As reported in HFMA’s Weekly News on Sept. 19, a spike in the overnight London interbank offered rate (LIBOR) on Tuesday night (Sept. 16) was said by The Wall Street Journal to be the largest on record. Central banks at home and abroad responded Wednesday with an infusion of $200 billion to try to unfreeze bank lending, and the overnight rate fell. The three-month LIBOR remains high, however, and was only slightly affected by the central banks’ actions.
To find out how turmoil in the credit markets might affect healthcare providers, we sat down with Richard Clarke, HFMA president and CEO; Randy Fuller, HFMA director of thought leadership; and Catherine Jacobson, senior vice president of strategic planning and finance, CFO, and treasurer at Rush University Medical Center, Chicago, and chairman-elect of the HFMA Board of Trustees.
1. If LIBOR remains at a high rate, how will credit markets be affected? How might that affect access to capital for healthcare providers?
Richard Clarke: Access will be limited or in some cases not available at all. This couldn’t come at a worse time, as many providers were still trying to restructure out of auction-rate securities (ARS) with variable rate demand bonds (VRDBs), which often require a liquidity feature such as a bank letter of credit (LOC). Banks increasingly aren’t issuing those or are charging very high rates. Default rates on ARS and VRDBs and pricing of LOCs often are based on LIBOR. All of this indicates an increase (maybe substantial) in interest cost. Also, with limited access to LOCs there is a renewal risk for those with LOCs whose term is expiring—debt may be put back to the provider or bought by an investment bank (which is increasingly unlikely). The default rate on these bonds often is LIBOR. This could foretell an increased default on bonds—which in the past has been very unusual.
Finally, all of this mess is risking interest rate swaps—synthetic methods to convert variable debt to fixed or vice versa. These swaps use counterparties such as investment banks or insurance companies. There is concern about the liquidity of counterparties—hence the rescue of Bear Stearns. The book value of these swaps is negatively impacted by volatile interest rates, causing further write-downs by providers and their counterparties. Failures of swaps could require substantial cash from providers to unwind them.
Randy Fuller: This move in the LIBOR overnight and three-month rates is indicative of a dramatic, short-term flight to safety with funds flowing out of investments with higher perceived risk and into safer investments like Treasuries. The flight to quality is having a significant negative impact on many credit markets, including the municipal bond markets that most not-for-profit providers rely on for large project financing. In recent days we’ve seen the municipal bond market essentially freeze due to lack of investor interest, and borrowers have withdrawn their issues. The likely ramification of all of these market movements is that we will see wider risk-based rate spreads being re-established in the capital markets. While all borrowers are likely to see higher borrowing costs than they have for the past three to four years, borrowers with lower ratings will face much higher borrowing costs, if they can find capital at all. BBB- healthcare borrowers are already seeing borrowing costs 100 basis points higher than AA+ borrowers and the gap appears to be widening. This appears to be a return to the baseline risk pricing pattern seen in the years following the AHERF bankruptcy, when the credit spread between AA+ and BBB- borrowers was 150 basis points.
Catherine Jacobson: From the provider’s perspective, an elevated LIBOR would have two main effects. First, if you are in the swap market, a rise in the three-month LIBOR might work to your advantage if you have variable-to-fixed swaps. There have been persistent dislocations in the LIBOR-SIFMA spread, with LIBOR at an unnaturally low rate. As LIBOR rises, you should get more money from your variable-to-fixed swaps. If you have fixed-to-variable swaps, the effect will be the opposite.
Second, if you use taxable lines of credit for working capital, a low LIBOR has been good. As LIBOR rises, you will take a hit on draws on the lines of credit. Still, even at the current LIBOR, taxable lines of credit have a lower capital cost than you could pay right now in the variable tax-exempt market.
As for accessibility to capital, you generally can’t get any LIBOR-based capital right now unless you have A-rated credit. Your underlying credit rating is much more important than LIBOR for access.
2. Many healthcare providers already encountered credit problems when the auction-rate securities market failed earlier this year. If variable rate debt also comes under pressure, what other financing structures are available for providers looking to raise capital?
Clarke: Shifting out of the variable market and going fixed rate is a main strategy, especially for providers with strong credit ratings. That reduces exposure to short-term liquidity concerns and the need for LOCs. The problem for providers with weaker credit ratings is to obtain credit enhancements to improve ratings—there is very little high-quality capacity left with bond insurers and banks. And in the short term, investors are fleeing to short-term high-quality investments (U.S. Treasuries), which works against a reasonable market for fixed-rate debt. Again, interest rates will increase. For those who can’t restructure, the future is bleak in the short term. In some markets, taxable alternatives are possible if the hospital has a positive relationship with banks. But generally, a hospital should be very worried about both interest rate hikes and “put risk”—that is, having to pay off the face value of the bonds because of a failure to provide a liquidity vehicle such as a LOC. Most providers don’t have that much available liquid cash, as explained below.
Fuller: I think we will see borrowers moving toward simpler fixed-rate structures as a result of the lessons learned over the past few months. Variable-to-fixed-rate swaps expose the borrower to risk due to the status of the party providing credit enhancements and counterparty risk. The current environment makes it difficult to see exactly what other credit options might exist as rising rates and the lack of credit enhancements make variable rate debt instruments unattractive. Certainly there have been a number of commercial credit and real estate companies active in providing alternatives to the municipal bond market over the past several years. The key here will be to see what pricing looks like for these alternatives once the credit markets settle down. Most of these companies will be facing shifting cost of funds and loss of active capital market investors to enhance their yields, so pricing for alternative products could change significantly.
Jacobson: For tax-exempt organizations, two options remain. First are VRDBs with a bank LOC, which are generally available right now only to A-rated organizations. The second are fixed-rated, uninsured bonds, which again will require you to go on your own credit rating. A possible bright note is that municipal tax-exempt bonds have generally been seen as a stable investment source. Municipal bonds may well look attractive to investors returning to the market.
Providers with VRDBs based on a LOC should be paying attention to the LOC expiration date. Credit rating agencies are also putting much more attention on providers’ put risk and liquidity.
3. Healthcare companies have also encountered risk on the investment side. For example, Wellpoint recently reported a $214 million write-down in the value of Freddie Mac and Fannie Mae shares in its portfolio. How might healthcare companies be affected by this week’s collapse of Lehman Brothers, the sale of Merrill Lynch, and the government takeover of AIG?
Clarke: Overall, investment portfolios are taking a beating. Before this week, the Dow was down almost 15 percent this calendar year, and it’s even worse now. Most providers are diversified outside of just the domestic financial sectors, and some have hedge funds that compensate somewhat. But with the whole market in turmoil, significant write-downs are likely. There is also some concern about bond covenants that require debt or capitalization to equity (net assets) to be maintained at a certain level. With the write-down of an investment portfolio, equity drops. Finally, there are liquidity concerns with mutual funds as providers attempt to redeem their investments in funds.
Fuller: With the value of virtually every investment category down significantly over the past year, I would expect that provider portfolios and investment income will have declined sharply. With nonoperating income representing a significant portion of many healthcare providers’ margins, the industry may well see moves to more aggressive cost cutting to shore up sagging bottom lines.
Jacobson: Providers simply have to know what they have in their investment portfolios. A big question is mutual funds—do you know where they have invested? Also, if you have been doing overnight securities lending, you will want to be comfortable with the safety of those loans and the collateral. My own organization has learned that diversification has paid off immensely in spreading risk.
As for the takeover of AIG--AIG held hundreds of millions in municipal debt. If AIG had been allowed to go bankrupt, this debt would have had to have been liquidated and very well could have overwhelmed the municipal bond market.
