By John Cheney and Grant Ostlund

Commercial banks are continuing to lend to not-for-profit and publicly-owned hospitals and healthcare systems by directly purchasing tax-exempt debt (with fixed or variable interest rates).

Over the past two calendar years, commercial banks have been a significant source of tax-exempt financing for healthcare organizations. Driven by an expanded definition of "bank-qualified debt" provided in the American Recovery and Reinvestment Act of 2009, commercial banks issued approximately $70 billion of direct tax-exempt loans in 2009 and 2010, according to The Bond Buyer.

See sidebar:History of Tax-Exempt Bank Loans  

The temporary debt provisions (i.e., $30 million bank-qualified and 2 percent de minimis exceptions) expired on December 31, 2010. Nonetheless, and somewhat surprisingly, many banks have continued to actively buy "non-bank qualified" tax-exempt debt issue on behalf of healthcare organizations.

This is a sample article from HFMA's subscription newsletter, Strategic Financial Planning, which helps senior financial leaders respond to reform and federal/state budget cuts, improve strategic planning, access and allocate capital, identify and respond to risk, and take advantage of growth opportunities.

Learn more and subscribe to Strategic Financial Planning.

Reasons for Continued Investment

While each individual bank has its own reasons for continued investment in tax-exempt debt, the following seem to be common themes in our discussions with many bankers.

Available capital. Currently banks have capital to lend, and investment grade-rated (BBB-or better) hospitals and health systems are credit-worthy lending opportunities. In today's weak economy, demand for bank lending in the private for-profit sector continues to be slow, and many organizations with debt needs are lower rated credits. Investment in BBB- and better rated healthcare credits is attractive to many banks since the demand is present and the creditworthiness of these organizations is generally acceptable.

Market risk reduction. For years, banks have issued letters and lines of credit in support of their qualified healthcare clients' tax-exempt variable rate demand bond issues (demand bonds). The majority of demand bonds are purchased by tax-exempt money market funds. During the financial market crisis in 2008, many bank letters and lines of credit were drawn on to purchase demand bonds tendered by money market funds as investors redeemed their shares. The draws forced many banks to purchase large amounts of tendered bonds at tremendous expense, while at the same time sharply increasing their healthcare clients' cost of borrowing. Consequently, banks prefer direct purchase of tax-exempt bonds to reduce their "contingent liquidity risk" created by letters and lines of credit for demand bonds.

Credit ratings. Many banks interested in extending credit to not-for-profit healthcare organizations no longer have sufficient long and/or short-term debt ratings to adequately support demand bonds in the market. Money market funds, the largest purchaser of demand bonds, will usually not invest in a demand bond if the supporting bank's long-term debt rating is below A and/or their short-term (liquidity) rating is less than P1. However, banks with insufficient ratings can still participant in the tax-exempt financing market by buying tax-exempt debt issued by their healthcare clients.

Low capital costs. Even though the bank's cost of carry is no longer deductible, the cost of carrying these securities remains extremely low. Interest rates on bank-purchased tax-exempt debt are still higher than most banks' cost of carrying them. Currently, the banks' benchmark borrowing rate (the Fed Funds rate) is just 0.25 percent. Additionally, many banks rely on customer deposits for funding loans, which can have a funding cost of zero. As a result, the banks still see a profit when lending money at tax-exempt interest rates to their clients.

Customer service. Direct debt purchases are an attractive alternative for healthcare clients when compared to other types of tax-exempt debt offerings. A public issuance of debt is time consuming and expensive when compared to debt placed directly with a bank. Additionally and importantly, when considering demand bonds, the banks' healthcare clients recognize the reduced risks of non-bank qualified debt, such as credit risk, put risk, and basis risk. To many banks, purchasing tax-exempt debt is providing a vital service to their customers.

Future availability of liquidity (Basel III). In the future, healthcare borrowers may be more reluctant to purchase or renew bank letters of credit because of impending bank industry regulation known as Basel III. Basel III is an international banking accord with rules that are set to take effect in January 2015 and be enforced in the United States by the Federal Reserve Bank.

Under Basel III, banks must set aside high-quality reserves, such as cash or U.S. Treasury securities, for 100 percent of their guarantee obligations such as letters of credit for tax-exempt debt issues. Banks are currently required to reserve much less for these same guarantees (typically, 10 percent). The higher cost of the bank reserve requirements is expected to reduce the availability of bank letters of credit and raise their annual costs significantly. By purchasing tax-exempt debt, instead of issuing supporting letters and lines of credit, the banks are limiting their exposure and their clients' exposure to the possible negative effects of Basel III.


The theoretical pricing of a non-bank qualified loan is relatively straight forward. The bank offers a loan at an interest rate that incorporates the tax-exempt status of the interest income, while covering its cost of capital and compensating itself for the risk it is undertaking to extend credit to a borrower. The risk compensation portion of the interest rate varies with the creditworthiness of the borrower and the length of time the loan is scheduled to remain outstanding (typically referred to as the "credit spread").

With bank-qualified debt, in addition to the tax-exempt interest component, 80 percent of its cost of capital is allowable as an expense deduction. The combination of the deduction and the exemption allows the banks to price the capital cost component of the interest rate at very aggressive levels. While the credit spread component is subject to individual banking analysis, the overall interest rate on bank-qualified debt is, in general, very competitive when compared to public debt issuance levels. In many cases (if not most) the pricing is more aggressive than for public debt issuance levels when the demand bond risk factors (such as put risk, credit risk, and basis risk), bond remarketing fees, and issuance costs are incorporated into the comparison.

The cost of capital for non-bank qualified debt is much more dynamic in today's marketplace. Not only is the bank's cost of capital no longer deductible as an expense but the exempt income portion may be considered an unknown since the profitability of many banks is at risk (what good is tax-exempt income if there is no income?). Additionally, many banks will reduce their interest rates in return for a client's deposit accounts or purchase of other bank services, thus compounding the factors affecting how a bank will price the debt.

As a result, pricing varies significantly from bank to bank for non-bank qualified tax-exempt debt. For example, on a variable rate bank qualified loan, it is typical to see a pricing formula with a capital cost component equal to 67 percent of one month LIBOR (plus the credit spread). For non-bank qualified debt, the percentage can vary from 67 percent to 90 percent of one month LIBOR. And, in the case of one bank, the credit spread will vary over time with changes in one month LIBOR! While each bank may have a different approach to pricing based on a different capital cost, non-bank qualified debt continues to be a viable and competitive alternative to public debt especially when the reduced levels of risk and lower issuance costs are considered.


Like other long-term, tax-exempt healthcare revenue bonds, bank-bought debt generally amortizes over long-term periods (20 to 30 years or possibly longer). However, the bank purchaser will require the right to demand that the borrower purchase the debt after a shorter period of time-that is, usually in five, seven, or 10 years. At the end of the agreed-on time period, the bank can accelerate principal or extend the financing to a new "put date" up to and including the maturity date of the debt. On the put date, the healthcare borrower can remarket the debt to another bank or a different type of investor, or refund them with a different bond offering, if the initial bank purchaser does not extend.

Bank-bought tax-exempt debt bearing interest at a variable rate is usually pre-payable without penalty at any time. Fixed rate debt is pre-payable either with a "make whole" provision at any time (similar to the structure present on taxable corporate bonds) or non-callable for a certain period of time with a "call premium" after the initial non-call period. Under the "make-whole" prepayment scenario, the borrower has the right to make a lump sum payment to redeem the debt derived from a formula based on the net present value of interest payments that will not be paid because of the call.

Banks can provide a draw-down feature for the debt proceeds-so that a healthcare borrower can obtain the borrowed funds from the bank as needed. This feature is not only convenient but can save a significant amount of money since the borrower does not have to reinvest the construction funds in short-term, low yielding investments during the construction period. (This also avoids capitalizing a portion of interest payments on the debt during the construction period.) Given today's unusually low reinvestment rates, the savings are usually quite significant.


Even though most bank-bought debt will be on "parity" with the borrower's other long-term debt (and, thus, share in the security interest in hospital revenues and any other pledged property), a bank will require a few of its own financial covenants and different events of default and default remedies compared to a traditional fixed-rate debt issue sold to the investing public. In some cases, these different default events and remedies can negatively affect bond ratings and should be considered. Any additional covenants will be similar in scope and level to the additional covenants found in the same bank's letters of credit and standby bond purchase agreements.

Many banks also expect that the healthcare borrower purchase non-credit banking services now or in the future. This new business requirement can make the financing more complicated, but often leads to the conclusion that a healthcare organization should be buying all or a portion of its non-credit banking services from a bank which "lends its balance sheet" in support.

Banks Still a Source

While it was disappointing to see the $30 million bank-qualified and 2 percent de minimis exceptions eliminated, not-for-profit healthcare organizations should not disregard the banks as a source of tax-exempt financing. Non-bank qualified debt is available at competitive interest rates particularly when risk exposure and issuance costs are incorporated into the decision formula.

John Cheney is managing director, Ponder & Company, Baltimore, Md., and a member of HFMA's Maryland chapter (

Grant Ostlund is managing director, Ponder & Company, Hawthorne, Fla. (

This article is reprinted with permission from a Ponder & Co. white paper, Tax-Exempt Bank Loans Still an Option. Questions about the report can be directed to Ken Downey, managing director, Ponder & Company, Brentwood, Tenn. ( 


See related sidebar:History of Tax-Exempt Bank Loans

Publication Date: Thursday, March 31, 2011