursue strategies to establish and defend an appropriate level of risk in the capital markets, given their available resources, risk tolerance, and credit position.

At a Glance

Given the likelihood that volatility and unexpected events will continue to challenge the capital markets, healthcare borrowers should implement the following strategic responses:

  • Protect the organization's credit rating.   
  • Identify and address organizationwide risk.   
  • Establish a global capital strategy for the hospital.  
  • Diversify debt and investments.  
  • Anticipate challenges in the banking market.  
  • Anticipate challenges in the municipal bond market.  
  • Fully integrate leasing into the organization's capital structure strategy.  
  • Ensure the solidity of the organization's financial plan and future strategies.  

Volatility and uncertainty in the capital markets, as experienced in recent years by borrowers and investors, continue to affect all hospitals and health systems. Although 2009 and 2010 generally provided adequate access to capital for credit worthy hospital borrowers in the municipal market-the primary source of tax-exempt debt for hospitals-concerns remain about the market's stability into the future. Fears about whether Greece, Portugal, and other sovereign nations might default slow the U.S. economic recovery, and the turmoil occurring in numerous Arab nations continues to send ripples through various markets. The concern is that yet another macrolevel shock could affect worldwide capital liquidity and rapidly create access and cost challenges for hospital borrowers in the bond and bank markets. In addition, significant focus on and fear regarding stressed U.S. municipalities have played a major role in the current volatility in the tax-exempt markets.

As a response to these circumstances, healthcare borrowers should consider pursuing eight strategies, described below, to establish and defend an appropriate level of organizational risks, given their available resources, risk tolerance, and credit position. To understand the basis for these recommended strategies, it is helpful first to look at key market issues occurring in 2009 and 2010.

2009 and 2010 Market Issues

The capital markets environment for healthcare organizations in 2009 and 2010, although experiencing some strong periods, was not as robust as the environment that existed before the credit crisis of 2007 to 2008. Overall, in 2009 and 2010, hospitals and health systems had more limited capital access, fewer options, higher costs, more restrictive terms, and less flexibility than in previous years. Healthcare borrowers had to contend with four key areas of concern, beyond the volatility and instability in the global markets, in 2009 and 2010:

  • The effect of fiscal and monetary actions
  • Uncertainty regarding the "new normal" in the municipal market
  • Turmoil in the municipal market
  • Lower borrowing in the bank market

(For a discussion of a fifth topic area, see "Changing Laws and Regulations Affecting Healthcare Borrowers.")

Effect of fiscal and monetary actions. The federal government continued taking aggressive fiscal steps to address the effect of the global crisis on the U.S. economy, enacting the American Recovery and Reinvestment Act (ARRA) in 2009. In particular, the Build America Bond (BAB) program, initiated through ARRA, allowed government entities to issue taxable bonds and receive a federal subsidy that would result in significant savings over traditional tax-exempt bonds.

The ensuing movement of new debt from the tax-exempt market into the taxable space lowered the supply of debt in the municipal market, thereby driving down interest rates. At the same time, capital was flowing into the municipal market, increasing demand to the benefit of hospitals. Another ARRA provision increased the limit for "bank-qualified" tax-exempt bonds to $30 million from $10 million, helping some not-for-profit healthcare organizations with limited borrowing needs to access capital through commercial banks.

The Federal Reserve (the Fed) continued to take aggressive monetary steps, which directly affected the market for U.S. Treasuries, off of which municipal bonds price. Throughout 2010, the Fed maintained the low federal funds rate of 0.25 percent, the goal of which was to make it cheaper for banks to borrow money and more attractive for them to make loans to businesses and individuals.

This usually powerful tool had only limited success in stimulating the economy, so by August 2010, the Fed signaled its intent to implement round two of its other major strategy-"quantitative easing." The New York Times describes this effort as follows:

The most usual approach [with quantitative easing] is large-scale purchases of debt. The effect is the same as printing money in vast quantities, but without ever turning on the printing presses. The Fed buys government or other bonds and writes down that it has done so-what is called "expanding the balance sheet." The [Fed] bank then makes that money available for banks to borrow, thereby expanding the amount of money sloshing around the economy, thereby, it hopes, reducing long-term interest rates.a  

In early November 2010, the Fed started "QE2," which will pump another $900 billion into the economy through the end of the third quarter of 2011, adding to the nearly $2 trillion in bonds and other assets during QE1. Although short-term borrowing rates have remained low because of the low Fed funds rate, the quantitative easing strategy hasn't consistently lowered long-term interest rates. Thirty-year Treasury yields rose in late 2010. The disappointing response may have reflected concerns about the long-term consequences of the strategy, particularly concerns about the value of the dollar and inflation. The upward trend in Treasury yields was seen in municipal bond pricing as well, with bond prices increasing significantly by year-end 2010.

Uncertainty regarding the "new normal" in the municipal market. The $2.9 trillion U.S. municipal bond market fared reasonably well for much of 2009 and 2010, before taking a deep slide at year-end 2010. For most of the year, generally lower Treasury yields (relative to yields in previous years) and volatility in the stock market increased investor interest in municipal debt and healthcare debt, in particular. Capital moved from the stock market to the bond markets and from money-market bond funds to intermediate and long-term funds during 2010. Retail (primarily individuals) and institutional buyers had cash to put to work and focused in on municipal bonds as providing an attractive risk-return opportunity.

Total municipal bond issuance reached a record high of $430.1 billion in 2010, while the taxable BAB program constituted 27.4 percent of the new issuances or $117.3 billion (Thomson Reuters, Municipal Review: Underwriters and Financial Advisors, Year End 2010). Despite the lingering effects of the credit crisis, and the ensuing recession, creditworthy healthcare organizations were able to access new money and address impaired or suboptimal capital structures for much of 2009 and 2010. Reflecting market uncertainty, higher capital costs, and an unusually high volume of long-term debt restructuring in 2009, hospitals and health systems issued less debt in 2010- $31 billion in bonds, down 47 percent from the $45.6 billion issued in 2009.

Eighty-seven percent of public hospital and health system bonds in 2010 were fixed-rate issuances. This high proportion reflects the fact that many organizations wanted to take risk off the table-specifically, risk of bank downgrades, interest-rate fluctuations, and nonrenewal present in variable-rate debt offerings. It also reflects the fact that an increasing amount of floating rate exposure occurred through direct bank placements rather than public offerings. (The 2008 credit crisis virtually eliminated the auction rate securities [ARS] market, forcing hospitals that had used ARS to scramble for replacement financings.)

Exhibit 1


All benchmark rates experienced near-historical lows for most of 2010. The BAB program had a positive effect on tax-exempt healthcare issuance throughout the year. Reduced tax-exempt municipal supply brought the benchmark index for municipal debt prices, the Municipal Market Data (MMD) index, to a lower level ("normalizing" it relative to Treasuries) and reduced credit spreads for higher-grade borrowers.

Healthcare credit spreads narrowed for much of the year, which meant that the difference in capital cost between higher-rated and lower-rated credits was not as great. Spreads generally correlate closely to overall market liquidity and risk perception. Consequently, low yields for most of the year allowed access to capital at historically favorable rates for healthcare borrowers across the credit spectrum.

Turmoil in the municipal market. In the final months of 2010, the municipal market experienced significant turmoil. From the beginning of November 2010 to the end of January 2011, investors withdrew approximately $34 billion from municipal-bond funds, while adding only $11 billion of new purchases, for a net total outflow of $23 billion.

Any combination (or all) of the following may have been causes of the net outflow:

  • Individual investors may have been starting to feel more comfortable about "re-risking" their portfolios by moving back into the equity markets or into other higher-risk/higher-return opportunities.
  • The negative press in late 2010 and early 2011 about possible defaults in the municipal market may have caused some investors to rethink risk versus return for tax-exempt debt and induced fear among others. Some influential market leaders commented that municipals may not be as safe as previously thought.
  • Inflationary concerns may have increased, thereby reducing the attractiveness of bonds.
  • The supply of tax-exempt offerings was expected to increase due to the fact that the BAB legislation was not renewed for 2011.

The effect on MMD was severe, with yields across the yield curve up 70 to 80 basis points. The municipal yield curve (like most fixed-income yield curves) got steeper as well and was at its steepest point ever in February 2011. Wider credit spreads across the curve, particularly for lower-rated credits, further increase the slope's steepness, so the "actual yield curve" for some hospitals is extraordinarily steep, making the cost of capital higher across maturity dates.

Exhibit 2


The fear factor related to the safety of municipal debt and the nonrenewal of the BAB program are large negatives for hospitals in 2011. Although fear could dissipate as rapidly as it emerged and investors could start differentiating healthcare bonds from those of troubled cities and states, the question going forward into 2011 is whether investors will return in sufficient strength and numbers to absorb the supply of new municipal debt sitting on the sidelines and forthcoming during the year.

Lower borrowing in the bank market. Bank capacity to make direct loans to hospitals and health systems improved in 2010, at least partly due to the availability of capital freed up when hospitals converted their variable-rate demand bonds (VRDBs) or variable-rate demand notes (VRDNs) to fixed-rate vehicles. Improvement also occurred as ARRA increased the limit for "bank-qualified" tax-exempt bonds, as described previously. (This limit has not been extended by Congress into 2011, which may have a dampening effect on some bank lending.)

Issuance of VRDBs by hospitals continued to decline during the year, despite exceptionally low floating rates. After experiencing the down side of risk with the ARS meltdown, hospitals continued to take "put risk" off the table. VRDBs are put bonds, which means they can be redeemed by bondholders for their full face value on any rate reset date (generally daily or weekly). Put exposure creates the potential for increased stress on an organization's balance sheet liquidity, and represents one of the most significant ongoing sources of capital structure risk. Many hospitals also chose to assume floating-rate exposure through direct bank placements rather than public VRDB offerings. The principal advantage of this approach is the elimination of week-to-week put risk, although renewal risk is retained.

Credit enhancement and liquidity were highly concentrated during 2009 and 2010, with a few banks providing the bulk of the issuances, including standby bond purchase agreements and letters of credit (LOCs). The strongest healthcare credits were better able to secure LOCs than those further down the credit curve.

Strategies for 2011

The fragility and volatility of the worldwide capital markets continue to be a concern. Also of concern is unexpected or developing stress across the banking sector or a significant default by a sovereign nation, municipality, or hospital. The most important thing hospital and health system executives can do at this point is to expect that volatility and unexpected events will occur, with all of the potentially damaging consequences. The following proactive set of strategic responses is highly recommended.

Protect the organization's credit rating. All healthcare executives should be focused on maintaining a strong credit rating. Boards and management teams should do everything they can to protect as high a bond rating as possible. The stronger the rating, the more alternatives and flexibility the organization will have to solve the many significant strategic and financial challenges going

Identify and address organizationwide risk. The confluence of current risks for healthcare organizations makes the stakes extremely high. The downside of any specific risk, singly or in combination with other risk sources, can come rapidly, leaving little to no response time.

Given the shifting business model for healthcare providers, in addition to the turmoil and risks mentioned above, enterprise risk management (ERM) has become critically important for the healthcare industry. Although the term means different things to different people, as used here, it refers to the methods and processes used by healthcare systems to manage risks and seize opportunities related to the achievement of their objectives and strategies. ERM includes an integrated strategic assessment of all organizational risks measured from a financial point of view, including strategic, operating, capital structure, and other forms or sources of risk. This article's authors firmly believe that ERM should be the responsibility of the CEO and the board; it is a strategic activity involving the entire organization. It also requires the disciplined use of both strategic and corporate finance tools, including integrated strategy, treasury, and financial planning, and scenario planning.

Establish a global capital strategy for the hospital. This strategy should include both assets and liabilities and their interrelationship, concrete parameters regarding where the hospital management team wants the organization to be on volatility and risk-reward spectrums, and metrics to gauge where it is on those spectrums. Part of this work requires developing an understanding of how the organization "values" risk and what it would be willing to pay to reduce risk ahead of different volatility scenarios. This information can then be used to set parameters for making final decisions and taking action.

It is important that hospital executives not only understand the moving parts of the organization's capital structure, but also know how they will respond to swings in different rates and relative relationships. They also should understand the current costs of holding onto positions in the hope or belief that volatility or market shifts will reduce the ultimate cost of "de-risking." This is hard and uncertain work, but it is the only way to make informed and effective decisions, including the decision to hold everything in place.

Make it a point to diversify. Diversification reduces risk and volatility associated with any one particular debt vehicle or investment. Choosing the mix of debt products and investments that best meets the hospital's overall capital structure strategy should be an ongoing high-priority task for leadership. Accomplishing this task requires a clear understanding of what products or tactics can be used to restructure risk and working closely with advisers to evaluate potential financing programs. There continue to be positive reasons for organizations to use derivatives or swaps to adjust debt mix in response to market changes so as to achieve risk-reward objectives over time.

Anticipate challenges in the municipal bond market. With the dip downward in the bond market at year-end 2010 and, as of this date, lacking the help of the BAB program going forward, healthcare borrowers should expect a challenging market in 2011. Market challenges have already been present in the fixed-rate market during January, February, and March of 2011. To build as large a distribution channel as possible for new fixed-rate bond issuances, hospitals and health systems will need to ensure that their bankers are marketing the bonds broadly and effectively to a wide investor base. Also, particular attention should be paid to obtaining security and covenant provisions that are consistent with market comparables. Lastly, with less demand for bonds, organizations should pay attention to market timing and the other transactions that may be competing (as additional bond supply) in the market at any given time.

Anticipate challenges in the banking market. Because banks may face difficult new liquidity and leverage requirements from Basel III regulations, hospital borrowers should evaluate each LOC or other credit provider to assess the likelihood of renewals or new capital loans over the next few years and start the renewal process of credit facilities as early as possible (JPMorgan Chase & Co., "Basel III Overview and Implications," November 2010). Diversification of banks, long repayment terms, and cash and/or reserve fund balances can mitigate nonrenewal risk (Moody's Investors Service, "U.S. Public Finance Borrowers Face Increasing Renewal Risk of Bank Facilities," Special Comment, Sept. 28, 2010). However, it should be noted that many bank lending agreements have provisions that allow banks to reprice the LOC or direct loan structure if future banking regulation cause an increase in cost to the bank.

Fully integrate leasing into the organization's capital structure strategy. Although use of leases as an alternative source of capital is entirely appropriate and effective in certain cases, the approach to leasing used by many organizations can and should change. Too often, healthcare providers are working without a well-defined strategy for how leasing as a source of financing should be managed or a clear picture of the impact of leasing activity on their balance sheet, credit, and financial performance.

Finance executives should spearhead an evaluation of current lease use and weigh use of leasing for qualified projects carefully against other funding alternatives. Review of debt covenants for possible violations and pre-emptive renegotiation of those covenants may also be necessary, given the pending potential accounting changes.

Ensure the solidity of the organization's financial plan and future strategies. All hospitals should model the possible impact of various volume, capacity, and payment scenarios resulting from healthcare reform and the new business model (see Kim, C., Majka, D., and Sussman, J., "Modeling the Impact of Healthcare Reform" hfm, January 2011). Detailed knowledge of the organization's capital position will be critical to strategic decision making going forward.

Allocating capital will involve thorough utilization and financial projections, with much more proactive "what-if analyses" on underlying variables and assumptions. A corporate orientation will be vitally important, and hospitals may wish to consider a "return-on-capital" approach to capital spending. Developing a strategic-financial approach to physician integration, IT, and service line distribution will be key. Dollars may need to be reallocated toward these areas and away from other initiatives and markets that do not position the hospital as a "must-have, high-value" provider.

No Time for Complacency

Given changes now occurring and on the horizon, the healthcare industry is experiencing a challenging time, making it not only a period of high urgency for the nation's healthcare executives, but also a period of great opportunity. In the capital markets, uncertainty and volatility are likely to prevail into the near term, if not longer. Notwithstanding a major source of market dislocation, healthcare demand and supply issues, in the very least, can be expected to significantly affect access to and cost of municipal bonds, LOCs, and direct loans into 2011 and beyond. For those guiding hospitals, focusing on the eight items outlined here will help to ensure that their organizations can pursue opportunities and enjoy a stronger strategic-financial future.

James W. Blake is managing director, Kaufman, Hall & Associates, Inc., Skokie, Ill. (blake@kaufmanhall.com).

Eric A. Jordahl is managing director, Kaufman, Hall & Associates, Inc., Skokie, Ill. (ejordahl@kaufmanhall.com).

Andrew J. Majka is managing director and COO, Kaufman, Hall & Associates, Inc., Skokie, Ill., and a member of HFMA's First Illinois Chapter (amajka@kaufmanhall.com).

a. " Quantitative Easing",The New York Tines, Updated Dec. 14, 2010, topics.nytimes.com/top/reference/timestopics/subjects/q/quantitative_easing/index.html

Publication Date: Friday, April 01, 2011

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