In the heart of Times Square, a "national debt clock" ticks off America's mounting deficit a penny at a time. Uncle Sam's tab exceeded $5.1 trillion on May 30, or about $19,500 per person.
If bondholders were to erect a similar tote board for tax-exempt healthcare debt, it would read $115 billion, according to a fall 1993 study by Christopher Conley, a senior vice president with the Stamford, Conn., office of Tucker Anthony, a Boston-based regional investment banking firm. The study, from the database of Baltimore-based HCIA, a healthcare information company, is the latest assessment of healthcare debt outstanding.
Based on subsequent debt repayments and new bond sales, Conley believes the total outstanding debt has remained constant, and he estimates that acute-care hospitals are responsible for a good $100 billion of it. That's $110,000 for each of the 902,000 staffed beds in the nation.
Proposals to shrink the national debt have roused furious debate in Washington. But scarcely an eyebrow has been raised over the prospect of future defaults on hospitals' heap of debt. Industry consolidation seems to have calmed fears of massive financial unrest.
More than half of all outstanding tax-exempt healthcare debt is "unenhanced," meaning it carries no commercial bond insurance or other guarantees of repayment by private or governmental sources, said Steven Renn, first vice president and portfolio manager at AMBAC, a New York-based financial services company that provides bond insurance. About
$5 billion to $10 billion of the unenhanced portion represents riskier, speculative-grade issues, otherwise known as junk bonds, he said.
Bond issuers and underwriters fully expect a number of weaker hospitals to fold under the pressure of increased managed-care penetration and competition for patients. Financially troubled hospitals in overbedded markets are extremely vulnerable. A number of hospitals have been passed over as potential merger partners because of their debt load, bond counsels and underwriters said.
So why aren't buyers and insurers of healthcare bonds losing sleep over the industry's indebtedness?
"The healthcare industry is arguably in the best financial position it's ever been in," said Glenn N. Wagner, a principal and director of municipal research at Morgan Stanley & Co., a New York-based investment banking firm. A lot of well-managed providers have anticipated the changes affecting the industry today, he said.
No doubt some of the frailer providers will succumb to the storm. But there are enough happy endings to sustain people's optimism.
By one barometer-the rise and fall of credit ratings-the healthcare industry appears to be gaining strength. In 1995, Standard & Poor's Corp., a New York-based rating agency, raised 63 healthcare ratings on $2.4 billion of debt and lowered 55 ratings on issues worth $1.9 billion. It was the first time in a decade that upgrades outpaced downgrades.
Because of the pace of change, healthcare is still the most volatile sector of the municipal bond market. But the number of "positive" credit outlooks assigned by Standard & Poor's now exceeds "negative" outlooks by 2 to 1, a sign that credit quality is stabilizing.
Fears ease in Massachusetts. One state's experience shows that worries of fiscal calamity have eased substantially in recent months. Less than two years have lapsed since the Massachusetts Business Roundtable convened a special meeting to assess debt situation of the state's hospitals. Seeing $4 billion of outstanding debt and declining inpatient census, business leaders demanded to know how not-for-profit healthcare providers in the Bay State expected to meet their obligations and raise additional capital for future needs.
While the issue remains a long-term concern, it has dropped from business leaders' immediate agenda. Alan MacDonald, the coalition's executive director, says he's optimistic that hospitals in the state are adequately addressing the problem based on mergers and system formation initiatives he sees sprouting across the state.
Indeed, in a May 1995 report, Moody's Investors Service, New York, said Massachusetts hospitals' year-to-year financial performance improved for the first time since 1992. The 1995 results reflect major cost reductions achieved through staff restructuring and layoffs, Moody's said. As a result, the agency raised ratings on three credits and confirmed 22.
While the financial performance of most Bay State hospitals appear to be improving, Moody's also lowered ratings on five hospitals. Three of the downgrades reflected "weakened financial performance and liquidity position in a changing market." Ratings for Sisters of Providence Health System in Springfield and Holyoke (Mass.) Hospital were lowered partly due to their failed merger attempt.
Failed mergers have been frequent occurrences across the country recently, but they pale in comparison with the volume of mergers and acquisitions that have been completed. In 1995, 735 hospitals were involved in mergers and acquisitions, a 9%increase from the prior year (Dec. 18/25, 1995, p. 43).
"As the industry consolidates, a couple of things are happening. One is debt is begin assumed at the system level," said Edward M. Murphy, senior vice president of public finance at Tucker Anthony.
For example, after Cooley Dickinson Hospital in Northampton, Mass., joined the Lebanon, N.H.-based Hitchcock Alliance in October 1993, Cooley's $39 million of debt became an obligation of the participants in the stronger Hitchcock Alliance. Systems generally wield more clout with payers and can operate more efficiently than individual institutions, which earns them higher credit ratings.
Because of its August 1995 merger with the financially stronger Beverly (Mass.) Hospital, Moody's lifted the speculative-grade Baa1 rating of Addison Gilbert Hospital in Gloucester, Mass., to an investment-grade rating of A.
For-profits to the rescue. Meanwhile, another development is helping some not-for-profits ease their debt burden. Proprietary chains are buying or entering joint ventures with not-for-profit hospitals at an unprecedented pace. Since for-profits can't assume tax-exempt debt, any outstanding bonds must be defeased or "tendered," depending on the age of the bonds and other factors. In a defeasance, an escrow fund is established to continue debt service payments until the bonds mature or can be called. In a tender offer, the bonds are purchased, usually at a premium above par, and the debt is retired.
On May 1, MetroWest Medical Center, which operates acute-care hospitals in Natick, Mass., and Framingham, Mass., in the Boston suburbs, became the first hospital in the state to change tax status. Because of an 80-20 joint venture with Columbia/HCA Healthcare Corp., MetroWest's $62.3 million of tax-exempt revenue bonds needed to be retired. Bondholders who accepted the tender offer received a premium of 15 basis points, or 0.15% over the defeased value of the bonds.
Except for some labor union discontent, "there appeared to be very little opposition" to the deal, said Lawrence Kaplan, M.D., president and chief executive officer of the 400-bed system.
When Kaplan joined MetroWest 11/2 years ago, the institution carried $83 million of debt and anticipated $50 million in future capital needs. One reason MetroWest agreed to the joint venture was to obtain access to capital, he said.
In addition to retiring MetroWest's debt, Columbia will contribute $50 million to a not-for-profit foundation. Interest income on that amount will generate twice what United Way spends locally, Kaplan noted.
Such strategies will continue "as long as the consolidators and the converters feel financially able to absorb the nonprofit debt obligation" and remain unfettered by regulatory barriers, said Daniel M. Fox, president of the Milbank Memorial Fund, a research foundation in New York. Public scrutiny of such conversions could make future deals more costly, he said.
Concerns about debt repayment are minimal. "One of the things that you do not see happening with all the changes going on is wholesale defaults," said Tucker Anthony's Conley.
Recent exceptions include defaults by Michigan Health Care Corp. in Detroit, Hialeah (Fla.) Hospital and Jackson Park Hospital Foundation in Chicago. But even in a default situation, all is not lost.
Standard & Poor's has a positive outlook for Hialeah's D rating because of Tenet Healthcare Corp.'s proposed acquisition of the hospital and plans for redeeming Hialeah's $60.5 million of tax-exempt bonds.
Standard & Poor's also has a positive view of a plan to cure Jackson Park's default on $11.8 million of bonds. Meanwhile, Moody's maintains a D rating on 556-bed Michigan Health Care, which filed for Chapter 11 bankruptcy to restructure $200 million of debt incurred in the mid-1980s.
AMBAC's portfolio of 500 insured hospital credits, 85.3%of which are rated A or better, continues to change as previously freestanding hospitals get acquired, said Renn, the bond insurer's portfolio manager. However, the default rate remains a low 0.1%of outstanding debt insured by AMBAC. In many cases, hospital executives or boards of trustees will "take drastic actions," even selling to a for-profit, to avoid a technical default, he said.
In late April, the board of Winsted (Conn.) Memorial Hospital proposed its own drastic solution, voting to terminate inpatient services to avoid a potential bankruptcy. The board's plan included converting the hospital to a spectrum of post-acute-care services. Now, the plan is being challenged by the community, which has collected 11,000 signatures in a battle to retain the small rural hospital (June 10, p. 9).
Studies show that hospitals' historical default rate, compared with other municipal sectors, is remarkably low. According to the Miami Lakes, Fla.-based Bond Investors Association, 65 acute-care hospitals have defaulted on $1.3 billion of debt since 1980. That compares with a total of 1,705 defaults on $23 billion of debt sold by a wide variety of tax-exempt issuers.
Even among nonrated healthcare bonds, which are considered riskier than bonds carrying credit ratings, the default rate is low compared with other municipal sectors. According to a 1993 study by the Public Securities Association, New York, 4.1%of the $7.7 billion in nonrated tax-exempt healthcare bonds issued from 1986 to 1991 defaulted, compared with a 7.2%rate for transportation bonds, a major municipal sector.
Ratings serve as indicators of hospitals' creditworthiness and likelihood of default. Nonrated bonds carry higher interest rates because issuers cannot qualify for an investment-grade rating or choose to go without a rating.
To qualify for an AAA rating, hospitals must purchase insurance against the risk of default. Municipal bond insurance premiums generally range from 0.1%to 2%of principal and interest payments to be made over the life of the issue. Healthcare issuers' premiums tend to be at the higher end of the range because of the degree of credit analysis demanded and the required capital reserves. For many issuers, the interest savings generated from the higher rating may not exceed the cost of the insurance.
Covenants offer protection. In most cases, bond covenants contain significant protections for bondholders. If a hospital fails to make timely principal and interest payments, the bond trustee may tap the debt service reserve fund.
That's what happened when Orlando, Fla.-based Princeton Hospital risked missing a payment this year. Although never in default, the hospital dipped into reserves to pay a portion of its Jan. 1 interest payment on $45.5 million of tax-exempt debt, said Dan Carter, president of International Trading Group, a Naples, Fla.-based broker-dealer and majority stakeholder in the hospital's outstanding bonds. Carter has been directly involved in the hospital's financial turnaround since the hospital "hit the skids" in 1995. "I'm mainly involved in trying to get the right people in (to do the job)," he said.
When a hospital hits the skids in Maryland, it's everybody's business. Under the state's bond indemnification program, the outstanding debt of hospitals that close is paid through fees assessed on all hospitals. For example, when North Charles Hospital closed in fall 1990, the state's Health Services Cost Review Commission allowed all other hospitals in the state to raise their rates. The additional $3.7 million collected by hospitals was used to make payments to bondholders of the shuttered facility.
Maryland's bondholder protection program is unique to a state that still sets hospital rates. Few bond buyers can count on a state-mandated bailout in the event of a default.
To manage the risk, institutional investors are stepping up surveillance.
Massachusetts Financial Services, a Boston-based buyer of high-yield tax-exempt securities, has updated spreadsheets to incorporate more detail and calls issuers more frequently, said John Goetz, the mutual fund company's vice president and senior credit analyst for healthcare.
Despite the risks, tax-exempt healthcare bonds still remain a favorite of investors seeking yield. In today's market, a 30-year A-rated tax-exempt healthcare bond is yielding 6.5% compared with a yield of 6%for 20-year general obligation bonds and 7%for 30-year U.S. Treasury bonds.
"We're looking at the riskier transactions and trying to pick the cream of the crop in the riskier segment," said Tom Weyl, a municipal credit analyst at Eaton Vance Management, a Boston-based money manager. Of the $9 million in tax-exempt bonds managed by the firm, about $800 million represents uninsured hospital debt.
Columbia's recent entry into the Cleveland market bodes well for Eaton Vance's investment in Meridia Health System bonds. As part of its proposed acquisition of Blue Cross and Blue Shield of Ohio, Columbia will assume the Blues' interest in a joint venture with the four-hospital Meridia system. "We liked Meridia before, and we like it even more now," Weyl said.
The feds may lose. So who gets left holding the bag if hospitals start defaulting?
One of the biggest losers could be the federal government. The U.S. Department of Housing and Urban Development, through the Federal Housing Administration's hospital mortgage program, insures nearly $5 billion of hospital debt, and $4.2 billion of it is for capital projects in New York state.
Constrained for years by an inpatient rate-setting system, New York hospitals have the weakest credit ratings in the nation. Four of the 63 New York projects backed by HUD are in default, and other at-risk facilities are under close surveillance.
New York state's rate-setting system expires June 30, and Gov. George Pataki has proposed that hospitals begin negotiating rates thereafter. The transition is likely to be tumultuous, especially in New York City, which has a disproportionate share of high-cost teaching and financially distressed institutions.
"It isn't clear what prevents them from going into Chapter 11," said Joseph T. Lynaugh, president and CEO of NYLCare Health Plans, a New York-based managed-care products. "Some are so debt-encumbered there's literally no way out," he said. Lynaugh headed the New York City Health and Hospitals Corp. from 1977 to 1979 and prior to that was the first director of New York City's health planning agency.
"It's obviously something we recognize as an area of increased risk," acknowledged John U. Sepulveda, director of the federal hospital mortgage insurance program. Sepulveda is meeting with lawmakers and state officials in Albany to discuss the competitive system's impact on FHA-insured hospitals.
State officials also have a direct interest in preserving hospitals' financial solvency. The state assures payment on nearly $1 billion of the $6.9 billion of hospital debt outstanding. In addition, the New York State Dormitory Authority, which issues bonds on hospitals' behalf, relies on access to FHA insurance to get the bonds sold on the market.
Because of existing state and federal credit enhancements, "the bondholders are very well protected, and that is as it should be," said Tucker Anthony's Conley.
Furthermore, many observers believe a move to negotiated rates will aid marketplace consolidation and help avert defaults. Even John Rodat, a Delmar, N.Y.-based healthcare consultant who last year co-authored a proposal for bailing out New York hospitals that have defaulted, agrees. If there are defaults, "those institutions that remain are going to have less competition, and all else being equal, they will be healthier," he said.