It seemed like a reasonable strategy at the time--getting the lowest possible interest rates on debt issuance by using auction-rate financing and by obtaining insurance backing to reassure investors. In fact, since 1984, when auction rate debt first emerged in tax-exempt hospital financings, the strategy has worked well. At auction, investors stepped up to purchase the insured debt in virtually every case. (In the course of two decades, only 13 auctions failed to place the debt offering). Hospitals benefited from lower rates, and investors felt relatively secure in their hospital bond holdings.
Along came the subprime mortgage frenzy, and hospital capital markets have been drawn directly into the eye of the storm. The connection between subprime mortgage lending and hospital tax-exempt bonds is not an intuitively obvious one. The connecting links include bond insurance companies such as FGIC and MBIA that also guaranteed mortgage-related securities and investors who fear that these insurers may not be able to cover the pending mortgage losses. The credit downgrades of FGIC (Financial Guaranty Insurance), XL Capital Assurance, and ACA Financial Guaranty (three of the handful of insurance providers for bond financings), along with the potential downgrade of MBIA and other insurers, leaves investors wondering what security these insurers really bring to tax-exempt bonds.
Perceiving higher risk, investors insist on higher returns, driving tax-exempt rates skyward or, in the extreme, resulting in no interested buyers at any reasonable interest rate. In the second half of 2007, for example, there were 31 failed auctions for auction-rate debt, according to Moody's. In mid-February 2008, the situation deteriorated with many more failed auctions and soaring rates. After a failed auction, the Port Authority of New York and New Jersey is now paying 20 percent on its auction-rate bonds where it used to pay 4 percent. The capital crunch facing the nation's banks as they struggle to cover mortgage write-downs also means that they are not an available resource to help stabilize the bond auction market.
Short term impact
As a result of the turbulent market, some hospital systems have seen the interest rates on their auction-rate debt soar from 2 percent to 3 percent to more than 10 percent in some auctions. This swing in rates has nothing to do with the underlying creditworthiness of the borrower, but rather with the state of the bond market. While the bond market may stabilize somewhat over coming months, the long-term high demand for capital in the hospital industry and the continuing liquidity pressure on financial institutions means that capital will be tight and tax-exempt interest rates are likely to be considerably higher than they were in the past few years.
What can hospitals do?
For hospitals and systems with insured auction-rate debt, there are several strategies to consider:
In addition to the financing strategies above, hospitals and hospital systems should consider the following lessons learned from this volatile marketplace: