Swaps Backfire on Hospitals Firing Workers to Pay Wall Street
South County Hospital Chief Financial Officer Thomas Breen thought he’d seen the worst of the credit market’s seizure when the interest rate on $52 million of its debt doubled to 12 percent a year ago.
That was just the start. The Wakefield, Rhode Island, hospital has also been forced to give Merrill Lynch & Co. $12.7 million of collateral for an interest-rate swap that backfired. South County could have used those funds to counter a drop in state aid for treating uninsured patients, compensate for declining admissions or buy four years’ of orthopedic supplies. Instead, the facility is firing workers and cutting pay.
“We’ve been working extraordinarily hard to try to find a way out of this,” said Breen, who joined the hospital in 2007, a year after it bought the swap. “It’s threatening to the institution.”
South County is one of at least 500 nonprofits that entered into the derivatives with Wall Street in an effort to cut costs, according to Moody’s Investors Service. Instead of being able to take advantage of the lowest interest rates since Dwight D. Eisenhower was president, tax-exempt groups are getting hit with a double whammy of rising borrowing costs and demands for collateral from financing tools they didn’t understand.
While the federal government can borrow at near record low rates, the weekly Bond Buyer 20, which tracks yields on 20-year general obligation debt, rose to 5.03 percent as of March 12, from last year’s low of 4.52 percent in May and 4.03 percent in December 2006.
Negotiated Deals
The swaps are failing because borrowers didn’t anticipate that the value of the contracts, which often mature in 30 years, would tumble as central banks cut rates. The Federal Reserve reduced its target rate for overnight lending between banks to near zero percent in December, from 5.25 percent in 2007. Swaps are agreements to exchange interest payments, usually a fixed payment for one that varies based on an index.
Hospitals are losing on swaps that are a byproduct of so- called negotiated municipal debt sales, where state and local politicians and nonprofits decide in advance which banks will market the bonds instead of auctioning them to the underwriter who promises the lowest all-in borrowing cost to taxpayers.
The South County swap, which was negotiated, not only contributed to a $1.5 million operating loss in the last quarter of 2008, it also failed to hedge against the higher weekly interest on the auction-rate bonds it was tied to when the market collapsed in February 2007. That resulted in a $1 million increase in quarterly interest expense.
‘Major Headache’
“It’s another major headache,” said John Nelson, a Moody’s analyst. About one-third of the nonprofits tracked by the New York-based credit rating company have had to put up collateral, Nelson said.
South County’s costs are nowhere near the highest involving swaps. Vanderbilt University in Nashville, Tennessee, posted $190 million in collateral to banks on Feb. 28, according to Moody’s. The AA rated school sold $250 million in taxable notes in January in order to make the bank payment on $1.7 billion in swaps and replenish working capital, according to rating companies and financial reports it filed.
“We’re comfortable with the strategy we had,” said Betty Price, the chief financial officer at Vanderbilt. The school derives 64 percent of its revenue from the 600-bed Vanderbilt University Hospital as well as other medical facilities.
The University of Maryland Medical System in Baltimore gave its bankers $105.7 million in December. Robert Chrencik, the chief executive officer at the center didn’t return calls for comment.
Maryland Hospital System
The Maryland medical system consists of eight hospitals in and around Baltimore with a total of 1,809 beds. The complex reported a net loss of $224.2 million in the six months ended Dec. 31 after it posted $105.7 million in collateral for its swaps, according to a financial report from the nonprofit. The system had $610.1 million in swaps with Bank of America and JPMorgan Chase, according to Moody’s.
In a swap, parties agree to exchange interest payments, usually a fixed payment for one that varies based on an index. Borrowers may use the swaps to lower interest expenses or lock in rates for future bond sales. Swaps are private contracts, and the market for them isn’t regulated. In the municipal market, they are typically done in conjunction with negotiated bond offerings.
Negotiated Costs
Last year, states, cities and nonprofits sold $391.5 billion in long-term bonds, according to Thomson Reuters. Of that total, 86 percent was negotiated and the rest was opened to competitive bids. As recently as 1970, municipalities made securities firms bid for the majority of sales.
Underwriters have promoted negotiated deals, saying they can get the best prices for taxpayers by tailoring the debt to investor demand.
Competitive sales saved issuers 17 to 48 basis points, “on average and all else equal,” according to a study published in the Winter 2008 issue of the Municipal Finance Journal. A basis point is 0.01 percentage point. On $100 million of debt, the savings mean $1.7 million to $4.8 million less interest over the life of a 10-year security.
Losses on swaps couldn’t come at a worse time for hospitals, said Caroline Steinberg, an analyst at the Washington-based American Hospital Association. The investment income the nonprofits use to subsidize their operations fell $831.5 million in the third quarter last year while more patients without insurance seek care as unemployment rises, she said.
Credit Freeze
The freeze in credit markets triggered by the meltdown of subprime mortgages in 2007 increased interest expenses at hospitals 15 percent in the third quarter, the American Hospital Association found. Of the 430 hospitals Thomson Reuters tracks, half posted operating losses in that period, according to a March 2 report.
South County fired 20 people from its non-medical staff, cut top management pay by a combined $100,000 and sold securities from its endowment at a discount to raise cash for the Merrill Lynch payment, Breen said.
The amount of collateral changes from week to week with interest indexes, Breen said. It reached a high of $12.7 million in December and totaled $8.9 million last week, he said.
William Halldin, a spokesman for Merrill Lynch, which was acquired by Charlotte, North Carolina-based Bank of America Corp. last year, declined to comment.
“Most organizations don’t have that big of a cash pool that they can sustain that substantial a draw on their liquidity,” said Johan Rosenberg, president of DerivActiv LLC, an Eden Prairie, Minnesota-based company that values and monitors swaps for borrowers.
Standard Feature
So-called collateral postings are a standard feature in contracts in the $400 trillion interest-rate swap market, Rosenberg said. Swaps are derivatives, or contracts whose value is tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.
The amount of collateral depends on the value of the swap. When long-term market indexes fall, so does the value of fixed- rate swaps, which can trigger requirements to put up more cash, he said.
Most swaps in the municipal market are pegged to the London interbank offered rate, or Libor. The 20-year index tied to Libor fell to a record low of 2.44 percent in December from 5.2 percent in June, according to Bloomberg data. Libor dropped as low as 1.08 percent on Jan. 14 and has since risen to 1.30 percent. Libor is used to calculate rates on $360 trillion of financial products worldwide, according to the Bank for International Settlements in Basel, Switzerland.
Corporate Postings
Nonprofits post more collateral than corporations because swaps in the municipal market stretch over 30 years while the agreements in the taxable market last fewer than 10, Rosenberg said. Cities and states that use swaps typically aren’t required to post collateral, he said.
South County got into the swap when it agreed to pay an annual fixed rate of 3.52 percent to Merrill Lynch for 30 years after it sold $52 million in auction-rate securities, or debt with interest that resets at periodic bidding every 7, 28 or 35 days.
The average rate for a comparable fixed-rate hospital bond at the time was 4.5 percent, according to Bloomberg data. The hospital gets 67 percent of one-month Libor from the bank to cover the cost of the auction-rate bonds, which reset weekly.
Imploding Market
The $330 billion auction-rate market imploded a year ago when underwriters stopped stepping in as buyers of last resort as demand for the securities fell. Thousands of auctions failed, including those for South County, which resulted in rates on its bonds costing as much as 12 percent.
The hospital, which is rated Baa3 with a “negative” outlook by Moody’s, hired New York-based Oppenheimer & Co. in an effort to restructure its debt, Breen said. Replacing the bonds would be even more expensive now. The average yield on 20-year fixed rate hospital bonds was 6.75 percent on March 17, up from 5.24 percent on May 22, according to Bloomberg data.
“It’s one indignity on top of another,” said Andy Majka, a partner at Skokie, Illinois-based Kaufman, Hall & Associates, a financial adviser to nonprofit hospitals. “That’s just been the story in the capital markets in the past 12 months; you think you get the bottom and another thing comes up.”
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Jim |
