Hospitals' financial deals now liabilities

Low interest rates turn protective 'swaps' into losses

March 28, 2009|By Stephanie Desmon | Stephanie Desmon,

The complex financial arrangements that recently caused huge paper losses at Maryland's largest hospitals have been commonly used for years to protect them against big interest rate increases when they sell bonds to pay for construction projects and the like.

But volatile and highly unusual market conditions, including some of the steepest interest rate declines on record, quickly turned these supposed hedges into huge liabilities late last year.

On Thursday, the Maryland Hospital Association said 34 hospitals had total losses of $466 million in the fourth quarter of 2008. Many of the losses can be traced to these deals known as interest rate swaps. Health care operations, while being squeezed, are still in the black overall.

These reversals came at a time hospitals are suffering major losses from investments, people are putting off elective surgeries and others are unable to pay for treatment. "Many organizations find themselves ill prepared for the sudden drain on liquidity that swap liabilities can cause," according to a report by Moody's Investors Service's health care policy team last month.

"Interest rate swap" is one of many exotic financial terms that have gone Main Street in recent months as the economic crisis has spread from Wall Street. Hospitals aren't the only ones using these arrangements, which are common among not-for-profit borrowers. For the most part, institutions using them are not gambling, several experts said.

Simply put, a hospital, in this case, makes a financial contract with some other party to protect itself in case interest rate increases drive up the costs on variable-rate bonds it sells to investors. It promises to pay the other party a fixed rate of interest in exchange for getting a variable rate back. So if rates rise, the hospital's increased income from its part of the swap offsets the higher interest it has to pay on its bonds, and perhaps generates a gain.

But when interest rates plummeted last year in response to the recession, the hospitals were left paying far higher fixed rates on the swap contracts than they were getting back in variable rates.

In some cases, the contracts lost so much value that the hospitals were forced to quickly post cash for collateral.

"They're not speculative transactions - these were very mainstream, well-accepted mechanisms for funding legitimate capital projects," said Brad E. Spielman, a Moody's senior analyst. But, he added, "these are very extraordinary times. Where we are is off the charts in terms of what was expected" when hospitals signed these deals.

The Johns Hopkins Health System, for example, had $675.2 million worth of swap contracts outstanding at the end of 2008, according to its financial statements. Its contracts paid out fixed rates ranging from 3.3265 percent to 3.946 percent, but the other parties' interest rate was 67 percent of the one-month Libor, or London Interbank Offered Rate. On Friday, that rate was 0.52 percent.

As a result, Hopkins was forced to post $103.3 million in cash to offset the declining value of the swap agreements and take an accounting write-down of $152.4 million in the fourth quarter, leading to a loss of $134.5 million for the period. Hopkins officials could not be reached for comment.

The University of Maryland Medical System recorded a loss of $128.7 million in the fourth quarter and had to post $105.7 million in collateral. The system raised the money through a line of credit, Hank Franey, senior vice president and chief financial officer, said Friday.

He played down the losses - which led to the University of Maryland Medical Center losing 77 cents on every dollar of revenue in the fourth quarter of 2008 - saying, "We're not troubled by it at all.

"This is a financial instrument," Franey said. "If interest rates go up - and we are at unbelievably low rates - we in theory could have a $105 million asset.

"Other investors have used this as a speculative investment, trying to bet against what is going to happen with interest rates. We don't do that."

Franey's bigger concern right now is the sharp decline in the value of the medical system's investments. The system has counted on pumping $15 million to $20 million in interest income each year into its operating budgets.

"It's coming at a not-great time," said Ken Kaufman, managing partner at Kaufman Hall, Chicago-based financial advisers to hospitals, including some in Maryland. "For years, it worked fine. Hospitals saved lots and lots of money, not only in Maryland but around the country.

"You couldn't point to another period and say, 'Watch out for this,' because it had never happened before."

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