An HFMA Healthcare Financial Pulse Resource
by Michael Dowding
As detailed in an April 2009 report from Moody’s Investors Service, the rating agency is paying special attention to six critical factors when determining how not-for-profit hospitals are holding up during the current economic downturn—and whether credit rating changes are warranted.
The critical factors include four credit risks:
- Weaker market demand and declining cash flow margins
- Investment losses and weaker balance sheets
- Debt structure and liquidity stress
- Market access problems
In addition, Moody’s is assessing two risk mitigants:
- Management and governance actions
- Federal government stimulus
How can hospitals avoid rating downgrades under the revised surveillance criteria? Lisa Goldstein, senior vice president, Moody’s Investors Service provides some tips in the following Q&A.
From your perspective, what should be on the radar for financial executives?
Goldstein: Perhaps the most pragmatic issue today is that weaker demand from patients is pressuring cash flow margins. We’re hearing of patients self-rationing and delaying elective care, which contributes to softer volume growth, and even some actual declines in admissions and surgeries.
The employment picture is also shifting the patient mix to a greater number of self-pay and Medicaid-eligible patients. That’s stretching collections and increasing write-offs for bad debts.
We anticipate that 2009 will be soft for nearly all providers, and it is still unclear when the economic outlook will improve.
What other trends are affecting hospital financials today?
Goldstein: Investment losses are weakening balance sheets. Hospitals are facing sharp declines in wealth and liquidity because most hospitals now invest a meaningful portion of their unrestricted cash and investments in equities, with a growing number investing in alternative investments (for example, private equity or hedge funds).
While an equity-based portfolio might yield higher risk-adjusted returns over the long run, the current losses seem especially abrupt and unexpected, coming at a time when there’s a sharply increased need for immediate cash liquidity.
What’s more, hospitals with defined benefit pension plans will require significantly higher funding as asset value has declined materially, creating yet another demand on liquidity.
Tell us how debt financing has changed in recent months.
Goldstein: Without question, a reduced level of confidence from bond investors and the cost and scarcity of bank liquidity are creating major liquidity challenges. One need only look at the unprecedented collapse of the auction rate market in early 2008 and the spike in short-term interest rates in late 2008 to see the risks of variable rate debt.
Most bank liquidity facilities have a days-cash-on-hand test or rate-coverage requirements measured at least once during a fiscal year. Failure to meet these tests is an event of default in most bank documents. Upon breaching a covenant, the bank can declare an event of default, give notice of a mandatory tender, and require immediate repayment by the hospital—which can easily wipe out all or a large portion of a hospital’s cash, leaving no liquidity for the fixed rate bondholders. Hospitals that have limited headroom to bank covenants may face rating or outlook pressure.
When will hospitals be able to access the capital they need?
Goldstein: Until recently, investment-grade hospitals in all categories could always access the tax-exempt bond market. Recently, however, some lower-rated hospitals are unable to access that market. Higher-rated hospitals will likely have continued access, but rates may be higher and spreads will be wider. Until access returns, some institutions and systems may have to increase their use of capital or operating leases or pull back on capital spending.
What steps are healthcare systems taking to mitigate the difficulties that you are observing?
Goldstein: Many hospitals are stabilizing the income statement. That means instituting operational improvement plans, such as improving labor or the supply chain. Hospitals are looking at every department to find opportunities to reduce expenses or improve revenue.
Also, many hospitals are stabilizing the balance sheet and are in “liquidity preservation” mode. Many hospitals are reducing their capital spending and putting various capital projects on hold—some are even changing their capital plans entirely. Now, they’re not cutting back on essentials, like quality, safety, or IT-related investments—that continues. Many hospitals are also moving out of variable-rate debt and into safer fixed rate debt.
How else can hospitals improve their creditworthiness? What are agencies like Moody’s watching?
Goldstein: It’s really about governance and agility in the boardroom. Decisive management action to avoid looming financial problems and implement immediate corrective strategies is a strong factor in avoiding rating downgrades. Management and governance has always been viewed as an essential element of rating analysis.
Well-managed hospitals swiftly execute operational, liquidity, and capital strategies—with full board support—even if economic troubles haven’t materialized. They “get ready” for what other hospitals have already experienced. For instance, some hospitals are considering changes to defined-benefit pension plans, including conversion to defined-contribution plans. They’re recognizing that they face much higher funding levels over the next couple of years, which is yet another demand on liquidity.
Liquidity preservation is a common strategy right now—and that can involve a few key strategies. We are observing many hospitals securing operating lines of credit from local commercial banks. Those can be very handy for working capital needs. Others are revisiting their asset allocation, moving away from riskier investment strategies, removing some of the variable-rate risk on the liability side, and reducing heavy exposure to one or a few commercial banks. Some hospitals are also terminating interest rate swaps—even if that requires a termination payment.
Will the federal fiscal stimulus plan meaningfully help hospitals and health systems?
Goldstein: Without question, the federal stimulus plan will have a positive impact on hospitals over the short term. There will be more than $87 billion in additional Medicaid funding for states to deploy. This will help many hospitals, especially those with high Medicaid exposure, such as safety net hospitals, academic medical centers, and children’s hospitals.
Another $40 billion will go to extended COBRA coverage for unemployed people. That will help lower some of the bad debt from self-pay patients. We’re also expecting to see funding for electronic medical records initiatives.
Over the longer term, the picture isn’t as clear. The President’s promise to cover 47 million uninsured people is a bold agenda but the funding is yet to be determined. We might see reduced Medicare reimbursements to help fund that, and commercial payers might be asked to contribute as well. That could translate into lower reimbursements per procedure, which will create more financial strain.
For more on this topic, see Moody's list of warning signs that would likely trigger a rating review.
Michael Dowding of Wordscape Communications is a freelance writer based in Millis, Mass.