In the October issue of hfm, Michael McCue of Virginia Commonwealth University and Julie Peterman of BB&T Capital Markets will examine the rise and fall of the auction-rate securities (ARS) market, the implications of the ARS market collapse for the hospital industry, and the alternatives available to CFOs seeking to finance capital projects.
This preview of the article highlights the factors that led to the ARS market’s collapse and the impact of that collapse on the hospital industry.
The ARS Market and Its Collapse
- ARSs, first introduced in 1988, became an important source of long-term financing for hospitals and healthcare systems over the past decade. From 2001 to 2007, there was a 350 percent total growth in par amount in ARSs issued by hospitals and healthcare systems.
- ARSs allowed the long-term financing of debt at short-term rates through the use of periodic auctions that reset interest rates at the end of each interest payment period (usually every seven, 28, or 35 days).
- Issuers of ARSs would purchase bond insurance to enhance the security of the bond, thereby lowering the overall interest rate. Early in 2008, bond insurers began to face credit rating downgrades because of their exposure to mortgage-backed securities. The deterioration of bond insurers’ credit caused a collapse in demand for ARSs and a significant increase in the interest rates on auction rate debt.
Impact of the ARS Market Collapse on the Hospital Industry
- Hospitals and healthcare systems can no longer economically justify the purchase of bond insurance. Turmoil within the subprime-related industry and related mortgage-backed security exposure caused the ratings of the bond insurers to decline below AAA and, in many instances, below the underlying ratings of hospitals and healthcare systems. Today, there is no bond insurer that has a triple-A rating from all three rating agencies. Even with bond insurance, many facilities in the hospital industry will be unable to achieve the highest credit rating and a lower cost of debt.
- Late in 2008, hospitals and healthcare systems started to return to the new-issue market and issued variable rate debt in lieu of ARS debt, typically with a letter-of-credit backing from a bank. However, it appears that this avenue also may be coming to an end. The costs associated with letters of credit have increased significantly, and the covenant restrictions necessary to garner the letters-of-credit wrapping have become stricter.
- Hospital systems will likely return to issuing fixed-rate debt. One negative consequence of this approach will be a higher cost of debt: Long-term rates for triple-B healthcare credits are 7 percent to 8 percent, as compared with 4.5 percent to 5.5 percent a couple of years ago.* Hospitals and healthcare systems also may be confronted with extended market conditions whereby the returns on their cash and long-term investments are lower than the cost of fixed-rate debt. Under these market conditions, hospitals and healthcare systems may need cash from their operating sources to cover their principal and interest payments.
In short, the combined effect of the collapse of the ARS market and the adverse conditions confronting financial guarantors will be an environment in which hospitals and healthcare systems face higher borrowing rates.
Look for the full copy of the article in the October issue of hfm to learn more about the impact of this environment on the hospital industry’s debt capacity, the ability of individual hospitals and healthcare systems to finance new capital projects, and alternative sources of funding available to CFOs.
* Shields, Y., “Health Care and Nothing But,” The Bond Buyer, June 23, 2009).